Financial Update from Brewin Dolphin - 22 July 2022

July 2022

The Weekly Round-up

Friday 22 July 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, assesses the week’s changes to Eurozone and what it might mean for Italy.

We have reached the end of the first really full-throated week of second quarter earnings in the US. The headline statistics are in line with historical precedent. An impressive sounding 70% of companies have beaten estimates (mostly from the financial sector during this early stage of the season). Around half have beaten revenue forecasts. Banks have continued to endorse the view that consumers are in good shape, are spending reasonably freely, and retain historically substantial cash balances. These beats and misses ratios seem stable, reflecting the fact that companies normally manage to guide analysts’ estimates down ahead of release, rather than reflecting a macroeconomic trend. Much more informative is the guidance that companies issue for future periods.

As we go into next week though, the focus will shift to some more technology-related companies. In terms of bellwethers, positive guidance from Netflix helped the stocks and reassured investors that, as consumers economise in the face of rising costs, streaming subscriptions aren’t collapsing. Despite two quarters of subscriber contraction Netflix expects to return to growth next quarter. SNAP avoided giving guidance for the forthcoming quarter, raising the question of whether advertising revenues could be a headwind for big technology companies who report next week. However, the company has many idiosyncratic factors that may mean it suffers headwinds that others avoid.

Eurozone interest rates

The main refinancing rate is the rate which the ECB uses to provide more liquidity to the banking system, effectively by lending the money to banks in exchange for collateral. This rose for the first time in seven years from 0 to 0.5%. There is also a deposit facility rate which is the rate earned for storing money at the ECB. Banks had been finding they had excess liquidity which they needed to store at the ECB, but since 2014 there has been a negative interest rate which banks are charged, rather than a positive rate they can earn, to encourage them to lend that liquidity into the real economy. Despite this, use of the facility remains pretty much as high as ever and this is really the most meaningful policy interest. The higher it goes the more banks can earn by keeping money out of the real economy and with the ECB. There is also a marginal lending facility rate which has risen and reflects the amount banks pay to borrow extra from the ECB.

Perhaps as important as the interest rates was the announcement of the Transmission Protection Instrument (TPI). The TPI is the ECB’s new fragmentation tool. It is probably worth reminding ourselves why an anti-fragmentation tool is necessary.

The Transmission Protection Instrument

The drivers of the European integration project partly reflect the troubled political history of the region but a desire to improve its economic performance is also key. The onset of floating exchange rates, following the collapse of the Bretton Woods arrangement, resulted in a period of sporadic and frequent currency crises, some explosions of inflation and some huge interest rate volatility. After a period of convergence, and with the onset of the Eurozone proper, interest rate dispersion became a thing of the past. As did bond yield dispersion for almost a decade until investors became sensitive to the implied credit risk or fragmentation risk. At that time we saw remarkable increases in spreads and most notably increasing yields on peripheral country debt at a time when yields were falling for core countries. This exposed two things:

1. The first was that monetary policy would not work properly if it was not translated to the real economy via traditional means. That means if the ECB cut interest rates then they need to believe that those cuts to interest rates will result in lower borrowing costs for companies and households.

2. That risk fed a second risk that countries’ debt could become unstainable because their bond yields rose to levels at which they might be unable to service their debt. By sharing an underlying currency Eurozone members were less able to print currency to support debt issuance, creating a form of credit risk that most developed markets are immune to.

So for that reason Mario Draghi, acting as President of the European Central Bank, emphasised very clearly that the European central bank would do “whatever it takes to preserve the euro.” After which the problem went away.

The problem has however shown signs of re-emerging recently as spreads have been widening. This widening is currently imperceptible compared to the challenges of the Eurozone debt crisis. Policy rates, bond yields and effective borrowing rates for companies and households are historically relatively similar. But investors are sensing a change, mainly due to challenges emanating from Italy.

So in that context the ECB announced the TPI, which allows for unlimited purchases of securities without leading to persistent expansion of the ECB balance sheet (implying that purchases must be sterilised by the sale or issuance of other securities), in order to support the transmission of monetary policy. In practical terms this means buying Italian securities to prevent their yields from rising too much. Countries eligible to have their bonds purchased would need to fulfil the following criteria:

1. Compliance with the EU fiscal framework: not being subject to an excessive deficit procedure, or not being assessed as having failed to take effective action;

2. Absence of severe macroeconomic imbalances: not being subject to an excessive imbalance procedure or not being assessed as having failed to take the recommended corrective action;

3. Fiscal sustainability: the Governing Council will take into account external analysis from the Commission, the European Stability Mechanism, the International Monetary Fund and others, as well as internal ECB analysis; and

4. Sound and sustainable macroeconomic policies: complying with the commitments submitted in the recovery and resilience plans and with the Commission’s country-specific recommendations.

So will this tool work?

It is debateable how many, if any, of these criteria Italy meets. However, the most significant doubt exists on debt sustainability. Hawks on the governing council can argue that Italy is not eligible, although in the past those hawks have tended to be outvoted.

Perhaps most challenging is the question of whether an interest rate that achieves price stability for Europe would be affordable for Italy – even if the spread were eliminated by central bank purchases. And politically it seems quite possible that Italy takes steps that make its debt burden less sustainable rather than more sustainable.

This week, as expected, Prime Minister Draghi tendered his resignation. Last week he lost the support of the Five Star Movement. This week he tried to pressure parties into explicitly supporting his national unity government in a confidence vote which he won, but with the abstention of Five Star plus the major right wing parties League and Silvio Berlusconi’s Forza Italia who wanted a new coalition that excluded Five Star. The main factor uniting the major parties in Italy now seems to be a desire not to have a united government. An election will take place on 25 September. In the meantime, there will be a delay to the reforms necessary to unlock the next instalment of the EU’s covid recovery funds.

Polling suggests that the far-right Brothers of Italy stand the best chance of trying to lead a government, but they would need coalition partners, whom they may seek to find amongst other right-wing parties. However, it may be that they do not win enough seats, or are unable to agree amongst themselves, or that swings in opinion during the campaign mean that they are no longer the most popular party when the results emerge.

The economic backdrop to the current political crisis is not a helpful one. Today’s purchasing managers’ indices were weaker than expected, showing the manufacturing sector slipping into contraction and the services sector barely remaining in expansion. That was enough to pull down all European government bond yields as investors anticipated a reduced pace of rate hiking. However, the UK PMIs showed the same kind of trends but with both series remaining in expansionary territory.