Financial update from Brewin Dolphin 29 April 2022

April 2022

The Weekly Round-up

Friday 29 April 2022

In this week’s round-up, Janet Mui, our Head of Market Analysis, discusses Russia’s decision to cut off gas supplies to Poland and Bulgaria, the slump in the yen, and disappointing US GDP figures.

Earnings season is now in full swing and has been a dominant driver for markets this week. So far, 40% of companies in the US and 28% of companies in Europe have reported their first quarter results. Earnings growth is lower than in previous quarters, as the base effects are tougher and activity is softer, which is widely expected. 79% of the S&P 500 companies that have reported so far beat earnings per share (EPS) estimates, compared with 69% of STOXX 600 companies.

Overall, earnings are better than expected, with EPS surprising by +6% in the US and +9% in Europe. However, investors are becoming much more sceptical and demanding, with companies that are missing estimates being penalised sharply. This is particularly a feature for big tech companies as investors reassess their post-pandemic growth trends. Volatility remains high on an intra-day and daily basis, as markets have plenty on the radar including inflation, the Ukraine war, China’s Covid-19 outbreak, and interest rate rises.

Russia cuts off gas to Poland and Bulgaria

In a major escalation in the conflict, Russia has cut off its natural gas supply to Poland and Bulgaria. President Vladimir Putin is wielding the gas weapon and has threatened to cut off gas supplies to any EU countries which do not pay in roubles.

The market impact on risk assets has been surprisingly small, aside from the fall in the euro exchange rate. This is due to a variety of reasons. First, of the roughly 155 billion cubic metres (bcm) the EU bought last year from Russia, Poland accounted for about 10bcm, and Bulgaria for 3bcm. Poland has been reducing its reliance on Russian gas and says it has enough supplies for a month. Second, there were reports that a few companies have complied and paid in roubles, whereas more companies have opened accounts at Gazprombank in anticipation of eventually transacting with Russia. While there is no imminent disruption, as the war progresses and the threats from Putin intensify, the tail risk of gas being shut off to major EU economies like Germany and Italy cannot be ignored. Such an act will lead to terrible economic consequences as gas will need to be rationed, with many economists expecting an outright recession in such a scenario.

The era of cheap Russian gas powering industrial growth is probably over. Alternative gas supplies are likely to come at a higher price and may affect Germany’s competitiveness in industrial production. A future where renewables are the primary energy source is still a long way. It is a painful situation of choosing between the moral high ground and the economy. So far, there is a lack of clarity on how leaders will proceed and the development remains very fluid.

Right now, there are both economic and social costs associated with higher inflation, mostly driven by energy prices. The growth mix in the eurozone has worsened and the stakes are high given the ongoing risks around energy supply. The latest eurozone consumer price index (CPI) measured 7.5% YoY in April and the core CPI jumped to 3.5% YoY from 2.9%. Meanwhile, first quarter gross domestic product (GDP) in the eurozone grew by 0.2% quarter-on-quarter, slowing from 0.3% growth previously.

Russian central bank cuts interest rates

Being the most sanctioned country on earth, Russia faces huge economic headwinds and sky-high inflation. The Russian central bank issued new projections that showed Russia’s economy may contract by 8-10% this year, while inflation is set to reach 18-23% by the end of this year. Economic distress will deepen in the coming months and supply chains will be severely impacted by a lack of imported components. As the rouble is currently trading more strongly than just before the war, effectively erasing the steep losses in the initial week of the invasion, Russia’s central bank cut the benchmark interest rate from 17% to 14% this week. Given a return of stability to the rouble due to strict capital controls, the central bank is now prioritising supporting economic activity versus defending the currency or fighting inflation.

Yen slumps to 20-year low

The yen slid to the closely watched level of ¥130 against the dollar on Thursday, after the Bank of Japan (BoJ) maintained its dovish stance and said it was committed to defending its ten-year Japanese government bond (JGB) yield target.

The BoJ’s official guidance is that it will allow the ten-year JGB yield to move flexibly around its 0% target, as long as it stays below the 0.25% upper limit. Recently, yields have been testing that level as global bond yields are rising due to hawkish central banks. The key driver of the weaker yen is monetary policy divergence – we are talking about a scenario where the US federal funds rate could be 2.5% by the end of 2022 whereas the BoJ policy rate remains negative.

The big picture on the currency market is broad dollar strength, with the dollar index posting a five-year high this week. Geopolitics favour the dollar now, as it gets boosted by a tumbling euro when worries about an escalation in the Ukraine war linger.

China pledges more support for the economy

China continues to be a key focus for markets but, thankfully, this week there was more good news on balance. While the strict zero-Covid policy continues, the Chinese authorities can no longer ignore the ballooning economic costs. With growth set to deteriorate, China is back to using its old tools to support the economy as it commits to defend its (rather modest) 5.5% GDP growth target this year. China has pledged more stimulus in the form of more construction and infrastructure spending, which is a direct way to boost GDP on paper.

Markets were also encouraged by news that China is looking to pause its regulatory crackdown on big techs. That helped to spur a rebound in Chinese stocks, with the Hang Seng Tech index up as much as 11% this week. Whether the stock market rally is sustainable is questionable – there is a reluctance to cut key policy rates despite low inflation, and markets are still counting the costs of lockdown on industrial production, logistics, supply chains and retail sales.

US GDP sees first quarterly contraction since 2020

In a surprise for markets, US first quarter GDP contracted by 1.4% on a quarter-on-quarter annualised rate, following a 6.9% expansion at the end of last year. On the surface, this looks discouraging as the technical definition of a recession is two consecutive quarters of negative growth – so we are one quarter away from the “R” word that many fear. However, drilling into the data shows the key drag was net exports, which single-handedly detracted growth by 3.2%. The contraction was due to a jump in imports and a drop in exports, which in a way shows demand is pretty strong. Another drag was a slower build-up of company stockpiles. Inventory change detracted growth by 0.84%, which was a payback for red-hot inventory accumulation in Q4, which added 5.8% to growth back then.

On a positive note, consumer spending rose at a 2.7% annualised pace in the fourth quarter, roughly in line with the 2.5% pace in Q4 2021. Smoothing out the quarterly volatility, GDP growth averaged 2.8% over the Q4 to Q1 period. Having said that, there is a consensus view that growth will slow from here due to the squeeze on consumers and tightening financial conditions. On that front, we will get the very important Federal Reserve meeting next week, where markets have fully priced in a 50-basis-point rate increase.