- Global recession risks rise as corporate earnings disappoint
- European central bank lays groundwork for peripheral support while easing
- Energy uncertainty rises in Europe
Equities have rallied this month, despite no real improvement on the outlook for growth and inflation. Central banks continue to reaffirm their intention to control inflation at all costs. Price increases are accelerating, whilst also broadening across all areas of the economy. The Fed and the ECB are left with little choice other than to temper aggregate demand in order to combat inflation.
At the same time, weaker consumer data, poor manufacturing sentiment and a slowing housing market are raising concerns. Economists are reaching consensus of a recession in Europe, and likely in the US, before the end of the year. The labour market, while still very tight, is showing early signs of faltering. As a late cycle indicator, the labour market will likely be the last part of the economy to collapse - allowing the National Bureau of Economic Research to officially designate a recession.
What is not in question is that we are facing a sustained slowdown, due in part to inflationary pressures on the economy. Companies are under immense pressure to maintain margins and reported second quarter earnings are mixed thus far. Earnings momentum is fading, with fewer companies reporting strong beats than what is typical for this point of the reporting cycle. Estimates for earnings next year are also being revised downward, especially when excluding energy companies.
During the month, the European Central Bank (ECB) raised its policy rate for the first time since 2011 to combat inflation. It can be argued that inflation in the Eurozone is concentrated around its energy crisis, where the price of natural gas is more than 5 times higher than in the US in USD. As a consequence of this tightening of financial conditions, spreads on Italian and Greek government bonds are widening versus those on the German bund.
To address this, the ECB has started a new asset purchase program, named the Transmission Protection Instrument (TPI). This “anti-fragmentation” tool is designed to keep the spreads of the peripheral nations in check during periods where the ECB is tightening policy. Because of the limitations of the bloc, the business cycles of member states can often become de-synced. Policy at the Eurozone level may be too tight or too loose for more vulnerable member states, such as Italy. This is partly to blame for the stagnant real GDP per capita that these nations endure. The TPI effectively backstops the borrowing of these countries, keeping spreads under control. By acting as a buyer of last resort of distressed debt, it will allow the ECB to directly support member states on a country-by-country basis.
Since the announcement, bond markets have remained skeptical of the TPI. Spreads have not tightened significantly yet. Political uncertainty, such as a likely fresh election in a member state, may reduce the effectiveness of such a program.
We have seen further escalation of energy brinkmanship from Russia this month. Following an annual maintenance window, Putin signalled a return of Nord Stream 1 to 40% of capacity on 21 July, but supply fell back to 20% as Russia halted another turbine delivery from Canada. If these supply levels persist, it is likely that Europe will need to enforce rationing unless exports are cut. Voluntary curbs are politically difficult. While a deal was agreed between members states to cut usage, too much flexibility in the deal limits its effectiveness. EU members can limit their demand cuts if they export more and certain industries can remain exempt. European Natural Gas futures have risen to their highest price since the beginning of the invasion of Ukraine.
We remain defensively positioned across all asset classes. We have reduced risk across our equity exposure, preferring defensively orientated strategies with high free cash flow exposure, and have reduced exposure to emerging markets and high yield fixed income, where default rates are expected to rise.