by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the European Central Bank’s decision to raise rates by 50 bps. Next, we examine changes in governments in the U.K. and Italy, followed by an update on the Russia-Ukraine war. The report ends with a review of the warning signs of a possible downturn in the U.S. economy.

 Central Bank News:  Under pressure due to rising energy prices, central banks are being forced to choose whether they will prioritize economic growth or price stability as they set their monetary policy.

• European Central Bank: The ECB raised rates by 50 bps for the first time in 11 years as the EU looks to tame historically high inflation. The hike was above expectations of 25 bps. In addition to tightening policy, the ECB unveiled the Transmission Protection Instrument (TPI) designed to combat fragmentation. The combined rate increase and new fragmentation tool did not lead to panic from investors. After the rate news, the euro strengthened against the dollar, while the spread between Italian and German 10-year bond spreads widened by 9 bps from 223 bps to 232 bps.
• • The ECB stated that the new tool will not be limited by “ex-ante” restrictions suggesting that the bank has not put a cap on the level of intervention.
• Bank of Japan: The BOJ continues to defy expectations by continuing its ultra-low interest rate policy despite rising inflation. The central bank expects core CPI, which excludes food, to rise 2.3% from the prior year. BOJ Governor Haruhiko Kuroda dismissed the possibility of raising rates as the country recovers from the pandemic. The decision to maintain its monetary policy suggests that the yen’s weakness against the dollar will continue for the foreseeable future. Moreover, the currency’s recent depreciation has exacerbated its inflation problem as rising global commodity prices, which are elevated in dollar terms, make it difficult for Japanese firms and households to control costs.

Moving away from negative rates will be difficult for both the ECB and BOJ to navigate. The BOJ’s burgeoning debt burden limits its ability to raise rates. Meanwhile, the ECB needs to ensure that borrowing costs remain close among EU members to prevent a break-up of the bloc. That said, it is unlikely that the moves by either central bank will calm market concerns as rising inflation threatens both countries’ economic outlooks. At this time, we view the investing environment for Japan and Europe as risky.

Shake Up in Europe:  Leadership changes in Italy and the U.K. will likely not have an impact on the Ukraine war but could lead to more friction within the western alliance.

• Italian Crisis: Italian Prime Minister Mario Draghi was forced to resign on Wednesday after several key parties within his coalition boycotted a no-confidence vote. Draghi’s departure will plunge the country into political turmoil as investors fret over the possibility of a less market-friendly Italian government. Italian President Sergio Mattarella is expected to hold snap elections in early 2023. At this time, recent polls suggest that the center-right bloc led by the populist Brothers of Italy will likely take over the government. The unfortunate exit of Draghi will probably weigh on Italian equities as it appears that a new government could be less friendly toward the European Union.
• U.K. Premiership: Foreign Secretary Liz Truss and former Finance Minister Rishi Sunak are set to face off in the final round of Tory voting to become the leader of the party and the U.K.’s next prime minister. Sunak, who has led all voting rounds, vowed to maintain taxes at current levels, while his opponent Truss is running on a platform of deregulation and tax cuts. The result of the final vote will be released on September 5, with betting sites showing Truss, a notable Brexiteer, as a favorite to win.

The change in government in the U.K. should be favorable to British equities as it may provide some political calm. However, the rise of eurosceptics in both U.K. and Italy could lead to renewed clashes with the European Union.

Russia-Ukraine: Russia’s push for more territory and the West’s continued backing of Ukraine suggest that the geopolitical risks from the war will likely persist.

• Moscow Wants More: In a supposed shift, Russia declared that it would take complete control over regions outside of eastern Ukraine, including the Kherson and Zaporizhzhia regions in the south. Earlier in the year, Moscow stated that its goal was to “liberate” the east Donbas border region. After several months of fighting, Moscow claims that its objective has changed because Kyiv refused to agree to peace talks. The move by Moscow to expand its geographical aims was not surprising. On Tuesday, the White House warned that Russia had plans to annex southern parts of Ukraine.
• Russian Aims: Russia’s desire to expand its gains into areas within Ukraine is likely a negotiation tactic. Although it has had some recent success over the last several weeks, the West’s delivery of long-range missiles to Ukraine has opened Russia up to a fierce counter-offensive. Ukraine’s weapon capabilities have ratcheted up the cost for Russian forces to hold ground in newly gained territory. As the war continues, Russia will be inclined to annex the freshly controlled regions to strengthen its leverage against Ukraine and secure support at home.
  • The Paris Club, a group of international creditors, suspended Ukrainian debt service until at least the end of 2023. The move will save Ukraine around $6 billion over the next two years and will likely prevent the country from defaulting on its debt.
  • The White House may provide Ukraine with fighter jets and the training to operate them. The measure would drastically increase the West’s war involvement, and possibly escalate tension with Russia.
  • Gas flows from the Nord Stream 1 pipeline restarted on Thursday after a ten-day annual maintenance break. There was concern that the gas flow would slow after the pipeline returned online; however, orders indicate that flows are on pace to return to 40% of the capacity level reached before maintenance.
  • The U.S. is expected to impose a price cap on Russian oil in December as the EU prepares to impose a ban on companies insuring Russian vessels delivering the commodity.

Warning Signs:  Growing reports of a slowdown in hiring, a cooling housing market, and weaker consumer spending suggest the economy may be headed toward a downturn.

• Labor Market: More companies are announcing plans to either reduce hiring or lay off workers as economic conditions deteriorate. Ford (F, $12.73) is expected to cut as many as 8,000 roles as it shifts its focus away from internal combustion engines and toward electric vehicles. Meanwhile, tech companies Alphabet (GOOG, $113.90), Lyft (LYFT, $14.07), and Microsoft (MSFT, $262.27) are all set to reduce hiring.
• Housing Market: Existing home sales fell for the fifth consecutive month in June as high mortgage rates and residential prices made it harder for potential home buyers to enter the market. Existing home sales dipped 5.4% from the prior year in June, while the median price for existing homes rose 13.4% in the same month.

• Spending Slowdown: Higher prices may lead to a broader consumption In Q1, major retailers such as Walmart and Target warned that households were shifting their preference away from discretionary products in favor of staple goods. However, recent data collected by Bloomberg in Q2 suggests that consumers have even cut the purchase of necessities such as shampoo and diapers.

As the economy begins to slow, we believe that real estate may be a good place to hide. Although there is a decline in demand, the lack of supply will be likely to keep property prices relatively elevated.

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