Weekly View - Back to zero

The European Central Bank sent a clear message to markets about its determination to anchor inflation last week by raising policy rates by 50 basis points (bps), back to zero. The euro stabilised and European yield curves flattened as a result. The ECB’s Governing Council reached an agreement around its anti-fragmentation tool (Transmission Protection Instrument, TPI), designed to restrict widening in peripheral bond spreads, intended to avert a sovereign yield potential crisis. In Italy, President Mario Draghi’s (second) resignation submission reinforces our negative stance on peripheral spreads. The only reassuring outcome of Draghi’s departure is that his government will stay on as the take care government in the meantime, meaning it can implement the steps to formally request the new EU stimulus funds for Italy. In the US, we expect the Federal Reserve to raise rates by 75 bps this week.

Meanwhile, Economic data in the US and Europe continues to deteriorate, with last week’s purchasing manager indices (PMI) coming out worse than expected. This flags the dilemma that central banks face as they continue to raise interest rates to combat inflation at the risk of triggering a recession in doing so. On such investor fears of an approaching recession, bond markets rallied considerably last week. We are neutral on US duration. We diverge from market expectations in that we do not believe that the Fed will reverse course in 2023 by cutting rates, as core inflation could prove to be stickier than expected. Rather, we expect the US central bank to maintain interest rates at their elevated levels. Elsewhere, a mortgage payment strike is underway in China, where we are keen to see a prompt resolution in order to avoid potential for contagion.

In markets, investors are lightly positing that corporate earnings results have been in line with expectations and that companies are not yet significantly lowering guidance for the time being, allowing for markets to rebound. We are neutral on equities. We expect a deterioration in Q3, as corporate margins begin to suffer from continued cost pressure and companies are less able to pass higher costs onto their customers. This week will be one of the busiest in terms of reporting, with the technology sector, which might have suffered relative to others, as suggested by Snap’s earnings hit in the wake of economic reopening and lower tech company spending on advertising.