Daily Comment (July 22, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment will begin with a discussion on Thursday’s ECB announcement and what it could mean for markets in the future. Next, we examine Russia’s notable military slowdown in Ukraine and other developments in the war. The report concludes with various international news stories that have the potential to influence markets.

 ECB Moment: A higher than expected rate rise, a new policy tool, and the end of forward guidance suggest that the ECB wants more flexibility during its tightening cycle as it aims to tackle rising inflation and growing fragmentation.

  • ECB: The European Central Bank unanimously agreed to create a bond-purchasing tool to prevent borrowing costs among member countries from diverging. The decision to develop a tool likely played a role in the central bank’s decision to hike rates by 50 bps instead of the anticipated 25 bps. However, the market’s reaction was moderate as the ECB remained relatively ambiguous about its next step forward. The euro initially strengthened against the dollar but weakened later in the day as investors were wary of the bank’s commitment to the bond-purchase program. The spread between 10-year Italian and German bonds climbed as high as 250 bps on Thursday before settling around 240 bps.
  • Whatever It Takes, Kind of? Unlike predecessor Mario Draghi, current European Central Bank President Christine Lagarde failed to reassure investors that the central bank was willing to do “whatever it takes” to preserve the euro. When describing the new anti-fragmentation tool, she stated that the central bank could use it to buy an unlimited number of bonds to prevent unwanted market dynamics, but later emphasized that she hopes never to have to use the tool. This apparent lack of commitment could mean that investors will likely be paying close attention to snap elections in Italy to determine whether they will continue to hold on to Italian bonds.
    • Italian Snap Elections: President Sergio Mattarella officially called for snap elections to take place on September 25. A conservative right-wing bloc led by the populist party Brothers of Italy is expected to win a majority of seats, setting up a possible clash between the EU and Italy over economic reforms. The heavily debt-laden Italy is set to receive 200 billion euros of aid on the condition that it makes structural changes to its economy. A eurosceptic government could slow these reforms, thus leading to a sell-off in the country’s bonds by risk-averse investors.
  • End of Forward Guidance: During the ECB press conference, Lagarde implied that the bank is set to abandon its forward-guidance policy as it seeks to maintain flexibility in its policy decisions. The decision to raise rates by 50 bps went against its forward guidance of 25 bps. The decision to do away with forward guidance is related to the central bank’s having to decide on appropriate monetary policy that will allow it to control inflation and prevent a recession. The death of forward guidance suggests that the market could be very responsive to surprises in the economic data.

The biggest unknown is how the European Central Bank will respond to rising uncertainty in Italy. If the country elects a eurosceptic government, investors will likely sell off Italian bonds in droves, thus pressuring the bank to intervene to keep borrowing costs downs. At this point, it is unclear how the ECB could respond to an Italian government that refuses to comply with mandated reforms. However, failure to prevent bond yields from spreading will likely weigh on the euro and could sink the currency to parity with the U.S. dollar or possibly lower.

Russia-Ukraine: The two sides finally agreed to allow Ukrainian wheat to be exported out of the Black Sea; however, the war does not appear to be close to ending. Meanwhile, Russia has been able to display its influence around the world.

  • Russia Vulnerable: The lack of available forces and weapons has led to a slowdown in the Russian offensive in Ukraine. Since taking over Lysychansk, Russian troops have not made much progress which has led to speculation that Russia may be losing steam. Leader of the U.K. secret intelligence service Richard Moore predicted that Ukrainian troops would be able to mount a strong counter-offensive against Russian forces in the coming weeks. In addition, he argued that the Russian military would eventually have to pause due to logistical and supply reasons. His comments suggest that the West plans to support Ukraine’s right to defend itself from the Russian invasion. As a result, this could mean energy uncertainty within Europe is likely to persist.
  • Russian Friends: Putin and Mohammed bin Salman met on Thursday in a sign of the close ties between Russia and Saudi Arabia. The meeting came several days after Biden met with MBS, and the juxtaposition showed the gap of influence between the U.S. and Russia in the Middle East. Earlier this week, Putin met with the leadership of Iran to discuss drone purchases. Meanwhile, Russian Foreign Minister Sergey Lavrov is set to meet with several African leaders next week to remind the continent of its long-standing ties with Russia, particularly during the colonial period.
  • Wheat Exports: Russia agreed to allow Ukrainian grain exports to leave the Black Sea. The deal will allow the shipment of wheat out of Ukrainian ports. This release of wheat will likely help reduce grain prices and prevent a potential global famine. However, there are still concerns that Russia could renege on its commitment.

As we mentioned in our June 6 Bi-Weekly Geopolitical Report, the world may be breaking into geopolitical and economic blocs. In the report, we showed that the Russia-China bloc likely has the advantage when it comes to supply, which it could use as leverage in disputes with the West.

International Uncertainty: Rising COVID cases, heightened security risks, and trade disputes continue to add to global-growth uncertainty.

  • COVID Cases: COVID cases are rising again. In Japan, daily cases topped 30,000 for the first time on Thursday. Meanwhile, infections in Europe have tripled in the last six weeks. President Biden has even contracted the virus. The new variant is proving to be more elusive and contagious than its predecessors; however, it is not creating the same level of economic disruptions.
  • Pelosi’s Visit to Taiwan: Tensions are rising between the U.S. and China due to House Speaker Nancy Pelosi’s plan to travel to Taiwan in August. Beijing has warned that it would forcefully respond if she were to travel to the sovereign island. Although it isn’t clear what China would do in response, President Biden cautioned Pelosi that the Pentagon does not think the trip is a good idea.
  • Japanese Defense Spending: Rising concerns over national security have led the Japanese government to ramp up its defense spending. Its latest security assessment cited the rising military cooperation between Russia and China as a reason to increase its military capabilities.
  • USMCA Spat: Mexico may be penalized $10 to $30 billion over its decision to prioritize its state-owned energy company over private renewable companies. The source of the dispute is related to Mexico’s decision to amend legislation to favor power distribution to state-owned CFE. The law change has led foreign firms to be shut out of Mexico’s energy sector. Canada and the U.S. have requested dispute-settlement talks with Mexico. If all parties cannot agree on a settlement, the U.S. and Canada could hit Mexico with tariffs.

Ongoing disputes between countries and rising COVID cases will lead to some international uncertainty but will be unlikely to have an impact on markets in the short-term. Although the rise in COVID cases is concerning, countries are more prepared to deal with them currently than in the past. Meanwhile, the trade dispute with Mexico and increased Japanese defense spending likely are not significant today, but they have the potential to be important in the future, especially if Mexico decides to leave the USMCA or if Japan becomes more assertive in its foreign policy. However, our biggest concern is that Pelosi’s trip to Taiwan will likely lead to deteriorating U.S. and China relations and could further accelerate the decoupling of the two major economies.

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