Surging Italian bond yields posed a now all too familiar quandary for the ECB in June 2022. While most central banks are currently juggling with the toxic burden of slowing economic growth combined with soaring inflation, European authorities have the added complexity of multiple growth profiles, and indeed debt burdens, for their individual member states all within the confines of the single Eurozone. Whilst nothing concrete was announced at the June meeting a “fragmentation tool” was promised to address the issue with details to follow in due course.
If the hope was that this announcement would be akin to Mario Draghi’s “whatever it takes” moment, then the result was likely deeply disappointing as reflected in the steep drop for European equities with the MSCI Europe ex UK Index ending down 7.0% for the month of June. Of course, it wasn’t just the lack of a specific announcement that drove this weakness. An interest rate rise of +25bps was promised for July with more to follow later in the year. At the same time forecasts for growth were downgraded and increased for inflation. A near perfect storm only exacerbated by the continued conflict in Ukraine and the logistics and supply mess that can be traced back to the pandemic induced disruptions past and still on-going in China in particular.
While the steep declines in equity markets so far this year start to make the asset class look relatively cheap on a historical basis, this may prove illusionary if earnings start to move in the wrong direction. Many companies appear well placed to pass on the cost increases they are currently experiencing, and component as well as personnel shortages makes the supply/demand equation still lean in their favour. But the excessive increases in living costs are starting to make a growth slowdown almost inevitable and it is the quantum of this decline that will determine the correct level for stock markets in the coming months. This should start to become clearer over the coming weeks in what is likely to be a volatile earnings season as we enter the third quarter of the year.