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European equities are mostly lower at the start of the week, as key themes including nerves around earnings season and concerns that the Federal Reserve will be under more pressure to hike rates after last week’s stronger than expected payrolls report from the US, dominate sentiment. The “good news is bad news” theme remains strong for now. Markets are falling at the start of a new week, after concerns mount that China will go back into lockdown. While these concerns are preoccupying sentiment, there are some fundamentals that are worth looking out for as they could determine the longer-term direction of markets after this summer madness quietens down.
Below we take a look at three themes that will drive market direction in the coming days and weeks:
1, EUR/USD parity
As we start a new week, the risk off theme is driving EUR/USD below the 1.01 handle and the sell off in the euro is gathering pace. The lack of upward momentum suggests a break below parity is now inevitable. But what would it actually mean? A weaker euro is surely good for the large German exporters, including the automotive industry and the large manufacturing sector? However, it’s not as simple as this and there are many moving parts and unintended consequences when you see historical moves in the world’s most important currencies. As you can see in the chart below, the Dax and EUR/USD have typically had a strong correlation so far in 2022, however, the relentless pressure on the euro is causing a divergence with the Dax. As EUR/USD reaches two-decade lows, the Dax is starting to outperform the euro. We will be watching this closely to see if this is maintained. While a weak euro should be good news for German exporters, it has a dark side that could spell bad news for the future of the Eurozone. It increases the cost base for German companies, as energy, which is priced in dollars, becomes ever more expensive. The reliance of large Eurozone economies on energy imports is the Achilles heel of the European economy. Coupled with the restrictions of energy imports from Russia, and the threat from Russia that it will cut off natural gas supplies, Europe’s energy position already looks weak. The currency decline is exacerbating this problem, as Europe looks to secure energy from other suppliers, but needs to pay more because of the declining euro. Thus, the Dax’s divergence from EUR/USD may not persist, or it will be a reflection of more people selling the euro, rather than favouring the Dax. Thus, a weak euro is a threat to Europe’s largest economy.
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However, another impact of EUR/USD parity is what it means for central banks. Will it trigger a more aggressive stance from the ECB, or could it cause the Fed to hold back on large rate hikes per meeting due to the impact they have on the FX market? As we move into the second half of this year, we believe that central banks may be more attentive to currency moves, with an increasing chance that the ECB and BOE will have to adjust their current policy stances and start matching Fed rate hikes to prop up their currencies. This could limit dollar strength in the long term. Also, as the euro reaches a multi-decade low vs. the USD, we will be watching to see if the single curtrency will fall further, or if it will bounce back. We predict a 75% chance that there could be more weakness for the euro if EUR/USD breaks parity.
2, Economic data watch
Key economic releases this week include US inflation data for June. The market expects another rise in the inflation rate to 8.7%, up from 8.6% in May. The market will trade off the monthly inflation figures, and these are likely to make grim reading from the Fed. The monthly rate of US inflation is expected to come in at 1%, driven by higher energy prices. The key drivers of inflation for June are expected to be energy prices, food costs, airline fares and shelter costs. Hence the rate of core inflation, without food and energy, is also expected to rise by 0.5% last month. While this is a slightly lower rate than the 0.6% rise in core inflation for May, it remains uncomfortably high for the Fed who embarked on a 75bp rate hike at its last meeting. We are unlikely to have reached peak inflation yet, which could keep markets nervous as we move through this week. It is worth noting that the June figures are unlikely to reflect the current slowdown in consumption that is expected after a record decline in consumer confidence in the US and rising US interest rates eating into consumer demand, particularly housing demand. Housing starts slumped more than 14% in May, which could be a sign of things to come. Added to this, existing home sales also fell by 3.4% in May. Thus, the signs are growing that home sales and other elements of consumption are starting to slow, however, it will take time for this to show up in the inflation figures. From a short-term market view, while inflation remains close to 10%, the onus is on the Fed to keep hiking rates at pace, which is negative for risk sentiment. Thus, bargain hunters beware, as a higher-than-expected reading for core inflation in the US could knock risk sentiment later this week.
3, Earnings season
The S&P 500 will start reporting Q2 2022 earnings from this week, with US banks taking centre stage. As of Friday, the S&P 500 was expected to report earnings growth of 4.3% for Q2, which is not bad considering the economy is meant to be slowing down and the Fed has hiked rates aggressively. According to FactSet, once you take account of some companies reporting positive earnings surprises, then the chances are that the blue-chip US index will report earnings growth somewhere between 9-12% for the previous quarter. FactSet also notes that over the last 5 years, S&P 500 companies have reported earnings that have exceeded estimated earnings by an average of 8.8%, with 77% of companies exceeding the mean earnings estimate on average. This suggests that analysts are an overly pessimistic bunch and US blue chips tend to do better than expected. We all know that this economic cycle is different, also in the last 5 years the Fed has not been hiking rates, however, of the 18 companies on the S&P 500 that have already reported Q2 earnings, 72% have reported actual EPS above analyst expectations and earnings have beaten expectations by an average of 3.5%. As FactSet says, at this early stage of earnings season, companies have exceeded earnings estimates closer to the 10-year average than the 5-year average, however the magnitude of the positive earnings surprise has been lower. Thus, this may not be a blow out earnings season, however, companies could do better than expected, which may boost risk sentiment later this week, especially if the biggest US banks report decent earnings later this week.
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