Contemplating the next driver for markets and ECB inflation woes
The biggest news at the start of this week is that Eurozone inflation beat expectations and is now at 3% for the currency bloc as a whole, which is the highest level for 10 years. In Germany, prices were even higher, and rose to a 13-year high at 3.4%. This news is only having a moderate impact on stock indices on Tuesday, with the German Dax index falling 0.5% at the time of writing. The markets are getting used to inflation; however, this leaves the ECB in a bind prior to their meeting next week. The focus for the rest of this week is likely to be on the euro, as the market tries to second guess if the ECB will notably shift its tone away from the ultra-dovish message that it has followed in recent months.
FX markets and inflation trends based on European travels
EUR/USD is higher in the aftermath of the Eurozone inflation news, it jumped 50 basis points, and has risen 200 pips in the last 2 weeks. EUR/GBP spiked to its highest level since June on the back of the news. Interestingly, after a fantastic run for European equities this summer, we believe that there could be more upside for EUR in the coming days as we lead up to next week’s ECB meeting. From a stock market perspective, the curse of inflation has reached the Eurozone’s shores and the trick will be to find companies that can perform well in inflationary environments. For those of us lucky enough to have travelled to Europe this summer, there was a notable jump in prices, this was certainly witnessed by the Minerva team who has spent the last few weeks in Portugal. Using a non-empirical analysis that includes plenty of anecdote, a café con liete in our favourite café near Lisbon was EUR 1.50 in 2019, it is now EUR 2.50. This is not the only price increase that we have noticed, dinner for 4 used to comfortably be in the EUR 100-150 bracket, now it is close to EUR200. While there may be some seasonal inflation, from our experience talking to restaurant owners, price rises are here to stay. The funny thing is, local Lisboans are heading out to eat in their droves, the other difference between now and 2019 is that you have to book tables everywhere. This leads us to the conclusion that people on the Continent have built up significant savings during the pandemic and are willing to spend, for now, and tolerate higher prices. We shall have to see if this is the case next year. For now, anecdote is backed up by consumer price inflation data and price increases for food etc are being passed onto the consumer. This is not impacting economic growth, as pent-up demand caused by the pandemic is proving to be one of the most potent drivers of growth since the post-war period.
When not if inflation breaks the stock market
This is a long-winded way of saying that inflation and economic growth are likely to rise in tandem in the next couple of quarters. History teaches us this is not always the case, and while equities can still rise under the burden of inflation, we think that markets could struggle in the autumn and winter months. This will be also be driven by a shift in tone from central banks. While Fed chair Jerome Powell highlighted that the FOMC will taper asset purchases this year, he tempered this by saying that interest rates are unlikely to rise for some time. Thus, liquidity will decrease in the coming months, but the world is awash with liquidity, so a small decrease is not going to do much damage. However, if the ECB shifts its message at next week’s meeting then that could shake equities. It is well known that the German authorities do not tolerate high levels of inflation so they could take more decisive action than the Fed to stamp out inflation. The national inflation rate, which is different from the ECB harmonised rate of 3.5%, rose to 3.9%, its highest level since 1993 when the German economy boomed after reunification. The price increase was down to higher food and energy prices, while core prices fell slightly to 2.8% from 2.9%. Temporary factors were also at play, including the end of a VAT cut in 2H 2021. The question will be how persistent inflation will prove to be, and with rising producer and import prices, high levels of inflation could be more persistent at the consumer level than some had previously thought.
Watch for a shifting debate at the ECB
The risk for next week’s ECB meeting, is that the debate within the ECB, which has been focussed on the risks of low inflation, could take a new direction to focus on the risks of persistent levels of rising or high inflation. The head of the German central bank has already voiced his concern that interest rates are too low, and that German inflation could surge to 5% this year. German wage growth is also not keeping up with inflation, which is a concern in an election year, with Chancellor Angela Merkel stepping down next month.
French vs. German stock indices
The recent bounce in the euro could work in the ECB’s favour ahead of next week’s meeting, however, it is a difficult balance as they do not want the euro rising too quickly as it may dent exports. We believe speculation and the prospect of even a subtle shift in the ECB’s message to a less dovish stance could play out in the FX markets in the coming days, and we think that upward pressure on the euro could persist. The next major resistance level for EUR/USD is $1.20, the highest level since mid-June. For EUR/GBP, £0.8650 is also in view, the high from 19/6. When it comes to stocks, we think that the French Cac could outperform the German Dax in the short to medium term, due to the prevalence of energy companies in the Cac since energy stocks tend to do well in a period of rising inflation. The Dax could also struggle as exporters experience a tougher environment on the back of a rising euro. While the euro isn’t too strong just yet, and the ECB is still dovish, it is worth remembering that stock markets tend to price things in 4-6 months in advance, so it’s best to have a view on what you think could happen in winter if you are interested in trading stock indices right now.
Chart: The Cac has started to outperform the Dax in recent weeks and we expect that this will continue.
