U.S. Consumers Spend, German Manufacturing Slumps
It was an eventful week so let’s get started.
First, U.S. growth is plodding along just fine if the second quarter GDP number is anything to go by. The first estimate for growth came in at +2.1%, modestly better than expected. As you can see below, growth cooled from the pace set in the first quarter, but it was nowhere near as weak as many were predicting.
Consumer spending was robust (up +4.3% at an annualized pace) while investment was soft. Residential investment decreased -1.5%, equipment investment increased at just +0.7% , and investment in non-residential structures decreased at a -10.6% pace.
The story in Europe remains very different. German factory executives have reported that industry conditions are in “free fall”. The Ifo Institute’s manufacturing business climate index slumped to minus -4.3 in July from +1.3 the previous month. The reading was the lowest in more than nine years, as you can see below.
Of course, manufacturing isn’t everything, but as we pointed out last week, it accounts for about a quarter of German growth versus just 12% in the U.S.
Second Quarter Earnings Look Pretty Good
Let’s pivot to U.S corporate earnings for the second quarter. Analysts were pretty bearish heading into this reporting season, forecasting almost a 3% contraction in earnings from a year ago. However, things are shaping up modestly better than that.
About a third of S&P companies have reported earnings so far, and 78% of them have beat estimates, as you can see below. Almost 60% of companies are beating sales expectations.
Year-over-year earnings growth is running at a +5% pace, almost 8% better than expected. All sectors barring commodities are showing growth. The energy and materials sectors are posting earnings contractions of -17% and -28% respectively. This is pulling the headline number down materially.
Another key point is that roughly 45% of companies have guided earnings higher. This is an improvement from last quarter and supports the case that the second quarter could mark the trough in this earnings cycle.
The Return of QE in Europe
The European Central Bank (ECB) met on Thursday and they set the stage for a renewed stimulus package. While they opted to keep rates on hold, they did note that the outlook was becoming “worse and worse” for the eurozone’s manufacturing sector. The ECB’s head Mario Draghi blamed “the general uncertainty that has been with us for more than a year and relates to trade wars, geopolitical tensions” as well as the prospect of a hard Brexit and the slowdown in the Chinese economy.
More importantly, Draghi noted that the ECB is exploring its options to ease policy at their next meeting in September. By way of background, the ECB ended their quantitative easing (QE) program back in 2018, and since then the size of their balance sheet has been shrinking modestly, as you can see below.
They want to start growing this again. The most likely scenario in September is a modest rate cut combined with renewed QE. As Goldman noted on Thursday:
“Today’s meeting reinforces our expectation for a significant easing package in September, including a 20bp deposit rate cut with tiering, enhanced forward guidance and a return to QE. We expect the asset purchases to include corporate bonds and sovereign debt…”
The note on corporate bonds is important. The ECB doesn’t have much room to buy sovereign bonds. And it wouldn’t do much good anyhow. High interest rates in Europe really aren’t a problem. After all, Greek 10-year bond yields fell below comparable U.S. rates this week, as you can see below (this is really amazing when you think about it!!).
But there is room to drive corporate borrowing costs lower. The ECB already owns about 178 billion euros of corporate bonds. Goldman figures there is about another $400 billion euros worth of corporate bonds that the ECB could buy. Expect the ECB to hoover up a good chunk of this.
Is it only a matter of time before they start buying stocks a la the Bank of Japan?
All Eyes on the Fed Next Week
This brings us to the Fed. They meet next Tuesday and Wednesday and pretty much everyone thinks they cut rates. The market is betting on a quarter point cut, as you see below.
It is very unlikely the Fed disappoints the market, for better or worse. Really, the key will be the statement and how the Fed changes their forecast for this year and next. Will they signal more cuts? How do they talk about the inflation backdrop? Are there any dissenters?
Elvis Has Entered the Building!!!
“My chances of being PM are about as good as the chances of finding Elvis on Mars or my being reincarnated as an olive.”
– New UK Prime Minister Boris Johnson, during an interview in 2004
Apparently, Elvis lives!!
As you probably saw in the news, Boris is now the U.K’s new PM. He comes to power promising to leave the EU on October 31st with or without a deal and take the U.K. into a new “golden age.” Ummmm….that seems unlikely.
As The Economist notes:
“But Boris Johnson’s ability to steer his country towards the ‘golden age’ he promises is constrained. He will lead a fragile government, with a working majority that will fall to just one if the Conservatives lose a by-election in Wales next week, as seems likely. His promise to leave the EU by October 31st, along with a further commitment to the ‘abolition’ of the backstop, a default position designed to avert a hard border in Ireland by keeping Britain in a customs union with the EU, make it hard to see how he can get a new deal with the EU; and yet reconciling a majority of MPS to leaving without a deal seems close to impossible.”
So how does this play out? Essentially the new PM hopes to succeed where now-former PM Theresa May failed—by persuading European negotiators to make him a new Brexit offer that can win a majority in the House of Commons.
Is this likely? Not really. Johnson has the same problem May had – his party is deeply divided on Brexit. Some members want to avoid a no-deal Brexit at all costs for fear it would inflict long-lasting damage on the UK’s economy and international standing. Others insist the new government must honor its commitment to deliver Brexit for the majority who voted for it, by whatever means necessary. For now, most within his party are content to give Johnson a chance. But it won’t be long before he must choose which path to follow. When he does, he’ll alienate large numbers of Tories on one side or the other.
European negotiators know all this. That’s why there is little reason for them to offer the Brexit concessions that Johnson is hoping for.
This means an early election (or even a new referendum) seems probable. There are two paths to this:
1) Labour leader Jeremy Corbyn could call for a vote of no-confidence in Johnson once it becomes apparent the Conservatives are fundamentally split on the issue. This would likely lead to new elections.
2) Johnson could call for an early election himself because he thinks the specter of a Prime Minister Jeremy Corbyn can help him use a new vote to win a bigger majority, strengthening his bargaining power with Europe.
How would new elections shape up? Johnson might be forced into an alliance of convenience with Nigel Farage and his Brexit Party, while disgust with the Conservative Party’s failure to sort out the Brexit mess might well send enough votes toward Labour to allow them to form a government that includes a voting agreement with Liberal Democrats and Scottish Nationalists.
Corbyn himself has never been an EU fan. But his party wants a revote, and he’s had to agree to support one. That’s why, if there are fresh elections and Corbyn becomes prime minister, a second Brexit referendum becomes much more likely. And so far, at least, Remain would win a new vote, as you can see below.
Have a good weekend.
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