Overview
What happened?
The European Central Bank finally joined the global hiking cycle with a larger-than-expected 50bp first step. Very high inflation was noted by ECB President Christine Lagarde as the key driver of the decision. In addition, Ms Lagarde announced unanimous support behind the Transmission Protection Instrument (TPI) designed to maintain order in sovereign credit markets as hiking starts. She also mentioned that support for the TPI made it possible for members to agree to a 50bp hike.
Our interpretation
The window to hike for the ECB is closing fast, with ongoing gas disruptions risking a serious recession in Q4/Q1. Moreover, on the TPI side, Ms Lagarde did say that the ECB can go “big” but also indicated conditions related to fiscal sustainability and absence of large macro imbalances. Given sharply rising political uncertainty in Italy, such conditionality runs the risk of circumventing the effectiveness of the tool. On the rates side, previous guidance on September was taken off the table and data dependency was introduced, which means continued uncertainty around the hiking cycle from here.
Our outlook
We continue to believe the ECB will have to abandon the hiking cycle after the September meeting as the damage to growth becomes visible. While gas flows from Russia through Nordstream 1 have restarted, they remain much below capacity and whether the flows will be maintained is highly uncertain. The European Commission has called for a voluntary 15 per cent gas consumption cut from member states. In the event of a full shutdown leading to large scale rationing, the hit to German GDP alone could be more than 5 percentage points. However, given gas flows from Russia are largely driven by geopolitics, the outlook remains volatile, though actual behavioural changes in terms of gas usage are already starting to take place.
Lastly, the strict conditionality introduced today on the TPI, although leaving room for flexibility in its interpretation, limits its potential usage and runs the risk of markets testing its credibility. The prospect of a new election in Italy, with far-right parties in the lead, means that Italy is unlikely to meet the conditions, at least in the short term, leading to concerns around whether the ECB will intervene or not. All eyes are now on the ECB’s tolerance for widening spreads and we believe there is reason to be cautious as Italy’s political crisis unfolds.
Asset allocation views
We are still cautious on risk with underweight positions in equity and credit.
