Cracks emerge in Europe's resilience

Putnam Fixed Income Team, 07/14/22


Europe’s economy has withstood very large shocks, but June data is beginning to cast doubt on whether it can remain resilient against recession. The region also faces new uncertainty about next winter’s energy supplies and the ECB’s plans to protect the periphery as rates rise.

Europe’s June Purchasing Manager Indexes (PMIs) weakened across the board. Manufacturing growth had been coming down for months; in June, services, too, slowed more noticeably. Service providers’ new orders, backlogs, future business expectations, and employment all declined. Businesses have reported the fading of pent-up demand from the pandemic, as well as a fall in banking and real estate activity. Consumer confidence continued to deteriorate. The details of manufacturing PMIs were weaker. New orders were already in contractionary territory; in June, backlogs moved into contraction, too.

Euro zone consumer confidence indicators

consumer confidence indicators

Sources: European Commmission, Growth for Knowledge (GfK), National Institute for Statistics and Economic Studies (INSEE).

War refugees join the labor market

Despite strength in Europe’s labor market through the month of May, the more recent German unemployment rate reading for June showed a jump from 5.0% to 5.3%. The German labor agency said that this increase is due to Ukrainian refugees now being recorded by job search agencies. The European Central Bank (ECB) estimates that refugees can increase the European labor force by as much as 1.3 million people. While the refugee flows can help alleviate the labor shortage issues in the long run, in the short run refugee flows tend to be inflationary.

The euro zone headline inflation increased to 8.6%, while the core inflation ticked down to 3.7% year over year in June. Food inflation continued to rise at a rapid pace. The month-over-month increase in energy prices was small, but the annual inflation remains high at 41.9%. Services inflation eased a bit thanks to the temporary reliefs the German government introduced against the surging cost of living. Examples include cheaper public transport tickets and a cut to fuel taxes, which reduced transportation inflation. Starting in July, the renewable energy tax on power bills will also be removed, which is likely to pressure some inflation components lower. The other services components remained strong.

Concerns about gas supplies for winter

Russian gas flows via the Nord Stream 1 pipeline came down significantly in June. The disruption is attributed to maintenance and is expected to last until late July. However, if the Russian supply is not restored by the end of July, Europe runs the risk of insufficient gas storage for the winter. Rationing of gas supplies, outlined as the third or “emergency” stage of the Emergency Gas Plan Germany implemented on March 30, is expected if the Russian flows do not pick up.

ECB’s rate increases could heighten fragmentation risk

Turbulence in rate markets was high during June, and equally so in European rates. With the ECB getting more hawkish, German 10-year Bund yields rose on some days even more than the U.S. 10-year yield. The rise in Bund yields came with widening peripheral spreads.

At the June ECB meeting, the Government Council (GC) concluded that the conditions to raise interest rates had been met. The Committee intends to raise the policy rate by 25 bps in July and is gravitating toward a 50-bps hike in September, followed by a gradual but sustained path of interest-rate increases toward the neutral. Some members want to go beyond neutral. As long as inflation remains high and economic contraction is not in sight, the ECB is likely to continue increasing the policy rate.

Despite speculation, the ECB might introduce a new tool to prevent fragmentation (a sudden rise in sovereign bond yields of countries on the periphery, such as Greece, Italy, Portugal, Spain, and Ireland), the June meeting ended without an announcement. As the pressure on peripheral yields mounted, the ECB held an emergency meeting to address the spreads.

Source stories and ECB President Lagarde’s comments indicated that the tool would go into effect when spreads widened beyond certain thresholds. However, some hawkish GC members, have been cautioning against using tools to cap risk premia.

The new antifragmentation tool is proposed to be named “Transmission Protection Mechanism,” but it is not clear if it will be ready by the next ECB meeting on July 21. The tool would work by selling some securities to buy peripheral assets. Alternatively, banks that are selling the peripheral securities to the ECB will be required to hold the cash from the transaction at the ECB’s deposit facility.

Despite delays, peripheral spreads narrowed later in June, in part because of the ECB’s efforts to provide a backstop. Like the U.S., the region faces the difficulties of reducing inflation without further reducing growth, but with the added risk of fragmentation.

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