Euro Macro & Rates: EU summit on Recovery Fund to leave important questions unanswered – The European Council will come together this Friday and Saturday to discuss the Multiannual Financial Framework (MFF) 2021-2027 and the Recovery Fund. Many member states still criticize the current shape of the Recovery Fund. We expect the EU-summit to result in a shared communiqué including total size of the fund and proportion loans versus grants, but to leave some important questions unanswered.
We expect the size of the Recovery Fund to remain EUR 750bn, as a significant reduction would send a signal that Europe is unable to put in place sufficient firepower given the size of the shock. Furthermore, due to continued criticism from the Frugal Four and Finland that the proportion of grants under the current proposal is disproportionally large, we expect the split between loans versus grants to become more even. However, EU-leaders will need more time to agree on the allocation key. At least 12 member states have been criticizing the EC’s allocation key in its current shape, reflecting member states’ capacity to recover from the crisis by taking into account unemployment over 2015-2019, and instead call for an allocation key reflecting the Covid-19 hit. The compromise proposal from European Council president Charles Michel indeed suggests to allocate part of the funds based on the Covid-19 related economic shock, proving that those criticisms have been heard. We think a group of member states will push for more funds to be allocated on the basis of such a key. Finally, we expect criticism from the northern states to result in reduced transfers to the south.
Spreads to widen on Recovery Fund disappointment – Firstly, we expect country spreads versus Germany to widen on the back of signs that the Recovery Fund will be watered down, with most significant impact across the periphery. Secondly, a revised allocation key will see winners and losers compared to the EC proposal, with Irish and French bonds outperforming and Portuguese and Italian bonds underperforming versus peers. Thirdly, we expect extended uncertainty on the exact shape of the Recovery Fund to result in increased spread volatility over the coming months. (Floortje Merten)
ECB View: Lagarde signals caution on outlook and full use of PEPP envelope – The ECB left its monetary policy and forward guidance completely unchanged following the July Governing Council meeting. In the press conference, President Christine Lagarde noted that the economy had bottomed out and activity had turned up, but remained extremely cautious about the outlook. She asserted that ‘high-frequency and survey indicators bottomed out in April and showed a significant, though uneven and partial, recovery in May and June, alongside the ongoing containment of the virus and the associated easing of the lockdown measures’, though ‘actual and expected job and income losses and the exceptionally elevated uncertainty about the evolution of the pandemic and the economic outlook continue to weigh on consumer spending and business investment’. As a result ‘the level of activity remains well below the levels prevailing before the coronavirus (COVID-19) pandemic and the outlook remains highly uncertain’.
This meant that ‘price pressures are expected to remain very subdued on account of the sharp decline in real GDP growth and the associated significant increase in economic slack’ and that ‘the Governing Council, therefore, continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry’. Indeed, in the Q&A, Mrs Lagarde confirmed that the full PEPP envelope will be employed unless ‘there were significant upside surprises’. Looking forward, we continue to expect a further increase in the PEPP envelope by EUR 500bn later this year. This reflects our view that inflationary pressures will weaken more than the ECB expects. In addition, the ECB will need the firepower to continue to mop up government bond supply in the coming quarters. Finally, although the ECB did not consider raising the tiering multiplier at this meeting (against our expectations), we think this is still likely going forward. (Nick Kounis)
US Macro: The remarkable bounce back continues. Can it last? – Retail sales surged again in June, this time by 7.5% mom, following an upwardly revised 18.2% gain in May. Remarkably, these cumulative gains have taken retail sales back very close to their pre-pandemic levels – total sales in June were just 0.6% lower than February, compared to the 21.7% shortfall in April. This occurred despite many states remaining partially closed, and indeed the eating out component of retail sales is still some 27% below pre-pandemic levels (April: -54%). Clothing sales also remain depressed. However, the details showed that other categories of retail sales have – against our expectations – made up for these losses, with building materials & garden supplies and sport & hobby goods joining grocery sales in registering double digit year-on-year growth.
Brace for a renewed dip – We have been surprised by the resilience of US consumers, who seem determined to spend, one way or another. However, we doubt the current growth in consumption can be sustained, for three reasons. First, the resurgent pandemic is denting the nascent recovery in eating out, as evidenced by the OpenTable data so far in July. This has come about not just through additional restrictions on indoor dining in certain states, but we are now seeing national declines in seated dining – suggesting that consumers are becoming broadly less comfortable eating out. Second, the categories that have seen surges in sales do not look to be sustainable, in our view; above-normal investments in home improvement can only persist for so long. Meanwhile, this type of discretionary consumption has probably been spurred by the government’s $1200 stimulus checks; indications so far are that another round of transfers – if they happen – will be much more narrowly targeted at lower income households. Thirdly, we are just now starting to see significant permanent damage being done to the labour market from the pandemic, with the June payrolls data showing surging permanent layoffs. With social distancing likely to continue restraining the hospitality sector, we expect such layoffs to persist in the coming months, and this will further weigh on consumption. (Bill Diviney)