Mario Draghi: “The ECB is ready to do whatever it takes to preserve the euro. Believe me, it will be enough.”

In July 2012, in the depths of the Eurozone sovereign debt crisis, the then president of the European Central Bank, Mario Draghi, came to the rescue of the Eurozone and its prized single currency by uttering these now infamous words. It stemmed the systemic panic spreading across the regional bloc that soaring government bond yields for the heavily indebted southern member nations of Italy and Greece were leading to an end of the Eurozone project.

The ECB went on to rapidly expand its balance sheet by trillions of euros from under €2 trillion before the debt crisis to nearly €9 trillion today, including purchases of billions of euros of peripheral government debt from 2015 when Greece became the first developed nation in history to miss a loan payment of €1.6 billion owed to the IMF, triggering another collapse in the value of the Euro.

Despite the extremes reached by this stress test of the Eurozone’s resilience, Euro weakness did not result in parity with the US Dollar, which would have been psychologically destructive for Eurozone policymakers. It had looked to have been permanently averted until it was ultimately reached in July this year, reviving memories of its difficult early noughties period soon after its formation, when it fell so low traders dubbed it the “toilet currency”. But why now, why again?

Much like the infectious line dance moves set to Marcia Griffiths and Bunny Wailer’s song, Electric Boogie, that can have you ‘electric sliding’ all night, the Euro has been on its own perpetual slide against the US Dollar since its pre-Global Financial Crisis peak in 2008. More recently, however, this 37% depreciation over the last 14 years has been driven by a culmination of higher risk premiums associated with the war in Ukraine and Russia’s longer-term strategic intentions, combined with a very strong period for the US Dollar as the Federal Reserve embarks on a historically aggressive financial tightening cycle to tackle elevated inflation levels and an overheating labour market.

Whatever the plight of the Eurozone and its single currency, it makes up a fifth of global foreign exchange reserves and a quarter of global bond issuance, so it can no longer be written off as flush-away waste. However, with a widening gulf between the long-term economic prospects of the US and the Eurozone, investors should consider that parity with the US Dollar may not be the end of this story, and perhaps further weakness may lie ahead.

Economic data continues to moderate in the US, raising fears that the probability of recession over the next 12 months is becoming likely. This is accompanied by strong inflationary pressures that are broad based. Both factors are weighing on the Federal Reserve as investors debate the pathway of the central bank despite the Fed setting their hawkish narrative as they prioritise lowering inflation at all costs.

The ECB achieved lift off in July, lifting its main deposit facility interest rate out of 8 years of negative territory and back to zero. Recession risks in Europe are primarily geopolitically driven. High gas prices and elevated uncertainty are already exerting a toll on the Eurozone. Base effects should bring energy inflation down across Europe in the months ahead, but contribution of energy to headline consumer price inflation will remain elevated. Markets are now discounting a faster pace of ECB rate hikes over the next several quarters.

Easing supply chain pressures and robust construction helped prop up May’s UK GDP data, however, a weak consumer and business services picture remains. A widening trade deficit is on course for the biggest annual contraction on record. Inflation to remain high on supply chain disruptions and higher energy prices, adding pressure on the Bank of England to pick up the pace in tightening financial conditions despite the negative effects on the UK economy. Conservative leader candidates Liz Truss and Rishi Sunak will battle it out to become the next prime Minister, with the former holding a comfortable lead in the polls.

Japan’s economic recovery has lagged behind other major economies, but its long-term trend growth rate is amongst the lowest in the G20. Yen weakness worries some policymakers with headline inflation hitting 8-year highs, but the Bank of Japan has signalled a lack of concern since wage pressures remain contained. The central bank is significantly out of step with its counterparts in North America, Europe, and Australasia where tighter monetary policies are in motion.

Chinese economic data is showing tentative signs of improvement, but the property market is experiencing its worst period on record, all exacerbated by the government’s zero Covid policies. Monetary (rate cuts) and fiscal (wider deficits and VAT rebates) stimulus continues. Unlike in most global economies this year, domestic inflation pressures have remained below target, leaving the People’s Bank of China as the only major central bank to cut interest rates in 2022.

North Asian economies would benefit hugely from improving Chinese growth, joined by Brazil and Argentina. A big driver of EM performance and overall economic conditions in general is the strengthening US Dollar, which as contributed to 16 emerging market countries registering as severely distressed (Credit Default Swap spreads > 1000 bps), the highest since 2010.

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