A question of balance for the ECB as Draghi quits, Tesla earnings mask much

The European Central Bank (ECB) is certain to raise interest rates today, the first such move in 11 years, having guided to do so at its last meeting. There has been some chatter about a double-hit 50bps hike, which has seen markets move swiftly to price in more aggressive tightening, lifting the euro from its multi-year lows. However, I believe it is not in the ECB’s nature to go off-beam and rip up the guidance it issued just weeks ago. In that sense it has been far more rigid than the Fed, which has been willing to abandon a more sedate pace of tightening when confronted with new data. The ECB has been stoically ignoring the signals – inflation close to 9% and moving higher – and I don’t think it has suddenly found an alacrity hitherto missing from it. 

Italy’s political turmoil will stay the hand of the ECB anyway. It seems all too apposite that Mario Draghi, the man who ‘saved’ the euro, is going to fall on his sword the very day the ECB raises rates for the first time in more than a decade, and that the economic problems in Italy that his policies papered over as ECB chief have not been resolved.

Moreover, the downside risks to the economic outlook have materially increased since the last meeting – look at Nord Stream 1 and look at the political uncertainty emerging in Italy. Uncertainty over the energy supply in Europe is another reason for the ECB not to go with 50bps at this meeting. To underline the problems facing Europe, yesterday’s European Commission report showed consumer confidence in the EU falling to a record low, dropping below where it reached even during the depths of the Covid crisis. The ‘window of opportunity’ for the ECB to do something great closed a long time ago, now is just about managing the damage.

At the last meeting, when updated staff projections were published, the ECB tied a 50bps hike in September to inflation being no better than it was. This is likely to remain the case, but the ECB will seek to maintain optionality even for the next meeting. 

The notes from the June meeting said that “If the medium-term inflation outlook persists or deteriorates; a larger increment will be appropriate at the September meeting”. Clarifying this later, Christine Lagarde said this would mean the 2024 inflation projection remaining at 2.1% or worse. I find it impossible to believe that this will improve, so I’d suggest that 50bps is looking very likely for September.   

The balancing act the ECB needs to perform is to gently, as it sees it, tighten monetary policy whilst simultaneously keeping the spread between core and peripheral debt markets on a tight leash. This is no easy task – some would argue that it not the job of the ECB – but it is a predicament nonetheless. So, markets will be closely watching what details emerge about the anti-fragmentation device.  

The political situation in Italy will be front of mind in the devising of this tool no doubt. Italian bond yields have risen again since tailing off markedly since the June meeting as the market largely seemed to buy into the anti-fragmentation story…now comes the proof of the pudding. 

On Italy, it is all but certain that the Draghi government’s goose is cooked. Although he won a confidence vote, the major parties in the coalition abstained. Italian debt markets swooned, the yield on the 10yr BTP jumping to 3.5%, and the spread with its German counterpart widening again, underlining the problem the ECB faces in devising a system where it can raise rates without leading to fragmentation. QE has for years papered over the cracks and allowed them to get worse, now the reckoning. 

Following on from this, European equity markets are a little lower this morning ahead of the ECB event. Italian banking stocks dragged, sending the FTSE MIB down almost 2% as markets reacted to the political uncertainty.  US markets rose yesterday as the earnings-based relief rally continues to drive the price action. With the S&P 500 breaking the near-term downtrend, we could yet see 4,200 tested – lots depending on next week’s megacap earnings.

The Bank of Japan left policy unchanged, but warned over currency volatility as the yen nearly breached 140 last week. This morning USDJPY trades around 138.60. BoJ Kuroda says yen weakness is ‘solo’ because of the dollar’s strength. I seem to remember Francois Villeroy de Galhau, France’s central bank chief and member of the ECB’s Governing Council saying recently that it’s not that they euro is weak, it’s that the dollar is strong. True up to a point – takes two to tango. 

Tesla earnings … lots to unpack here. A bit like a Tesla car, it looked good initially, but delve deeper and there’s trouble with some of the fixings. Revenue rose 42% to $16.9bn, while adjusted earnings per share rose 57%. 

Automotive gross margin declined to 27.9% from 32.9% last quarter and 28.4% a year ago. Ramping ‘inefficiencies’ at Berlin and Austin will provide further margin headwinds for the rest of the year. The Cybertruck, announced three years ago, is still in development…Musk said it will start deliveries next year. FSD and other products – some announced 5 years ago – are also still in development. So why is R&D spend down $198m from the prior quarter? Musk says, Tesla’s problem is supply not demand…although it seeing its backlog of orders fall even as production is rising. Maybe Tesla isn’t paying its bills. Tesla also sold three-quarters of its Bitcoin holding. In retrospect, it was inevitable.

Yes, I'd like to point out that $TSLA revenue DECLINED by $1.8 billion in Q2 vs. Q1 but accounts payable INCREASED by $41 million while accounts receivable DECLINED by $230M!

Tesla isn't paying its bills.

Put THAT in your "free cash flow" pipe and smoke it! https://t.co/Acbc0jtojp

— Stanphyl Capital (@StanphylCap) July 20, 2022

Elsewhere, existing home sales in the US fell for a fifth straight month home prices rose to a record high. Nord Stream 1 is flowing though not at 100%. The UK has blocked a Chinese firm from acquiring IP of vision sensing tech from Manchester University – which not only raises a point about the infiltration of our academic institutions by the CCP, but also a more assertive government stance when it comes to business deals, particularly around defence and technology.  

As of yesterday, before the latest batch after the close, over 78% of the 60 companies on the S&P 500 that have reported topped analyst expectations. So, earnings so far are not as bad as feared and that is allowing investors to see the glass half full after weeks of worry. It’s hard to punish stocks that have already derated even if expectations were quite low.  

Finally, some more Musk stuff…Matt Halbower, founder and CEO of Pentwater Capital Management and a specialist in merger arbitrage, has been betting Twitter will win its case against Musk. The investor has built a large stake in Twitter, becoming one of its top 10 shareholders, in a move designed to capitalise on the arbitrage opportunity that exists in the painful transaction, he told CNBC. It’s the exact opposite of the Hindenburg short when it seemed the deal might happen. As I said back in May once Hindenburg had covered its short and deal was falling apart, the risk reward might favour backing Musk to see it through and the board to enforce $54.20. I should have said: might favour a Delaware court enforcing specific performance on Musk and making him swallow the deal: the outcome is basically the same. Shares in Twitter are up 22% since July 11^th as traders bet on Musk losing. I think we should still be looking at Tesla stock over the coming days and weeks as Musk could be thinking about liquidating more stock while the stock still trades at a hefty multiple.