Insights

Monthly Cash Review - EUR EUR Liquidity LVNAV Fund



There was no meeting of the Governing Council of the European Central Bank (ECB) in August, with the next scheduled meeting on 8th September. Future interest rate decisions will be decided at each meeting based on data. Business surveys are now consistent with GDP contracting, contrary to the ECB’s forecast that growth would accelerate in the second half of the year. Inflationary pressures are growing and European gas prices have risen by about 50% since mid-July. Additional maintenance on the Nord Stream 1 pipeline in late August heightened concerns around future supply of Russian gas in Europe. Higher European gas prices tend to push up energy inflation with a lag of around three months and will also drive food price inflation by raising the cost of fertiliser and by increasing firms’ energy costs. Combined with a tight labour market, it is likely that the ECB will again need to revise its inflation outlook. The question of interest rates is now based around the size of the expected hike, given the ECB will act to try to contain inflation. Real incomes will likely continue to fall, and the risk of a recession continues to grow. The Italian elections are scheduled for 25th September, adding an element of political risk with pressure still on the BTP-Bund spreads.

Policy

There was no meeting of the ECB’s Governing Council in August. However, the minutes of the July meeting confirmed that most policymakers voted for a 50bps rate hike, focusing on their mandate to contain inflation rather than trying to avoid a recession. Those that argued for a 25bps increase were looking to “preserve consistency” with the ECB’s earlier communications rather than because they held a different view about the economic outlook.

Data

The second estimate of eurozone Q2 GDP was revised down from the preliminary flash estimate of 0.7% q/q to 0.6% – this was still much better than the original consensus forecasts of 0.2% and was driven primarily by the re-opening of the services sector. Germany’s economy flatlined in the quarter, but Italy and Spain posted growth of 1%.

Headline inflation increased from 8.9% in July to 9.1% in August, a new record high. Energy inflation edged down but remains high at 38.3% ,while food, alcohol and tobacco inflation rose to 10.6%. The core inflation rate increased to a new high of 4.3% versus consensus expectations of 4.1%.

German HICP inflation rose from 8.5% in July to 8.8% in August in line with the consensus, but with the temporary support for households ending in September and a gas levy due to be introduced in October, this will increase.

The composite purchasing managers’ index (PMI) fell from 49.9 in July to 49.2 in August, broadly in line with consensus. The services business activity index fell to 50.2 and the manufacturing output PMI of 46.5 was broadly unchanged. The German manufacturing and services PMI both fell, with the composite PMI at its lowest level since June 2020. The French composite PMI edged below 50 for the first time in 18 months. Readings below 50 are indicative of contracting activity.

The European Commission’s economic sentiment indicator (ESI) fell from 98.9 in July of 97.6 in August, with the biggest fall recorded in Germany. A rise in consumer confidence in August from July was offset by declines in industrial and services confidence indices.

The German Ifo Business Climate Index fell marginally from a an upwardly revised 88.7 in July to 88.5 in August. Both the current conditions and expectations components edged down, and the sectoral breakdown showed that the decline was broad based. The German ZEW economic sentiment indicator moved from -53.8 in July to -55.3 in August, below the consensus forecast and the lowest level since October 2008.

The eurozone’s jobless rate fell from an upwardly revised 6.7% in June to 6.6% in July. The number of unemployed people rose in both Germany and Spain, but fell in France and Italy.

Outlook

Data and increasing wholesale gas prices suggest that inflation projections will need to be revised higher by the ECB. Forward guidance has been amended, with decisions to be data-driven going forward. ECB Board member Isabel Schnabel said she “would not rule out that we enter a technical recession” and argued that central banks abandon caution and respond more “forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment”. ECB's Holzman has stated that a 75bps hike should be "part of the debate" in September with a 50bps hike considered a minimum. However, ECB Chief Economist Philip Lane cautioned against outsized interest rate moves to tackle record inflation. Market expectations are split 50/50 between a 50bps or a 75bps hike at the next meeting in September. The current expectation is that the year-end rate will be 1.50% or 1.75% and that it will continue to rise in 2023 to between 2.00% - 2.25%.

Markets

Inflationary pressure remains to the upside with increasing recessionary fears. Markets are split as to whether policy makers will implement a 50 or 75 bps hike. Euribor rates continued to move higher; one-month Euribor closed August at 0.23%; three-month Euribor at 0.65%; six-month Euribor at 1.20%; and one-year Euribor at 1.78%. Euro cash overnight deposit rates ranged between -0.07% and -0.15%. Core Government repo ranged from -0.15% to -0.20%. German 10-year Bund yields closed higher at the end of August at 1.54%, up from 0.81% at the end of July. Italian 10-year government yields followed suit, closing August at 3.88%, compared to 3.01% a month earlier.

Fund

The weighted average maturity (WAM) averaged 19 days in August with the weighted average maturity (WAL) averaged 31 days. We targeted high-quality credit issuers, focusing on a shorter duration for the fund, given expectations of higher interest rates in the eurozone. We invested in bank floating money market securities, linked to the €STR overnight index, offering attractive spreads and diversification now that we are seeing positive yields along the money market curve. We maintained our allocation to sovereign, agency and government guaranteed issuers to provide credit quality and maintain our liquidity buffers. Asset-backed paper continued to be in good supply, offering flexible duration and attractive returns compared to vanilla paper. As always, liquidity and capital preservation remained the key drivers for the portfolio, with yield a distant third.


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