Gradually, Then Suddenly

Authored by Stefan Koopman via Rabobank,

Gradually, then suddenly

There’s a passage in Ernest Hemingway’s 1926 novel The Sun Also Rises in which a character named Mike is asked how he went bankrupt. “Two ways,” he said. “Gradually, then suddenly.”

It reveals a lot when it comes to success and failure. It’s the way states go bankrupt, banks collapse, currencies implode, and prime ministers fall. It all happens gradually… and then suddenly.

There had been some huge qualms over Boris Johnson’s leadership abilities for the best part of the year, as he moved from one scandal to another, but he has now finally resigned as leader of the Conservative Party. This resignation doesn’t mean he’s moving out of No. 10 straight away, as one would normally expect, and Johnson instead plans to continue to serve as prime minister until a new Conservative leader is elected. This means that the actual handover could potentially take place as late as October, leaving British politics in limbo this summer unless Tory MPs finish the job before recess.

In his resignation speech, in which the word ‘resign’ wasn’t uttered once, Johnson fully blamed his departure upon “the herd instinct” of Westminster’s “Darwinian system” and failed to admit any of his own wrongdoings. This begs the question: was this really a resignation speech, or is Johnson seeing this as the start of a new beginning? We have to take note of what his former chief advisor, Dominic Cummings, posted on Twitter.

“I know that guy & I’m telling you -he doesn’t think it’s over, he’s thinking ‘there’s a war, weird shit happens in a war, play for time play for time, I can still get out of this, I got a mandate, members love me, get to September…’

If MPs leave him in situ there’ll be CARNAGE”

While it is an understatement to say there’s some animosity between the two, Johnson’s sort-of resignation is clearly not a satisfactory situation for the Tory party. The political uncertainty and the associated policy stasis creates yet another challenge for the British economy, which we already forecast to enter a recession later this year due to the cost-of-living squeeze. This looming recession makes it even more pressing to stabilise the current political situation, especially in light of the huge energy crisis Europe could potentially face this autumn.

For all the scandals, it is hard not to see Johnson’s looming departure as being closely linked to Brexit – without it, he probably wouldn’t even have received the keys to 10 Downing Street in the first place. Brexit is a beast which has now devoured three prime ministers: first Cameron, then May (who was, understandably, having a jolly good time yesterday) and now Johnson.

A fourth prime minister, whoever this might be, will be added to the menu too if the Tories fail to get their act together. The massive structural change that is Brexit has widened already existing divisions and requires the party to ask itself the important questions: is it a party of Thatcherites, or does it want the state to intervene in its markets? Is Brexit about free trade, or about protectionism? Is a price a signal, or something that needs to be controlled? Is unemployment a market outcome, or a political decision? Is the one nation tradition still running deep, or are regional divisions to be exploited for electoral gains? Is it worth breaking international law to seek leverage, or should the government lead by example?

As long as these fundamental questions remain unanswered, the UK will have difficulties moving forward and to find its new position in the increasingly fragmented world. This political rot feeds on itself. This week’s events clearly show these “Tory civil wars” suck oxygen out of any debate on the country’s long-term strategy. Stagnation is the result…

In completely other news, yesterday’s accounts of the latest ECB meeting contained no major surprises. The door was left ajar to a possible larger hike in July, but there did not seem to be a strong push for one. In fact, three reasons were listed why the ECB intends to start with a ‘normal’ 25 bp hike on July 21:

1) it would be the first hike in eleven years,

2) the ECB should avoid unwarranted volatility, and

3) there could be adverse economic surprises in the near term.

The recent depreciation of the euro and the increased normalcy of larger rate hikes might be enough to restart the debate within the Governing Council for a 50 bp move in July. We would, however, still argue that 25bp is the more likely move, considering that the ECB has some interest in taming market pricing of its policy rate path beyond September and that the efficacy of its new anti-fragmentation tool is still very much unknown. Note here as well that Bloomberg reported yesterday that the work on the ‘Transmission Protection Mechanism’ (still a project name at this stage) may not be fully done by July 21 due to disagreements within the Governing Council.

As inflation fears deepened throughout 2021 and the first half of 2022, the monthly releases of the US’ CPI figures became an increasingly dominant driver of overall market sentiment, even outdoing the pinnacle release of the Employment Report. But as these fears are gradually being superseded by a growth scare, with calls for a 2023 recession becoming less and less of an outlier and with inflation break-evens tumbling, the employment figures should gradually claw back some of their significance.

Truth be told, this growth scare is not unfounded. In fact, the Atlanta Fed’s nowcast for Q2 GDP growth has fallen to -1.9% annualized, following a -1.6% drop in GDP in the first quarter. This suggests the US is already in a technical recession, even though the recession-definers of the NBER probably won’t see it like that. This does make sense too: it is difficult to argue the US economy has really been in a recession whilst adding a total of 2.7 million jobs in 2022 H1 (assuming the 268k consensus for June is about right). That said, the expected drag from inventories and net trade in 2022 H1 does take the shine of last year’s rapid recovery.

With inflation running at 8.6%, there is no space for such nuances. In its recent communications, the FOMC has made it abundantly clear that its focus on price stability trumps the usual focus on employment; as they seek to squeeze inflation out of the economy, they *hope* it will merely affect the stock of vacancies, the turnover in the labor market and, eventually, the rate of earnings growth without leading to a rise in unemployment. With that in mind, today’s numbers will be interpreted as a bellwether for what the future will hold. Even as the unemployment rate remained steady at 3.6%, initial claims have started to tick up slightly. While the Fed is a long way off of pausing its hiking cycle, fears of a more pronounced labor market slowdown will eventually get a more prominent position in the FOMC’s policy trade-off.