Beyond Bulls & Bears

Equity

Notes from the Trading Desk – Europe

Franklin Templeton’s Notes from the Trading Desk offers a weekly overview of what our professional traders and analysts are watching in the markets. The European desk is manned by eight professionals based in Edinburgh, Scotland, with an average of 15 years of experience whose job it is to monitor the markets around the world. Their views are theirs alone and are not intended to be construed as investment advice.

Global equities closed last week generally higher, underpinned by optimism about progress in the US/China trade talks. Other factors influencing markets last week included another move lower in bond yields, a statement from European Central Bank (ECB) President Mario Draghi and (inevitably) Brexit.

Global equities’ performance last week contributed to their strongest quarter since 2010. The rally comes on the back of what was a weighty selloff for global equities into year-end last year.  Renewed hopes that a trade deal between the United States and China will eventually be struck drove the move higher, along with a more dovish attitude from the US Federal Reserve which alleviated some pressure on markets. US and Chinese equities have been at the forefront of this strength.

The Digest

Banks and Bond Yields Back in Focus

Bond yields have come back into focus in the last couple of weeks.

On Friday March 22, the US three-month/10-year US Treasury yield curve inverted, raising concerns that the United States could be inching closer to a recession.

The correlation between that inversion (when long-term rates fall below short-terms ones) and the timing of recessions in US equity markets in the last 40 years is quite stark.

Last Monday, we also noted weak economic data out of Germany and recent Brexit chaos which led to a fall in German Bund and UK Treasury yields.

Meanwhile, early on Wednesday of last week, the Reserve Bank of New Zealand released a surprisingly dovish statement, keeping rates on hold at 1.75%.

In the statement, the bank’s monetary policy committee cited a “weaker global economic outlook and reduced momentum in domestic spending”. It noted: “The more likely direction of our next OCR [official cash rate] move is down.”

Market commentators saw the communique as yet another indication from a central bank of an easing economic picture.

In Europe, we saw a widening of the German-Italian 10-year bond spread which put pressure on equity markets. Germany issued Bunds with negative yields for the first time since 2016.

Later, on Wednesday, reports emerged that the ECB was considering a tiered deposit rate to lower the cost of banks holding excess cash. The reports came on the back of comments from Draghi just after European stock markets opened. He said: “If necessary, we need to reflect on possible measures that can preserve the favourable implications of negative rates for the economy, while mitigating the side effects, if any.”

The hope would be that the new system might improve the profitability of some of the core eurozone banks. Reports suggested that the change could provide around €7 billion of annual profit relief. Bank stocks rallied in the immediate aftermath of the reports. Nonetheless, details of how the tiered system would work were sparse, with many reports not only questioning the set-up but also which banks would benefit most from the move.

The outgoing ECB Chief Economist Peter Praet said the central bank would need to be convinced that introducing a tiered deposit rate would address a monetary-policy question in an efficient way before countenancing the move.

Eurozone banks’ profitability issues cannot be totally blamed on negative interest rates. There are clearly further issues around the efficiencies of some of these institutions which are not going to be alleviated solely through reducing charges on excess liquidity.

Brexit: Plenty of Rhetoric But No Progress

The UK votes to leave the EU

Brexit remained in focus last week as UK members of parliament (MPs) prepared to take part in a third Meaningful Vote on Theresa May’s Brexit deal.

There was plenty of rhetoric from MPs through the week, with a number of Conservative Eurosceptics switching to support her deal. Ultimately though, May failed to win over the Democratic Unionist Party (DUP) as well some hardcore Brexiteers within her own party.

The result was that May lost the vote by 286 to 344. Sterling ended the week down just over 1.3% vs versus the US dollar, dipping below $1.30 on Friday for the first time in nearly three weeks.

In response to Friday’s vote, the European Union (EU) confirmed it would extend Article 50 until April 12. An extraordinary meeting of the leaders of the remaining EU states will take place on April 10 and the EU expects the UK government to signal its proposals for a way forward before that date.

So, what’s coming next?

With parliament failing to agree to a plan, the default is the United Kingdom leaves the EU on April 12 with no deal.

However, a majority of MPs have signalled they do not want to leave without a deal. Early this week, MPs are due to take part in another round of so-called “indicative votes” to see if there is a majority in parliament for any option. There is a chance we see that a majority of MPs vote to support a softer Brexit, with the UK in some form of customs union.

However, that is not the chosen option of the government. If that were to be parliament’s preference, the government could find itself negotiating for something it doesn’t believe in. Alternatively, it could ignore parliament’s wishes, but that would likely prompt a constitutional crisis and potentially a fresh snap election.

One opinion poll published over the weekend gave the Jeremy Corbyn-led Labour Party a lead over the Conservatives. An election could see Jeremy Corbyn becoming prime minister, leading a minority government.

There now seems to be a high chance the UK will have to ask for a longer extension to Article 50, but this will require unanimous support from the remaining 27 EU states and could come with conditions attached.

In summary, yet another week has gone by and we still remain unclear on what shape Brexit will take and when, if at all, it will take effect. We would say that it feels as if the market has not priced in a hard Brexit, so if that comes into focus we expect UK assets could be hit hard in the coming weeks.

Last Week

Europe

European equities enjoyed a positive performance last week, thanks to hope of fresh ECB stimulus and signs of progress in US/China trade talks.

Brexit uncertainty has weighed on sterling and UK equities to an extent, but broader European equity markets seem to have shrugged off any concerns for now.

Looking at sector performance, basic resources stocks were the star performers in Europe, thanks to improved sentiment around US/China talks. Despite the news that the ECB has moved to help the European banks, the banking sector was essentially flat on the week, as the tightening in European interest rates weighed on sentiment. German Bund yields fell 0.6% to the lowest level since 2016.

In European macro data, European inflation data, including Germany’s preliminary consumer price index figures, came in below expectations. European confidence data was mixed: Sweden beat expectations, Italy missed and France was in line with consensus.

Americas

All major US indices closed last week higher in what was a relatively quiet week for news flow. All sectors apart from utilities and communications made gains as optimism over trade talks with China helped sentiment.

US trade representatives arrived in China on Thursday, and on Friday US Treasury Secretary Steven Mnuchin tweeted that he and US Trade Representative Robert Lighthizer had concluded constructive trade talks, although there were no details given.

There was further positivity amid reports on Reuters that China had made “unprecedented proposals” on a number of issues including forced technology transfers.

In addition, the Wall Street Journal reported that China may give foreign tech companies better access to its cloud computing market and allow them to own data centres as part of a trade deal.

These potential concessions from China were well received, although US Economic Advisor Larry Kudlow made sure to temper expectations that a resolution was imminent, saying: “This is not time-dependent. This is policy- and enforcement-dependent.”

Stronger US Treasuries and the flattening of the yield curve garnered attention early in the week. Chicago Fed Bank President Charles Evans suggested the US Fed might have to put rate-hike plans on hold or even ease monetary policy if economic forecasts for 2019 disappoint. The market is now pricing in around a 70% likelihood of a Fed cut before the end of the year.

Yields did start to reverse towards the end of last week, which helped give a further boost to equities. Financials in particular benefitted from the reversal, with banks retracing some of the previous week’s lost ground.

The US macro picture seemed to support a more dovish approach from the Fed, with US Consumer Confidence for March missing estimates and fourth-quarter gross domestic product (GDP) revised lower.

February personal income and personal spending also came in light. It’s now a key week for data in the US, with both ISM manufacturing and nonfarm payroll data due out. Investors will be looking for encouragement in these releases.

Asia

Markets in the Asia Pacific (APAC) region underperformed other global equities last week as softer global flash purchasing manager index (PMI) data and concerns over growth and yield curve inversion weighed.

Trade and production data from the region was also weak and disappointing import figures from the US hinted towards negative demand. Defensive names unsurprisingly outperformed with this backdrop.

As part of the selloff, Japanese equities saw their worst daily decline of the year on Monday. Some disappointing corporate earnings did little to help.

However, Japanese equities still managed to post a gain for the first quarter of 2018 after a dismal fourth quarter in 2018. With this in mind, last week’s performance may have reflected some profit taking.

China also struggled at the start of last week. Sentiment improved by mid-week, however, with a speech from Premier Li Xinping reassuring investors on intellectual property (IP) protection and the further opening up of the financial sector.

The positive headlines on trade on Friday also helped equities to recover much of the earlier lost ground and losses on the week were muted.

Australian equities posted a small weekly decline but remained one of the top regional performers in the first quarter. Strength in commodities, which posted their best quarterly gain since 2016, helped provide a boost.

Week Ahead

We have the March US employment report coming up on Friday; recall that was a significant miss last month. In Europe, we have a number of inflation data points which the ECB will likely be watching closely.

Politics

  • US/China: Any rhetoric around the trade talks will be a key driver for financial markets. China says its top trade negotiator, Liu He, has left for talks in Washington.
  • Brexit: UK Parliament takes up indicative votes on Brexit proposals.
  • Turkey: Look for fallout from results of the weekend’s local elections.

Macro

  • Monday: US Retail Sales; US ISM Manufacturing
  • Tuesday: UK and Eurozone PMIs; Eurozone unemployment data; US durable goods
  • Wednesday: US, UK and eurozone services/composite PMI; European retail sales; China Caixin PMI composite, services
  • Thursday: Germany factory orders
  • Friday: Germany Industrial Production; US non-farm payrolls and employment data

Monetary Policy

  • ECB meeting minutes will be released on Thursday.

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For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn.

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