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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.

It was a mixed week for global equities. Stock markets in the United States paused for breath after another record-breaking performance the previous week. All three major US stock market indices closed last week in the red. The picture in Europe was fairly lacklustre, with an uncertain geopolitical and macroeconomic background weighing on indices. In the Asia-Pacific (APAC) region, Hong Kong’s market was the standout outperformer, while Japanese equities underperformed. Central bank rhetoric, earnings season, trade tensions and political uncertainty remained the key themes.

The Digest

A New Leader for The UK

It was a volatile week for sterling as the UK Conservative Party leadership race continued and the chances of a hard Brexit increased.

The pound sold off sharply in the first half of the week. It recovered the majority of the losses into the end of the week, but uncertainty remains elevated and expectations for sterling volatility over the next three months have spiked higher.

The winner of the UK leadership contest will be announced on Tuesday this week. On Wednesday, Queen Elizabeth is expected to ask said winner to become prime minister. We anticipate a speech from the new prime minister shortly afterwards. Markets will likely be keen to hear the tone of any Brexit-related remarks.

Boris Johnson remains the favourite to win, but will inherit a divided party. Both he and his rival, Jeremy Hunt, have been hardening their stances on Brexit.

Last Monday, both Hunt and Johnson stated they would not accept the contentious Irish backstop as part of a Withdrawal Agreement (WA), even if the European Union (EU) agreed to a time limit or unilateral exit mechanism.

In the eyes of most observers, these pronouncements have lowered the chance of a deal between the United Kingdom and EU and have increased the risk of a disorderly Brexit.

There are also reports that Boris Johnson wants to hold an early general election.

The pound hit a 27-month low versus the US dollar on Wednesday after selling off dramatically on Tuesday amid some speculation that if appointed prime minister, Johnson would attempt to suspend parliament in order to force through a no-deal exit from the EU in October.

Worries over this eased towards the end of the week, however. The pound bounced back after the UK parliament voted to block such a move.

Headlines suggesting the EU’s chief negotiator Michel Barnier is open to alternative agreements on the Irish border also helped the pound recover.

Barnier was also reported to have said he has “never been impressed” by the threat of a no-deal Brexit. Newly confirmed European Commission President Ursula von der Leyen also commented she is open to the idea of a Brexit extension beyond October if more time is needed.

Over the weekend, there was further evidence of the fractured nature of the Conservative Party as Chancellor of the Exchequer Philip Hammond stated that he would resign as chancellor should Johnson become prime minister. Hammond is opposed to a no-deal Brexit.

There could be more resignation announcements throughout the week, which seems likely to be busy and dramatic for UK politics. Some Conservative members of parliament (MPs) opposed to Johnson’s Brexit stance could also potentially defect to other parties, making it more difficult for the new prime minister to sustain his government.

Italian Uncertainty Heats Up

Italian equities underperformed significantly on Friday amid concerns over political instability and the chance of a snap election. Banks and utilities were hardest hit. Italian bond yields also widened, and the euro came under some pressure versus the US dollar.

Tensions have been rising between the two partners in the Italian government coalition, The League and Five Star. Contentious issues include the alleged illegal Russian funding of The League, as well as diverging views on central themes such as taxes, infrastructure and justice.

The most recent clash came over the election of Germany’s Ursula von der Leyen as the next president of the European Commission, in a vote that could endanger Italy’s hopes of securing a top position within the new commission. Five Star backed the new appointment, while the League opposed it.

These tensions prompted The League’s leader Matteo Salvini to say that he had lost confidence in his coalition partner. Salvini then refused to attend Friday’s cabinet meeting and criticised Five Star’s ministers. He claimed the coalition would only able to continue if his party’s reforms were adopted.

The majority of Salvini’s advisers are pushing for early snap elections, but the official statement from the League says Salvini has not yet made up his mind. The League look well placed in the event of an election, according to the latest polls.

Support for Salvini and his party was at 35.9% in an Ipsos poll conducted July 16-18, more than twice the level of support in the March 2018 general elections, and up from 33.3% in a survey by the same pollster last month. Support for Five Star was little changed from the previous poll at 17.4%, down from 32.7% in last year’s elections.

Despite this reported gain in popular support, Salvini likely has concerns about being the one to pull the trigger, given that many Italians remain in favour of the coalition and he may be blamed for triggering a crisis. There is also a risk that rather than triggering new elections, the collapse of the coalition would see Five Star try to form a different coalition, potentially sidelining The League.

President of the Republic Sergio Mattarella will have urged Salvini to clarify his stance as the window for snap elections this autumn is closing in. In Italy it takes 45-70 days to hold a vote following the dissolving of parliament. For a new government to have time to draft the 2020 Budget Law, this means parliament would have to be dissolved by the end of July so that the vote could take place in mid-September.

We expect further headlines and drama throughout the week and will be keeping a close eye on Italian equities and bond moves.

Last Week

Europe

It was a mixed week for European equities. The FTSE 100 Index was unchanged as uncertainty around the new prime minister and increased chance of a hard Brexit weighed on the pound, helping mute losses in export-oriented stocks. Italy was the clear underperformer, but Spain also struggled amid political uncertainty also weighing there.

Acting Spanish Prime Minister Pedro Sanchez, leader of the centre-left PSOE party, is seeking support from other parties to form a sustainable government after winning a general election back in October, but failing to secure a ruling majority. At the moment, it is by no means clear he will succeed. There is, however, a chance that Sanchez will get support from the left-wing Podemos party. He could attempt to make a deal in order to secure a majority. More headlines can be expected throughout the week.

Earnings season continued to ramp up last week and Germany remains a concern. Germany is still leading the way in terms of profit warnings and this is trickling through to sentiment. The German Economy Ministry also released its monthly report, which suggested growth would be weaker in the second quarter and that manufacturing remained sluggish.

Signs from the services sector also suggested growth was weaker. This is developing into a worrying theme and is certainly an area to keep watching.

With the traditional European powerhouse struggling, Thursday’s European Central Bank (ECB) meeting is sharply in focus.  Market participants now out the odds of an interest-rate cut at Thursday’s ECB meeting are now above 50%, with the recent dovish tone from the US Federal Reserve (US Fed) showing its global influence. This leaves some room for disappointment if no action materialises. Euro-area purchasing manager index (PMI) data is scheduled for release on Wednesday and is one of the final pieces of the economic puzzle that may impact the central bank’s decision.

Americas

US equity markets paused for breath last week after making fresh all-time highs the previous week.

Investor focus was on US Fed policy ahead of the upcoming meeting on July 31. The market believes we will see an interest rate cut of 0.25%, although some believe the cut could be 0.50%. With that in mind, commentary from US Fed speakers garnered a lot of attention.

In terms of stock sectors, the defensives outperformed, most notably consumer staples, which finished the week in positive territory. Meanwhile, energy names lagged, given a move lower in crude-oil prices. However, crude oil prices have rebounded somewhat in early trading this week amid heightened tensions in the Middle East.

There were a number of Fed speakers last week, but of note, New York Fed President John Williams stated monetary policy ought to be proactive and aggressive when confronting an “adverse” outlook.

He argued that when short-term interest rates are close to zero, policymakers shouldn’t “keep their powder dry” and that they could not afford to take a “wait-and-see approach to gain additional clarity about potentially adverse economic developments”.

In addition, Vice Chair Richard Clarida argued it was prudent to take preventative measures with monetary policy when close to the zero lower bound.

Finally, Fed Chair Jerome Powell reiterated the Fed needed to act as appropriate to sustain the expansion amid heightened uncertainties. With these statements, the market currently sees an 80% chance of a 0.25% rate cut on July 31, and a 20% chance of a 0.50% cut.

The US/China trade dispute was a touch quieter last week, with a few high-level comments. US President Donald Trump said the United States still had a long way to go to conclude a trade deal with China, but said it could impose tariffs on an additional US$325 billion worth of Chinese goods if it needed to do so. In addition, US Treasury Secretary Steve Mnuchin stated he was in discussions with the Chinese via telephone calls, with no face-to-face talks scheduled.

Asia

It was a mixed performance across Asian equity markets. South Korean equities outperformed after the Bank of Korea cut interest rates. Japanese equities lagged on the back of some weak Japanese trade data.

In China, equities held up thanks to some reassuring macro data, including gross domestic product (GDP), retail sales data and industrial production, which all came in ahead or in line with estimates. The positive data helped offset the lack of progress on US/China trade talks.

Hong Kong equities held up last week thanks to the Chinese macro data, but fell in early trading this week following a weekend of protests across the city. The Hong Kong Retail Management Association said last week that “most members” had reported a single-to-double-digit drop in average sales revenue between June and the first week of July.

Week Ahead

We expect the conclusion of the UK Conservative leadership battle and the stance of the UK’s new leader will dominate headlines this week. We can also expect more developments from both Italy and Spain on the political front. Earnings season in Europe will see its busiest week of the quarter so far, with single stock moves likely to impact indices. On the central-bank front, the ECB’s decision on Thursday and accompanying communique has the potential to impact markets.

Economic Data

It’s a quieter week for macro data, with global PMIs on Wednesday the key release, especially given the central-bank backdrop.

  • Europe: Euro area consumer confidence (Tuesday), Euro area PMIs (Wednesday), France business confidence (Weds), and French consumer price index (CPI) and producer price index (PPI) on Friday.
  • US: Existing home sales (Tuesday), New home sales (Wednesday), Durable goods (Thursday), advance second quarter GDP (Friday)
  • Asia & Pacific: Japan PMI (Wednesday)

Politics

  • The winner of the UK Conservative leadership contest should be announced on Tuesday, July 23.  That individual is expected to formally become prime minister on Wednesday, July 24.
  • Italy tries to avoid government collapse.
  • Spanish acting Prime Minister Sanchez is expected to try to form a coalition.
  • Hong Kong saw further widespread protests over the weekend. Such events are likely to continue to cause disruption.

 Monetary Policy

  • ECB meeting and press conference, Thursday July 25.

 

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of July 22, 2019, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton. Because market and economic conditions are often subject to rapid change, the analysis and opinions provided may change without notice. An assessment of a particular country, market, region, security, investment or strategy is not intended as an investment recommendation, nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. This article does not provide a complete analysis of every material fact regarding any country, region, market, industry or security.

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