Notes from the Trading Desk – Europe

The digest

Last week, we saw a broad-based rally in global bonds and equities, with the MSCI World Index closing the week up 1.8%. Regionally, the Euro Stoxx 600 Index outperformed, closing the week up 4.6%, the S&P 500 Index closed the week up 1.4%, and the MSCI Asia Pacific Index closed the week up 1.3%, missing Friday’s rally.¹ There was little change in terms of the macro themes from the prior week; however, the new calendar year brought about a notable rotation out of last year’s winners and into last year’s losers.

The situation around European gas reserves continues to improve, with reserves now at 83% capacity after a period of milder weather. Optimism over China’s COVID-19 reopening continues to build too, with the border fully reopened over the weekend. Macro data continues to be a market driver, which we witnessed on Friday with the US Institute for Supply Management (ISM) Services miss and a downward reversion in average hourly earnings in the December US employment report. “Bad news is good news” continues to be a theme, as investors are assuming that deteriorating activity will put an imminent end to the US Federal Reserve’s (Fed’s) tightening cycle.

Goodbye 2022, hello 2023

2022 was a crazy year for global financial markets amidst escalating geopolitical risk, record levels of inflation and the highest central bank hiking cycle ever witnessed. Inflation data rose to 40-year highs and, globally, the central banks of the top ten most-traded currencies delivered 2,700 basis points worth of tightening (across 54 rate hikes) to fight it.

In Europe, the Euro Stoxx 600 Index closed the year down 13%—even with a 10% rally in the fourth quarter. The bear market rallies last year were significant—the last time the Euro Stoxx 50 had back-to-back months of up over 10% (as it did in October and November) was back in 1999.

Growth stocks underperformed value in Europe last year, as the Euro Stoxx 600 Index returned to pre-COVID levels. After decades of underperformance, the UK FTSE 100 Index was slightly higher, as low valuations, its exposure to energy and a weak sterling helped provide a lift. Rate-sensitive stocks suffered the most in Europe, with real estate, retail and technology stocks hit particularly hard. High short interest stocks underperformed as hedge funds doubled down on their shorts. Oil and gas stocks in Europe outperformed last year, posting gains. It was an interesting year for technical traders too—whenever the Euro Stoxx 600 Index hit technically oversold levels last year, the market subsequently rallied.

In the United States, the S&P 500 Index closed the year down more than 19%, troughing with a 24.9% decline in October. Over the last 40 years, only 2002 and 2008 were worse for US equity markets.² Since 1928, there have only been six worse years for US stocks; historically, markets have rebounded sharply following such bearish years. Growth stocks suffered, closing the year down. Like in Europe, value stocks outperformed, but still closed down on the year. Energy and technology were the biggest movers from a sector perspective, with energy stocks higher while technology stocks slumped. The largest four stocks in the S&P 500 (APPL, MSFT, GOOGL and AMZN) each fell between 25% and 50% last year, whilst nine of the 10 best-performing stocks in the United States were in the energy space. US 10-year Treasury yields rallied through the year from ~1.6% to ~3.9%.

There is still a wariness as we head into the new year. We would note that it was only in October that we saw S&P 500 put option volume at record levels, suggesting investors are still seeking protection.

Global central banks have generally signalled they expect to continue to raise rates; however, the bond market has started to price in interest rate cuts towards the end of 2023. Global growth estimates for this year have been hammered, as they were consistently downgraded each month last year. Consensus expectations for earnings in Europe now stand at no growth to low single-digits. Inflation will remain a key focus this year, with investors wary that it could derail markets once again.

After the moves last week, the risk-reward seems weighted to the downside for European equities for now. Real yields (inverted) and equities have been moving in sync for the last 12 months. This all ended in fourth quarter when we saw equities rally, whilst real yields did not move to the same extent. That gap between real yields and European equities widened at the start of this year, suggesting that either yields or stocks will likely slow down.

Themes to start the year

Geopolitics in Europe and the subsequent knock-on effect for energy prices will likely continue to be a focus for investors. At the start of 2023, the European energy outlook seems encouraging. German gas reserves are back above 90% and Europe overall is at 83% as milder weather has seen a drop in demand.³ Even with the cold snap in December, pan-European demand was 11% below the five-year average last month, ICIS data shows.

In an interview last week, Klaus Mueller, president of Germany’s network regulator said: “We are very optimistic, which we weren’t really back in the fall… The more gas we have in storage facilities at the beginning of the year, the less stress and cost we will face in filling them again for next winter.”⁴

The fear of energy rationing in Germany seems greatly reduced, and European gas futures fell 45% over the past month. Oil prices were lower last week, with West Texas Intermediate (WTI) crude oil down 8%. Falling energy prices should be key driver of lower inflation reports in the coming months and likely to be closely watched.

China’s COVID reopening is another focal point for investors at the start of the year. The ending of the zero-COVID policy should provide a boost for the global economy. The border between China and Hong Kong officially reopened over the past weekend and the government is looking to relax restrictions on developer borrowing, which have hamstrung the real estate sector in recent times. Media reports convey that China’s economic growth is expected to return to “normal” as the government provides more support to households and companies to help them recover. And, the People’s Bank of China (PBOC) is expected to guide down borrowing costs in early 2023.

Macro data also continues to be a theme, as investors try to pre-empt central bank action through 2023. The global economy appears to be faring better than expected in some areas. The eurozone December Composite Purchasing Managers Index (PMI) came in at 49.3, which was higher than expected, with the services component higher but no revision on the manufacturing number. The US labour market appears to be resilient, with the ADP employment report and the December employment report coming in better than expected, with the unemployment rate falling to 3.5% from 3.7% in November.

However, the focal point for the market was the miss in average hourly earnings, which rose a less-than-expected 4.6%, cooling inflation expectations further. Weak US ISM Service data also buoyed the market, coming in at 49.6, also weaker than expected. Market bulls hope that these weaker reports will force the Fed to slow down on the path of rate hikes, raising hopes of a soft landing. It is pretty clear that macroeconomic data, as a driver of central bank action, should be a key catalyst for market moves in at least the first half of 2023.

Week in review

Europe

Last week, European equities logged their best start to a new year since 2009. The Euro Stoxx 600 Index closed the week up 4.6%, with all sectors higher. The rotation out of last year’s winners and into last year’s losers was clear for most of the week. Investors bought retail, tech and auto stocks, and sold oil, aero and defence stocks. Yet, Friday brought a reversal of that rotation, with investors moving back into some of last year’s winners.

Last week, in terms of macro themes, China’s reopening was a focus, with European equities viewed as a proxy for that trade. European gas prices remain at recent lows, with gas consumption falling sharply in December and liquified natural gas (LNG) imports increasing to new all-time highs, leading to an increase in storage levels during the second half of December.

In terms of data, the eurozone December headline Consumer Price Index (CPI) headline surprised to the downside, coming in at 9.2%, the first time in single digits since August. However, core CPI (which excludes food and energy) came in higher than expected, rising to 5.2% year-over-year, mostly due to strength in core goods component.

In terms of sectors, retail stocks led the way last week after some fairly notable underperformance in 2022. However, news flow remains negative in the space and, whilst the sector logged a nice gain last week, data suggests there is little momentum behind this move and short covering was likely the key driver. Autos were also better off last week given the momentum unwind.  Banks performed well, also up despite the rotation and drop in yields. Oil stocks were lower for much of the week but staged a late recovery on Friday to finish the week slightly higher. Value outperformed momentum last week, whilst cyclicals outperformed defencives overall.

United States

US equities saw a positive start to 2023, although with more subdued moves compared to Europe. The S&P 500 Index traded up 1.4% last week, and the Nasdaq 100 Index was up 0.9%. Looking at the technical picture over recent months, the S&P 500 Index feels rangebound between 3800 and 4000.

Although it’s a new year, market focus remains on familiar themes, with the Fed policy path front and centre. Fed December meeting minutes were published last week, which saw the Fed sticking to its hawkish narrative. Fed policymakers stated that inflation remains too high, and while the Federal Open Market Committee (FOMC) acknowledged recent improvement in the inflation data, more proof is needed to be sure that inflation is heading back toward its 2% objective. However, having made significant progress towards moving policy to a “sufficiently restrictive” stance, the FOMC unanimously approved slowing down the pace of rate hikes.

With that in mind, the release on Friday of the December employment report was a focal point last week. The non-farm payroll figure was better than expected at 223,000, and the unemployment rate fell to 3.5% from 3.7% in November. It was notable that, despite the strength in the labour market, the average hourly earnings came lower than expected at 4.6%, versus previous 5.1%, suggesting an easing of inflationary pressure.⁵

Meanwhile, the ISM Services headline number of 49.6 was weaker than expected but didn’t stop the market’s rally, confirming the argument is that “bad news is good news,” in that weaker macro data increases the chances of the Fed easing from their hawkish stance.

The US ISM Manufacturing figure printed in line with expectations 48.4, versus a prior reading of 49.0. The employment reading was at 51.4.

WTI crude oil fell 8.1% with some demand overhangs remaining, but also due to fading concerns around an energy supply crunch.

Elsewhere in the Americas, Brazilian equities will likely be a focus this week given the unrest over the weekend. Bolsonaro supporters stormed government buildings in response to incoming President Lula de Silva’s victory. Separately, there was volatility in the shares of some of Brazil’s state-controlled companies, such as Petrobras, overs fears the new government may be more interventionist.

Asia

Overall, we saw a positive start to the year in Asia, albeit the first week was a shortened week due to holidays. The MSCI Asia Pacific Index closed the week up 1.3%.

Hong Kong’s equity benchmark closed last week up 6.12% and was the standout performer, as investors welcomed China’s reopening and a series of pro-growth policies. Alibaba led the e-commerce/technology, media and telecommunications space higher after Ant got approval for a US$1.5 billion capital raise, boosting optimism that China’s regulatory clampdown on the sector is easing.

Chinese developers rallied as the country’s housing minister said that they will focus on meeting developers’ “reasonable” financing demands, signalled support for first-time home buyers and suggested banks should lower down-payment requirement and mortgage rates.

Consumer-related stocks such as catering, beer, sportswear and retailers advanced amid reopening momentum, and consumption recovery optimism.

On the other hand, Japan’s market closed last week down 0.46% as the global monetary policy tightening cycle and recessionary fears continued to weigh on sentiment. Investors speculated about the future trajectory of the Bank of Japan’s (BoJ’s) monetary policy, given the surprise modification to its yield curve control in late December. Nikkei news agency reported  that the BoJ could be set to raise its inflation forecasts in January, which could be perceived as providing grounds for a pivot.⁶

Japanese authorities continued to emphasise the importance of improvements in wage growth, with Prime Minister Fumio Kishida urging companies to deliver pay increases above the rate of inflation, warning of the risks of inflation outpacing wage growth, including the erosion of households’ purchasing power in an environment of low economic growth.

Mainland equities in China closed last week up 2.21% as local investors turned more optimistic in the new year amidst changes in COVID policy (e.g., Hong Kong reopening its border to mainland China), and production seems to be recovering. More positive property-related policies also helped market sentiment. Reportedly, China is planning to relax restrictions on developer borrowing, dialing back the stringent “three red lines” policy that exacerbated one of the biggest real estate meltdowns in the country’s history.

Separately, the PBOC announced that first-time homebuyers would be offered lower mortgage rates if new home prices fall for three consecutive months. Building materials and home appliance stocks gained as a result. New energy names, especially solar names, also rebounded as several Chinese solar panel manufacturers are temporarily boosting output on strong order demands and falling cost of materials. On the flip side, retailers, agriculture and coal names underperformed.

In economic news, the PMI data for manufacturing and non-manufacturing in China fell in December. Overall, the composite PMI fell to 42.6 from 47.1 in November, marking the biggest decline since February 2020, before the COVID-19 outbreak. The fall in economic activity was largely attributed to the surge in infections after China abandoned its zero-tolerance approach in early December.

Meanwhile, data from a private survey showed China’s manufacturing, services, and property sectors weakened sharply in the fourth quarter of 2022 due to virus-related disruptions, raising the prospect that the economy may have contracted in the final months of last year.

Week ahead

Holidays            

Monday 9 January:  Japan

Key events:

Monday 9 January: Germany Industrial Production

Thursday 12 January: US Consumer Price Index (CPI)

Friday 13 January: UK Monthly gross domestic product (GDP); Euro-Area Industrial Production

Monday 9 January

• Germany Industrial Production
• EMU Sentix Investor Confidence
• US Consumer Credit
• Japan Tokyo CPI

Tuesday 10 January

• UK BRC Sales Like-For-Like
• France CPI EU Harmonized/Ex-Tobacco Index
• US Wholesale Trade Sales/Inventories
• Australia CPI

Wednesday 11 January

• Germany Wholesale Price Index
• US MBA Mortgage Applications
• China CPI

Thursday 12 January    

• UK RICS House Price Balance
• Germany Current Account Balance
• US CPI/Ex-Food and Energy/CPI Index NSA/Core Index SA; Real Avg Hourly/Weekly Earnings;  Initial Jobless/Continuing Claims; Monthly Budget Statement
• China Trade report

Friday 13 January

• UK Monthly GDP
• Sweden CPIF Inflation
• Euro-Area Industrial Production
• Germany GDP NSA, Budget Maastricht % of GDP
• US Import Price Index/Ex-Petroleum; Export Price Index

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