Notes from the Trading Desk – Europe

The digest

The MSCI World Index finished last week down 0.1%, but the regional moves underneath were mixed. The Stoxx Europe 600 outperformed again, up 1.4% last week, whilst the S&P 500 Index closed down 0.3% and the MSCI Asia Pacific was down 2.2.¹

Investors seemed concerned about how sticky inflation is proving to be, leading the market to adjust its terminal rate expectations both in the United States and Europe. Inflation reports, as well as hawkish central bank commentary, kept markets in check on what was generally a quiet week for newsflow and market volumes. Market commentary was focused on a potential market pullback, given the move in stocks vs. yields (based on previous correlations) and the seasonality factor of the latter half of February (one of the weakest periods of the year for stock market performance). But, with investors still generally underweight stocks and overweight cash, there is still plenty of push and pull in these markets.

According to Bank of America’s “Flow Show” report, inflows resumed in European equity funds, with another US$1.5 billion invested. US equity funds saw further outflows, shedding US$2.2 billion, while bond funds saw their largest inflows in six weeks of $5.5 billion, notching their best start to a year since 2004.²

Sticky inflation and hawkish central banks

Equity market moves since the fourth quarter of last year would suggest there is plenty of optimism for a notable slowdown in inflation over the coming months. In theory, this should lead central banks to pare back on their latest hiking cycles. However, central bankers have been working hard to manage market expectations, with many doubling down on hawkish rhetoric to keep those expectations realistic. Recall, at the start of the month, the Federal Reserve (Fed) raised interest rates by a further 25 basis points (bps) to 4.75%, whilst the European Central Bank (ECB) and the Bank of England both opted for 50 bps hikes, to 2.5% and 4.0% respectively.

The market has been anticipating a policy pivot from the Fed, with the view that the US economy would not be able to cope with the pace of hikes and the Fed would need to pare back to offer support and avoid a recession. Yet, last week’s macroeconomic data releases did not support the view that this pivot is forthcoming.

The latest US Consumer Price Index (CPI) and Producer Price Index (PPI) reports showed inflation is not decelerating as quickly as the market expected and hoped. Year-on-year inflation to January came in at 6.4%, higher than anticipated. The PPI report came in strong too, showing a year-on-year increase of 6%. In addition, the prices paid component of the Empire Manufacturing survey rose to 45.0. Importantly, US retail sales came higher than expected at 3%, indicating that the US consumer remains strong. Also, the weekly initial jobless claims report showed low levels of layoffs, reinforcing the tight labour-market conditions.

These data releases triggered a slew of hawkish Fedspeak. For example, Fed Governor Michelle Bowman (voter) said the Fed still needs to see a consistent decline in inflation; interest rates were not high enough and she doesn’t see the rate hikes slowing the economy.

Market rate expectations moved last week to closer align with the Fed’s “dot plot” forecast. The market now expects a Fed terminal rate of 5.298% vs. 5.2% in the week prior and 4.904% a month ago. The 450 bps of hikes in the last 11 months represents the sharpest hiking cycle in decades. Also, the 10-year Treasury yield reached its highest level since the start of the year, whilst the two-year/10-year spread plunged to its lowest level since 1981.

The US dollar rallied through most of the week before pulling back into the close on Friday. For US equity markets, these developments led to a notable selloff in energy stocks. Given the higher rate expectations, real estate stocks also struggled last week. Note, the Fed’s meeting minutes from the 31 January–1 February meeting will be released on Wednesday this week and should help paint a picture on the rate-hike path.

There were also a series of hawkish comments from ECB members last week. ECB Executive Board Member Isabel Schnabel said there is a risk that markets underestimate inflation as well as the response from the ECB. She said: “They assume inflation is going to come down very quickly toward 2% and it is going to stay there, while the economy will do just fine. That would be a very good outcome, but there is a risk that inflation proves to be more persistent than is currently priced by financial markets”.³ She also noted that “we are still far away from claiming victory” and that the ECB may have to act “more forcefully”.

Recall, a 50 bp hike for March is all but confirmed, and ECB President Christine Lagarde reiterated that thinking last week to counter “underlying inflation pressures”.⁴ Markets now expect a terminal rate of 3.6% in October vs. 3.528% one week ago and 3.33% one month ago.

Week in review

Europe

European equities finished higher last week amidst relatively quiet newsflow and market volumes. European stock markets remain resilient despite continued inflationary pressure and central bank hawkishness, with short covering still a driving factor. The UK FTSE, the German DAX and the French CAC indices all hit new all-time highs throughout the week (in local currency terms).

The year-to-date rotation was evident again last week, with cyclicals outperforming defence stocks. Aero and defence stocks outperformed last week, with some supportive headlines around NATO defence spending driving gains. Travel and leisure stocks were also higher last week, amidst a strong showing from European airlines and the news that Flutter was considering a US listing.

Telecommunications stocks were also strong, rallying on better-than-expected earnings from Orange and news that Liberty Global has taken a 5% stake in Vodafone. Construction and materials stocks were up overall as cyclicals continue to outperform. In terms of the laggards, oil and gas gave back some of the previous week’s gains. Oil prices have fallen for a few reasons, including the year-to-date trend in seasonal larger builds, weaker refining margins, a shift in risk sentiment, higher-than-expected Russian exports and a firming dollar. Real estate stocks were also weaker last week, with rates now expected to be higher for longer.

In terms of data, UK Consumer Price Index (CPI) fell in January to 10.1% from 10.5% in December. Falling petrol prices, alongside easing prices in eating out, drove declines. The UK labour market continues to look strong, with average weekly earnings up 6.7% on the year to January.

It wasn’t a market-moving headline, but Nicola Sturgeon, leader of the Scottish National Party, announced her intention to resign as First Minister of Scotland. Sturgeon has been a fairly significant political force behind the pro-independence movement, so her departure should result in a reduction in UK political risk.

United States

US equity markets traded in a tight range last week, as investors focused on macro data and Fedspeak   Thursday stood out as a tough day for markets. The S&P 500 Index fell 1.38%, its worst day in a month as stubbornly high inflation data saw Fed rate expectations adjusted higher. In that context, the US 10-year Treasury yield reached its highest level since the start of the year, and the two-year/10-year spread plunged to its lowest level since 1981.

West Texas Intermediate crude oil fell 4.2% due to a sharp increase in US stockpiles, which rose by nearly 11 million barrels last week—the largest increase in five weeks. The US plans to sell 26 million barrels of crude from the strategic petroleum reserve, with deliveries estimated to occur between April and June, further increasing supply. With that, energy was the worst-performing sector last week.

Looking at geopolitics, relations between United States and China remain fraught as Chinese spokesman Wang Yi described Washington’s decision to shoot down a Chinese balloon as “absurd and  hysterical”,⁵ and US Secretary of State Antony Blinken said the object’s entry in US airspace was “irresponsible”. However, Blinken did state the United States is “not looking for a new Cold War”.⁶

Asia Pacific (APAC)

Asian markets were weaker last week, with Hong Kong’s benchmark down 2.22%. The only markets in the green were India (+0.44%) and Indonesia (+0.22%). Hedge funds were taking profits in APAC equities again, with local China shares (for the second consecutive week) and Hong Kong primarily driving the sales. Net flows in Japan were fairly muted with Ueda’s formal nomination seemingly having little impact on hedge fund sentiment in the market.

In Hong Kong, concerns escalating from US-China geopolitical tensions negatively impacted market sentiment. Pharmaceutical names were under pressure, and Chinese property stocks also retreated after an onshore article commentary warning the government to avoid overheating in tier-1 cities’ property market when implementing supportive measures. Airline stocks outperformed as the January operating data from three major Chinese airlines showed a strong recovery in the industry; passenger traffic posted high double-digit growth.

China’s mainland market closed down 1.12% last week as foreign inflows slowed down, again on the back of US-China geopolitical tensions, while domestic institutions continued to emphasise sector rotations.

Growth stocks continued to underperform, as the global demand outlook is gloomy, whereas value stocks are typically favoured when the onshore monetary outlook is dovish. Prices for new homes in China climbed in January, breaking a 16-month slide, as demand improved post the relaxation of COVID-19 restrictions.

The monetary policy outlook is the key focus in the region this week, after President Xi made a speech on Tuesday indicating a domestic demand spur, including housing and spending. Local media are reporting that China may request that banks cut mortgage loan rates for existing home buyers to increase affordability to households. Sector-wise, food and beverage stocks outperformed post Xi’s vow to boost domestic consumption. Oil stocks also rose with aid from a dovish People’s Bank of China (PBOC).

Renewables and semiconductors underperformed, as the market was concerned about China/US relations after the Iranian president’s visit.

Japan’s equity market closed lower in a week dominated by earnings, whilst on Friday stocks followed US shares downwards after hawkish commentary from Fed officials. Japan’s economy rebounded less than expected over the final quarter of last year, dampening market sentiment. The nomination of Kazuo Ueda as the next Bank of Japan (BoJ) governor prompted further speculation about the future trajectory of the central bank’s monetary policy. The market is focused on any hints of monetary policy tweaks as Ueda prepares to take the helm in April, when incumbent BoJ Governor Kuroda’s term finishes.

While Ueda has downplayed changes to BoJ’s ultra-loose stance anytime soon, his previous comments and actions suggest a more balanced tone, with consideration of the risks from excessive easing as well as the importance of reaching the 2% inflation target sustainably (with a focus on wage growth).

Looking at sectors, steel stocks dominated the gainers last week, followed by rubber stocks and shippers, while precision instruments, services, and electric appliances  lagged.

Week ahead

Holidays            

Monday 20 February: United States and Canada

Thursday 23 February: Japan

Euro-area key events

Monday 20 February: Sweden CPIF Inflation

Tuesday 21 February:  Euro-area Flash Composite PMI; UK Flash Composite PMI; Germany ZEW Expectations Survey

Wednesday 22 February:  Germany Ifo Expectations Survey

Thursday 23 February:  Euro-area final CPI inflation

Friday 24 February: Germany gross domestic product (GDP) and consumer confidence

Monday 20 February

• Reserve Bank of Australia meeting minutes
• Netherlands Consumer Confidence Index
• Sweden CPI
• Eurozone Construction Output
• Eurozone Consumer Confidence
• Riksbank minutes

Tuesday 21 February

• Euro-area Flash Composite PMI Survey
• UK Flash Composite PMI Survey
• Germany ZEW Survey
• Riksbank’s Ohlsson speaks
• UK Public Finances (PSNCR)
• Switzerland Swiss Watch Exports
• Eurozone EU27 New Car Registrations
• France S&P Global Manufacturing & Services PMI
• Germany S&P Global/BME Manufacturing & Services PMI
• US Existing home sales
• Canada CPI

Wednesday 22 February

• Reserve Bank of New Zealand preview
• Riksbank’s Thedeen speaks
• Germany Ifo Survey
• Germany CPI
• France Manufacturing Confidence
• Italy CPI EU Harmonized
• US FOMC minutes

Thursday 23 February   

• Euro-area final CPI inflation
• BoE’s Mann & Cunliffe both speak
• Norway Unemployment Rate Trend
• UK CBI Retailing reported sales
• US GDP
• US KC Fed manufacturing survey
• Fed’s Bostic speaks

Friday 24 February

• Japan national CPI
• BoE’s Tenreyro speaks
• UK Consumer Confidence
• Germany GDP & Consumer Confidence
• France Consumer Confidence
• Spain Producer Price Index (PPI)
• US Personal Consumption Expenditures prices & personal income
• US new home sales

Views you can use

Anatomy of a Recession: The Fed’s job problem

A review of the US economy with focus on the Federal Reserve (Fed), labor and housing with Jeff Schulze, investment strategist at ClearBridge Investments. Read more. 

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1. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

2. Source: Bloomberg, “BofA Says Says Hard Landing to Hit Stocks in Second Half.” 17 February 2023.

3. Source: Bloomberg, “Schnabel Says ECB Is Far From Victory Over Inflation: Interview,” 15 February 2023.

4. Source: Reuters, ECB to keep raising rates to tame price pressures, Lagarde says,” 15 February 2023.

5. Source: New York Times. “A top Chinese official calls the U.S. balloon response ‘hysterical’ and says the war in Ukraine must not continue”. 18 February 2023.

6. Source: Time, ‘We’re Not Looking for a New Cold War’: Biden to Speak With Xi to Deflate Ballooning Tensions,” 17 February 2023.