Notes from the Trading Desk – Europe

The digest

Last week was tricky for equity markets, which lost ground on fears inflation was proving stickier than anticipated and central banks would keep rates higher for longer as a result. The catalyst was some hotter-than-expected inflationary data and a more hawkish set of minutes from the most recent Federal Reserve (Fed) meeting. With that, bond yields climbed sharply—the US two-year Treasury yield rose to its highest level since 2007 and European bond yields also moved sharply higher. In this environment there was a clear “risk-off” trade. The MSCI World Index declined 2.6%, the S&P 500 Index declined 2.7%, the MSCI Asia Pacific Index declined 2.4% and the STOXX Europe 600 Index declined 1.4%.¹

The week in review

United States

The S&P 500 Index saw a third consecutive weekly decline, as hotter Personal Consumption Expenditures (PCE) inflation data brought increased concerns of a hawkish Fed. With the move lower, the S&P 500 Index fell through 4000 and looks to be nearing support at its 200-day moving average, a key technical marker.² Other US indices also saw declines, with the Nasdaq 100 Index down 3.1%, its second-worst weekly performance of the year, and the Russell 2000 Index was down 2.9%.

Inflationary fears in focus: Last week saw some key datapoints signal inflation may be proving stickier than hoped. The US January Purchasing Managers Index (PMI) Service data set off some alarm bells early in the week, as the prices-charged component saw an increase versus the prior month and logged its highest reading since October 2022. Furthermore, on Friday, the January PCE data headline reading saw a year-over-year (y/y) gain of 5.4%, also higher than the prior month. The Core PCE reading rose 4.7% y/y. This is one of the Fed’s favoured gauges for monitoring inflation; hence the market sold off sharply on this data.

On Wednesday, the minutes from the last Fed policy meeting were released and had a slightly hawkish tone. They showed some members warning that “insufficiently restrictive” policy could stall progress on moderating price pressures, suggesting the Fed is prepared to tighten interest rates beyond its December forecast of a 5.1% peak.

With all this, by the end of the week Fed fund futures has priced in peak rates of 5.40% in July, up from 5.283% in July at the end of the previous week. Derivative markets are now implying a 40% probability of rates topping 5.5% after the Fed’s July meeting.³ A month ago, traders had practically ruled out that possibility. The market’s inflation expectations have seen a notable increase, with the two-year breakeven now back to levels last seen in summer 2022.⁴

In a risk-off market, it was not surprising to see consumer discretionary and communications services stocks as the worst-performing sectors. The energy sector was the only one in positive territory last week as crude oil stabilised.

Unsurprisingly, investor sentiment has waned, with the CNN Fear & Greed index now almost back in “Neutral” territory, having been in “Extreme Greed” just a couple of weeks ago.⁵

Europe

European equities traded lower last week following a late selloff on Friday. The market shifted into risk-off mode on Friday following the US PCE data, which showed that inflation remains sticky. European equities closed lower overall, and European-focused equity funds logged a small outflow this week, shedding US$50 million.⁶

Cyclicals underperformed defencives last week. Media stocks rallied on positive earnings reports. Defencive sectors made up most of the outperformers, with food and beverage stocks slightly higher while utilities and telecomms were slightly lower. At the other end, basic resources closed the week with sharper losses for a number of reasons, but drivers included profit-taking on the China reopening trade as well as US dollar strength. Also, earnings in that space have been disappointing, with most of the main players trading lower after reporting earnings. Real estate stocks closed lower last week amidst the higher rate environment.

There was a flurry of macroeconomic data in Europe last week. Eurozone PMIs came in stronger-than-expected, mainly driven by services, with manufacturing a touch weaker. January Flash Composite PMIs came in at 52.3, slightly higher than expected, with Services at 53.0 and Manufacturing at 48.5. UK PMIs were also strong; the Composite figure came in at 53.0, while Services was at 53.3 and Manufacturing at 49.2. UK Consumer Confidence rose more than expected in February, coming in at +7, the largest month-over-month increase in almost two years.

Looking beyond the equity market, there have been some extreme moves in sovereign yields, with the market repricing a more hawkish central bank path. In the United Kingdom, two-year gilt yields climbed sharply, rising 15 basis points (bps) to 4.03%, the highest level since October. Also, German two-year yields rose as much as 15 bps to above 3.06% (the first time above 3% since 2008). Money markets now are pricing the ECB deposit rate to peak at around 3.85% later this year, compared to a terminal rate of around 3.5% predicted at the start of the year.⁷

This week also marked the one-year anniversary of Russia’s invasion of Ukraine. From a market perspective, over the last year, investors have moved notably into cash and have sold down bonds. Fund flows since February 2022: US$354 billion to cash, US$40 billion to equities, US$12 billion from gold, US$135 billion from bonds.⁸

Asia

Asian equities traded lower overall last week, despite missing the global market selloff on Friday. Hong Kong’s Hang Seng was particularly weak, down 3.4%. The Shanghai Composite outperformed, up 1.3%.

The main theme for markets was around increasing global rate-hike expectations, but the speed of China’s COVID-19 reopening also weighed on markets last week. Metals prices fell as concerns rose that China isn’t reopening as quickly as was hoped, and there are signs of COVID restrictions being reintroduced. Several schools were closed across China last week to prevent the spread. With that, copper and aluminium stockpiles are building in China. Also, the Yunnan province announced another round of production cuts to stabilise power supplies as the province’s hydro-electric grid struggles to cope with a prolonged drought and low reservoir levels.

Stocks in Hong Kong logged a fourth weekly loss, with earnings weighing on the market. Technology stocks plummeted following disappointing earnings from Alibaba and NetEase. There was also a headline that JD.com is planning a subsidy campaign, which will cause a surge in competition, threatening margins and spooking investors.

In Japan, Bank of Japan (BoJ) Chair nominee Kazuo Ueda addressed the Diet. His comments appeared to be reassuring, suggesting there would be no dramatic changes to loose BoJ monetary policy.

The week ahead

The United Kingdom will be in focus today as Rishi Sunak and Ursula von der Leyen meet for final talks ahead of an expected announcement of a post-Brexit settlement. Later in the week, the European Central Bank (ECB) meeting on Thursday will be a focus. A 50 bp rate hike is expected, with ECB President Christine Lagarde recent stating that there’s every reason to believe another would be coming in March.

Monday 27 February    

• Euro area: EMU: Retail Sales NSA
• Euro-area Credit Data
• US Durable Goods Ex-Transportation/Cap Goods Orders Nondef Ex-Air (Jan)

Tuesday 28 February

• Sweden fourth quarter gross domestic product
• France HICP Inflation
• Spain HICP Inflation
• US Advance Goods Trade Balance, Retail/Wholesale Inventories, House Price Purchase/FHFA House Price Index

Wednesday 1 March

• UK Nationwide House Price Survey; UK Mortgage Approvals
• Germany HICP Inflation
• US Construction Spending; MBA Mortgage Applications
• China PMI

Thursday 2 March   

• Euro-area Flash CPI Inflation
• Italy HICP Inflation
• ECB Monetary Policy Account
• UK Decision Maker Panel Survey
• US Unit Labour Costs, Nonfarm Productivity, Initial Jobless/Continuing Claims (Feb)

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