Notes from the Trading Desk – EuropeJun 3, 2019

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.

notes from the trading desk europe

Trade continued to dominate the headlines last week and sentiment was weak. The impact was felt globally, with stock markets in the United States, Europe and Asia all closing the week lower. Mainland China was the bright spot, with reports of state-sponsored buying explaining the move despite soggy macro and negative sentiment.

The lower yield environment and risk-off sentiment supported the relative outperformance of defensive sectors. Meanwhile, oversold cyclicals (such as industrials and basic resources) were the worst performers, along with the banks.

The Digest

Trade Concerns Dominate Investor Sentiment

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Trade impacted sentiment throughout last week. US President Donald Trump said that he was not yet ready to strike a deal with China, and in response a prominent Chinese state newspaper said the US should not underestimate China’s ability to fight a trade war. Notably, it used a Chinese phrase that means: “Don’t say I didn’t warn you”.

Focus last week fell on so-called rare-earth minerals, with China threatening to throttle the US supply. These materials are used in components for a wide variety of products including electronics, hybrid vehicles and energy storage systems. Importing from China is cheaper than producing domestically in the US and so the impact of this move could be dramatic.

Away from the conflict with China, the big news last week was an announcement from the US that it intends to invoke 5% tariffs on all imports from Mexico, rising to 25% by October, until perceived border security deficiencies are resolved.

The US Treasury also put nine countries on a watch-list for currency manipulation—Ireland, Italy, Vietnam, Singapore, Malaysia, China, Japan, South Korea and Germany. The US Treasury stopped short of naming any as currently a manipulator, but its concerns have been made clear and this will do little to help global tensions.

The impact of the geopolitical tensions on US macro data is being felt too: US first-quarter gross domestic product (GDP) data was revised lower last week. The downgrade was not as much as had been feared, but still points to data looking less impressive than we had become used to. Core personal consumption expenditure (PCE) inflation also remained low on a year-on-year basis and pending home sales unexpectedly declined in April.

With this, we think the chances of a US Federal Reserve (US Fed) rate cut have increased and yields continue to feel the pressure. The probability of a rate cut this year according to the Fed funds futures is now at 98% and a number of investment banks have turned more dovish in their forecasts, with some predicting two rate cuts this year.

Some commentary suggests that if tariffs on Mexico are raised all the way to 25%, the US Fed may need to cut by more than 0.5% in 2019.

Against this backdrop, the US 10-year Treasury yield dropped 0.19% and hit its lowest mark since September 2017, in what was its fourth week of declines.

In fact, the entire Treasury curve from 10-year to 2-year yield is below the Fed’s policy rate and the yield curve from three months to 10 years touched the most inverted level since 2007, with some commentators concerned that this is pointing towards a recession.

Europe Under Scrutiny as Politics and Macro Weigh

Trade wars are clearly weighing globally on markets, but Europe has been feeling the pain for some time. With worries over growth and concerns over politics in the UK and on the continent, European equities have struggled to attract investors.

The uncertain political landscape showed no sign of improvement following last week’s European Parliament elections.

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For the United Kingdom, the strong result for the Brexit party has led to an increase in the chance of a hard (no-deal) Brexit. We now expect the ruling Conservative Party will be under pressure to harden its stance on Brexit as it searches for a new leader.

We feel it’s also important to note the risk of a Jeremy Corbyn-led Labour government in the event of a UK general election. This would likely be taken badly by markets, given his left-leaning policies and the possibility of the nationalisation of services.

A number of data points clearly demonstrated the impact of Brexit last week: notably UK car manufacturing plummeted, with production in April slashed by almost a half after factories shut down in an effort to cope with disruption from the original March 29 exit date.

Italy and Greece Back in the Headlines

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In Italy, the results of the European Parliament election increase the chances of a new general election.

Deputy PM Matteo Salvini, whose Lega party performed strongly in the vote, has said he wants to keep Italy’s fractious coalition government going. However, he also made clear that he is prepared to see it collapse if he cannot push through his flat tax plans and other priority measures.

His flat tax proposal and a planned unwind of pension reform could further exacerbate Italy’s GDP/debt ratio. The ratings agencies would also likely take a dim view.

The European Commission (EC) wrote to the Italian government last week warning Italy was in breach of the bloc’s debt rules. The EC confirmed that it would take the first step in a disciplinary process that opens up the risk of financial penalties.

On Friday, the yield on the Italian five-year bond rose above the Greek equivalent for the first time since 2008. As well as political concerns, lacklustre growth for the Italian economy and the concerns over the debt ceiling have seen investors sell Italian bonds, pushing yields higher.

On the other hand, investors have started to move into Greek debt once again as the country emerges from its recent economic turmoil, and the Greek 10-year yield fell to a record low.

Looking at equities, Greece was also the best-performing country in Europe last week, up significantly after the European Parliament elections triggered a decision from Prime Minister Alexis Tsipras to move towards a snap election. His leftist party suffered heavy losses.

ECB Meeting Preview

Given how unloved Europe is feeling, there are a few potential catalysts to look out for this week. On the macro front, we expect inflation data from the eurozone tomorrow and purchasing manager index (PMI) data on Wednesday.

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The big event will be the European Central Bank (ECB) meeting and subsequent press conference on Thursday.

While we expect the ECB to keep rates and forward guidance unchanged, the focus will be on the details of the new round of liquidity operations for banks (TLTRO-III).

European banks have had a tough year and clarity on the conditions of the new round of liquidity operations have the potential to give the beaten-up sector a boost. Given the weaker economic activity and concerns over trade wars, there is a chance that the conditions attached to the programme will be relatively generous.

Last Week

Europe

European equities were broadly weaker last week as political uncertainty continued in the region. In terms of sectors, there was an overall defensive tone. Banks, healthcare and basic resources lagged. Meanwhile, telecommunications and media were the only two sectors to trade higher on the week.

In terms of data, French consumer confidence surprised on Tuesday, coming in ahead of expectations. Also, eurozone economic confidence also rose in May, beating expectations. On Wednesday, French data was mixed. First-quarter GDP grew 1.2% on the year, ahead of the 1.1% rise expected. German unemployment rose for the first time since 2013, hitting 5%. Spanish and German inflation also disappointed in May, which sets the tone ahead of the eurozone release on Tuesday this week.

Americas

US equity markets fell as the week went on as trade tensions continued to grip investor sentiment. Energy stocks lagged with oil prices down nearly 9% on the week. Retailers lagged, not helped by a series of poor earnings releases, while financials were dragged lower with the dip in yields. Real estate investment trusts (REITs) outperformed but were still down on the week.

In terms of data, inflation was firm in April. Meanwhile, consumer confidence came in ahead of expectations. Consumer spending was revised slightly higher, however first-quarter GDP was revised down, but not by as much as anticipated.

Asia

Asian equities were weaker overall last week. Despite trade tensions weighing on global markets, Chinese shares finished higher for the first time in six weeks supported by gains for Chinese autos amid reports the government would be looking at ways of boosting domestic car sales.

Japanese equities lagged the other major Asian indexes, as Japanese autos lagged after a President Trump tweet about tariffs in Mexico. Many Japanese car manufacturers have operations there.

Aside from the prevailing global trade headlines, Asian markets were light on macro themes last week.

Look Out For... (June 3-10):

Monday, June 3

  • Holiday in New Zealand

Tuesday, June 4

  • Reserve Bank of Australia Interest Rate Decision Link
  • Eurozone May Consumer Price Index Link
  • Eurozone April Unemployment Rate Link

Wednesday, June 5

  • Holiday in Singapore and India
  • Australia First-Quarter Gross Domestic Product Link

Thursday, June 6

  • Holiday in South Korea and Sweden
  • European Central Bank Interest Rate Decision Link
  • Eurozone First-Quarter GDP Link
  • US April Trade Balance Link
  • Canada April Trade Balance Link

Friday, June 7

  • Holiday in Hong Kong and China
  • German April Industrial Production Link
  • German April Trade Balance Link
  • US May Unemployment Rate Link
  • Canada May Unemployment Rate Link

Monday, June 10

  • Holiday in Australia, Switzerland, Norway and Germany
  • Japan First-Quarter GDP Link
  • UK April Manufacturing Production Link
  • UK April Trade Balance Link
  • US Job Openings and Labor Turnover Survey Published Link

Week Ahead

Politics

  • President Trump’s visit to the UK will no doubt receive a lot of media attention at the start of this week. His comments regarding Nigel Farage and Boris Johnson have already created some controversy ahead of his arrival. After the UK, Trump moves on to France later in the week.
  • Any trade war commentary will remain a key driver for sentiment.
  • On Friday June 7, Theresa May officially resigns as UK prime minister but she will remain in the role until the Conservative Party appoints a new leader.
  • A G7 Finance Ministers and Central Bank Governors meeting takes place in Fukuoka, Japan on Friday ahead of G20 Finance Ministers and Central Bank Governors meeting running Saturday to Sunday.

Macro Data

  • Tuesday: Euro area: (May) consumer price index (CPI), (April) Unemployment rate; US: (April) Factory orders
  • Wednesday: Global (May) All-industry PMI
  • Thursday: Euro area first-quarter GDP; Germany (Apr) Manufacturing orders
  • Friday: German Industrial Production

Central Banks

  • In the US, there are a number of Fed speakers through the week, but the highlight will be Fed Chair Jerome Powell speaking on Tuesday at the Fed Framework Conference. The Fed Beige Book is released on Wednesday.
  • The focus in Europe will be on the ECB decision on Thursday.
  • In Asia, The Reserve Bank of Australia (RBA) meets tomorrow for a rate decision, with the market pricing in a 99% chance of 0.25% rate cut (current rate is 1.5%).

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of June 3, 2019, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton Investments. 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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