Notes From the Trading Desk – EuropeFeb 4, 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 trading desk europe

The Digest

Last week saw equity markets successfully navigate some notable events to end the week with positive performance. We had a dovish stance from the US Federal Reserve (Fed) meeting, encouraging US/China Trade talks, and yet more noise from the United Kingdom around Brexit. On the week, the S&P 500 Index gained 1.6%, the Eurostoxx 600 Index 0.5%, and the MSCI Asia Pacific Index 0.9%.1

Fed’s Pivot to a Dovish Stance Complete

Last week’s Fed meeting saw the US central bank strike a dovish tone, as the commentary suggested interest rates are on hold for now given the financial conditions and muted inflation pressure. In addition, the Fed also softened commentary on the size of its balance sheet, suggesting that it was comfortable with a large balance sheet for now.

On interest rates, the Fed dropped the following commentary from its December statement: ‘Some further gradual increases in the target range for the fed funds rate will be consistent with sustained expansion of economic activity, strong labour market conditions, and inflation near the Committee’s symmetric 2% objective.’ That language was replaced with ‘in light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.’

The general market interpretation is the Fed is now essentially on hold in terms of raising interest rates, which is a significant departure from the message sent as recently as December.

In addition, the Fed released a comment on its balance sheet, noting 1) monetary policy will be implemented in a regime with an ample supply of reserves and 2) the Committee can adjust the size and composition of the balance sheet in light of economic and financial developments. Again, this is more dovish than some expected, especially given commentary from Fed Chair Jerome Powell in December that the runoff of the balance sheet had ‘served its purpose’.

On the back of all this, we saw a drop in Treasury yields. As of this writing, the market is now pricing in a probability of less than 5% by December 2019, down from nearly 40% at the end of last week.2

This completes a memorable pivot by the Fed from back in October, where you will recall the hawkish commentary from Powell was a significant factor in sparking the fourth-quarter selloff.

With that, the Fed seems set for a dovish path for the foreseeable future.

Amongst other positive macro releases last week, we saw a very strong January non-farm payroll number in Friday’s US employment report, showing 304,000 jobs added (versus an estimated 165,000). The market view appears to be that this was not enough to change the Fed’s view, however. Indeed, Fed speaker Kaplan commented after that data the Fed decision was ‘absolutely right’.

Brexit Update: May to Go Back to EU Again

Last week’s Brexit events saw us essentially back to where we have been before, with Prime Minister Theresa May set to go back to the European Union (EU) to try and negotiate concessions on the ‘Irish Backstop’ issues—that is, avoiding a hard border between Northern Ireland and the Irish Republic.

On Tuesday, Theresa May successfully negotiated a number of parliamentary votes on proposed amendments to the UK’s Brexit plans. Only two amendments were passed, the Brady amendment to seek ‘alternative arrangements’ for the Northern Ireland backstop and the Spelman amendment to prevent a “no-deal” Brexit by adding to the prime minister’s motion that Parliament ‘rejects the United Kingdom leaving the EU without a Withdrawal Agreement and a Framework for the Future Relationship’.

This shows us that the majority in parliament remain against a hard Brexit, but crucially the passing of the Brady amendment gives Theresa May grounds to go back to Europe and fight for concessions on the Irish Backstop and legitimately suggests to us that her plan could pass if she gets something on this issue.

For its part, Europe has been reluctant to give any concessions, with European Parliament’s Brexit Coordinator Guy Verhofstadt stating that he doesn’t think there’s room to reopen the pact, but ‘there is a possibility to discuss the future relationship.’ In addition, Irish politicians have been vocal in their defence of the Irish backstop arrangement.

Looking ahead, May has asked Brexit Secretary Stephen Barclay to come up with suggestions for ‘alternative arrangements’ to the Northern Ireland backstop. May is expected to travel to Brussels for further talks this week.

On the economic front, we would note that much of the European macro data continues to be soft, so for all the hard-line rhetoric, we think there is a desire to avoid a damaging hard Brexit. Over the course of last week, we saw the following:

  • Eurozone fourth-quarter gross domestic product (GDP) was revised lower to 1.2% year-over-year from 1.6% and inflation data from the region was lacklustre.
  • Italy’s economy fell into a technical recession at the end of 2018 as fourth-quarter GDP came in at -0.2% on a quarter-over-quarter basis.
  • European Central Bank (ECB) President Mario Draghi alluded to this in a speech saying that incoming data continues to be weaker and risks have “moved to the downside.”

This Week

Europe

European equities closed the week higher overall on what was a relatively quiet week for newsflow in the region. Most of the positive sentiment around equities stemmed from dovish central bank commentary. Much of the focus elsewhere was on corporate earnings as the pace picks up. By the end of last week, just over 17% of companies in the STOXX Europe 600 Index had reported. The broad economic slowdown in Asia as well as the weakness in Europe itself is being largely cited as the reason for relative weakness in the results so far. The euro was stronger on the week as the US dollar weakened.

Bank stocks were notable laggards last week as dovish central-bank sentiment took hold. With EU fourth quarter GDP revised lower, we think the ECB’s dovish stance is likely to persist. We also saw reports suggesting the ECB was pressuring European banks to alter the way they treat bad debt to improve the wellbeing of the European banking system.

On Thursday of last week, we received confirmation that the Italian economy is in recessionary territory, putting the government’s budget plan at risk. The technical recession is the first in the country since 2013.

Meanwhile, the political landscape in Italy has become more uncertain, with many calling for an early election. The Northern League are seeing support grow and party supporters are encouraging leader Matteo Salvini to call an early election, allowing them to oust their coalition partners, Five Star. If Salvini is able to gain more control, then he would likely be able to push forward with tax policies that his Five-Star counterparts have blocked with their own promises of increased welfare benefits.

In terms of macro data, as mentioned, eurozone fourth-quarter GDP was revised lower and inflation reports on the continent were also weak. Eurozone manufacturing indexes recorded their slowest pace of expansion in four years, but we did see reports of solid growth in France and Spain.

Americas

Look Out For... (February 4-11):

Monday, February 4

  • Week-Long Holiday in China—Chinese New Year
  • Holiday in South Korea (Feb 4-6)
  • Markets Close Early in Hong Kong and Singapore
  • Reserve Bank of Australia Interest Rate Decision Link
  • Australian December Trade Balance Link
  • Italian January Consumer Price Index Link

Tuesday, February 5

  • Holiday in Hong Kong (Feb 5-7)
  • Holiday in Singapore (Feb 5-6)

Wednesday, February 6

  • US November Goods Trade Balance Link

Thursday, February 7

  • German December Industrial Production Link
  • Bank of England Interest Rate Decision Link

Friday, February 8

  • Reserve Bank of Australia Monetary Policy Statement Link
  • German December Trade Balance Link

Monday, February 11

  • Holiday in Japan
  • UK December Trade Balance Link

All major US indices ended last week higher, amid a number of catalysts. The dramatically dovish Fed was a key driver, as discussed, and we also saw some solid macro and optimism around trade talks. In addition, earnings season is in full swing with company results not as bad as many had feared.

Last week, senior officials from China and the United States met in Washington to discuss trade and on Thursday afternoon President Donald Trump sounded encouraged as he spoke from the Oval Office with Chinese Vice Premier Liu He. Liu He said he is hopeful of a deal, adding that he hopes to accelerate the 90-day timetable. Further commentary from Chinese officials suggested that trade talks made important progress, with China vowing to buy substantially more agriculture and energy goods from the United States. They also said that they will aim to improve cooperation on intellectual property protection.

The remaining question at this point is when Washington and Beijing will lift tariffs—it is currently uncertain whether this will happen immediately or only after China has demonstrated compliance with its pledges. It is also worth noting that outside of the progress made in Washington, the United States charged China’s Huawei Technologies, its CFO, and two affiliates with bank and wire fraud to violate sanctions against Iran, so tensions remain.

With the US government shutdown now over, it is comforting to note that another shutdown is looking very unlikely. On Thursday night of last week, Trump hinted that he is leaning towards declaring an emergency and attempting to appropriate funds from an existing budget for his wall if a deal isn’t struck by the 15th of February. In our view, such an action is unlikely to impact markets near term, however, so it seems we can move on from this for the time being.

The US is now halfway through its earnings reporting season, with S&P 500 Index company earnings so far surprising on the upside.

Asia

Markets in the Asia-Pacific region were mostly stronger last week, with equities in mainland China and Hong Kong outperforming amid trade-talk optimism. Australia was the exception, trading down on the week as the weakness in financials stocks weighed on the market, alongside some disappointing economic data.

The macro data from the region was mixed, with flash manufacturing purchasing manager indexes (PMI) weaker across the board. And, we saw more evidence of a slowdown in China. Credit accessibility to small-and-medium enterprises remains a key challenge to the Chinese economy, with investors looking for a solution to this to help restore confidence and potentially instigate a rebound in industrial activity. Looking at components, weakness of domestic demand has exacerbated, but what is more worrying is that China’s slowing economic growth and its trade war with the United States are clearly impacting exports to China.

We also saw numerous local Chinese companies give profit warnings, but market reaction suggested that this was priced in and perhaps less impactful in the context of trade talks.

In Japan, the economic data was more mixed. Last week saw the release of minutes from the Bank of Japan (BOJ). The central bank remains very dovish, with one member making their view clear that the BoJ needs to continue with easing persistently. Deputy Governor Amamiya added that that the central bank has several tools to ease further, if needed. The yen finished the week pretty much flat.

Week Ahead

Again, much of the focus will be on corporate earnings season. Macro data releases this week are on the light side, especially in Asia due to the Lunar New Year Holiday. All eyes will be on Powell’s address on Thursday given last week’s dovish pivot.

Economic Data

  • Europe: UK composite PMIs on Tuesday; and German and Spanish industrial production on Thursday.
  • US: Trade balance data on Wednesday.

Politics

  • Angela Merkel is in Japan to meet Prime Minister Shinzo Abe for two days starting Monday.
  • US President Trump to make his State of the Union address on Tuesday.
  • The Brexit Debate will be front and centre in Europe.

Monetary Policy

  • Bank of England policy decision on Thursday.
  • Fed Chair Powell is due to speak on Thursday.

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