Notes from the Trading Desk – Europe

Global equities were lower across the board last week, while so-called “safe-haven” assets were the week’s winners as an escalation in the US/China trade spat and continued concerns over growth weighed on risk sentiment. Gold prices reached a six-year high on Friday and yields on global government bonds hit multi-year lows. Basic resources equities generally underperformed amid trade-war concerns. Meanwhile, banking stocks suffered as a result of the continued low-yield environment.

The Digest

Brexit Concerns Weigh on UK Sentiment

Sterling continued to feel the pressure last week and in early trading this week (August 12) hit its lowest level versus the euro since October 2016.

Shorts against the pound (investors betting against the currency) have risen to their highest level in more than two years, suggesting investors don’t see any respite any time soon.

Last week, the UK’s official leader of the opposition, Labour’s Jeremy Corbyn, confirmed he would try to bring down the government via a no-confidence vote in September.

UK Prime Minister Boris Johnson said he would call a general election “days after” the country leaves the European Union (EU) on October 31 if a no-confidence vote succeeds against his government.

Separately, other members of parliament (MPs) are working on plans to stop a no-deal Brexit if Johnson were to lose a confidence vote.

In our view, no-deal is looking increasingly likely with Johnson refusing to negotiate unless the European Union (EU) agrees to remove the controversial Irish backstop provision.

Latest gross domestic product (GDP) data exacerbated concerns around a no-deal Brexit and a potential general election. The GDP figures, published on Friday, showed the UK economy contracted in the second quarter for the first time in six years. The fall in GDP is—at least in part—due to an unwind of the inventory built up ahead of the initial March exit date, alongside continued uncertainty and a global slowdown.

As well as weighing on growth, the persistent threat of a hard Brexit appears to have impacted the risk appetite of UK businesses, with business investment stalling since the referendum vote.

Italy: Snap Elections Loom

Political uncertainty is on the rise on the Continent too. Italian politics came back into play last week and Italian equities underperformed significantly.

Italy’s Prime Minister Giuseppe Conte said late on Thursday that he would start parliamentary proceedings to call a vote of no confidence in the Italian government.

In response, coalition leader Matteo Salvini called for swift elections, criticising his partners in government and saying that the current coalition no longer holds a majority in parliament.

The suggested timing of a snap Italian election couldn’t have been much worse in our view, coming a week before the current Brexit deadline.

This will only heighten the sense of uncertainty and unease in Europe. European banking stocks sold off on high volume following this development, and Italian government bond yields spiked.

We expect confirmation early this week of the timing of any confidence vote in the Italian government.

In early trading this week, we’ve seen a small bounce from some of the stocks most heavily hit. This seems to be in response to the decision from a prominent credit rating agency not to downgrade Italy last week.

Trade and Central Banks: All About Yuan Direction

The US/China trade spat and US central bank policy are now intertwined, in our view. US President Donald Trump again attacked the US Federal Reserve (US Fed) on Wednesday last week. He said it was not China, but the Federal Reserve (Fed) that he was worried about.

Trump suggested US central bank policymakers were too proud to admit their mistakes and he seems to be using trade rhetoric as a way of hitting out at Fed Chair Jerome Powell.

Early last week, China had let its currency fall through a key level with the US dollar, sending a clear message to the Trump administration. Washington responded by formally labelling Beijing a currency manipulator.

This development saw equities sell off. Markets staged a late rally on Tuesday after signs China might not let the yuan fall much further.

Some dovish Fed commentary was also supportive and there was also some better-than-expected data from China as exports rose in July despite the trade war.

However, on Friday afternoon things deteriorated once again: Trump said September talks with China could be cancelled, sending US and European equities lower.

Trump also called on the Fed to dramatically cut rates by 1%, telling reporters outside the White House: “We are being handcuffed by the Federal Reserve.”

This level of hostile interaction between a US president and the central bank is unprecedented and adding to market nerves, in our view. The market is now pricing in greater chance of a 0.5% rate cut in September.

New Lows for Yields

Global bond yields have continued to plunge and remain a key talking point, with bonds seeing their 31^st straight week of inflows.

Aside from trade tensions and dovish central banks, some dismal data from Germany played into this dynamic.

The German 10-year bund yield hit a record low last week, while the US 10-year Treasury yield touched its lowest level since October 2016 on Wednesday.

The three-month/10-year US Treasury yield inversion has steepened as the three-month traded as much as 41 basis points (0.41%) above the 10-year on Wednesday. This is the widest spread since 2007, once again invoking recession fears.

While focus often falls on US Treasury and German bund yields, it’s worth noting that the Swiss 10-year sovereign bond yield is also making record lows.

As the German bund makes new lows, European banking stocks have fallen to three-year lows.  This will definitely be something to continue to watch, especially given the current central bank backdrop.

Last Week

Europe

European equities were broadly weaker last week, as political risks weighed alongside the ever-present trade overhang.

Italian equities were among the key underperformers last week amid the risk of fresh elections. We also saw the largest weekly rise year-to-date in the Italian 10-year bond yield.

Among sectors, cyclical stocks led the weakness. Media and health care were the only two to finish higher on the week. Basic resources lagged on the week, weighed on by moves in iron ore prices and a couple of earnings disappointments in the space. Banks, the year-to-date underperformer, also struggled amid fears of lower rates for longer.

There was focus on German macro data midweek last week. German industrial output fell more than expected in June, adding to signs that the eurozone’s largest economy is creeping towards its first recession since 2013.

Industrial output fell by 1.5% on the month, with a dip of 0.4% expected. Weaker production of intermediate and capital goods drove the move.

The United States and China are two major exporting destinations for Germany, so it is clear to see how the ongoing trade tensions are taking a large, disproportionate toll on the German economy. There were also headlines on Thursday noting a shift in German fiscal policy, with the government considering issuing new debt to finance a climate-change protection package.

Services purchasing manager index (PMI) data was also in focus with Italy’s July reading surprising to the upside. New orders also rose in June. French services PMI also came in ahead, while Spain’s disappointed. Spanish composite PMIs were also below consensus expectations. Finally, UK imports were down nearly 13% in the second quarter with Brexit uncertainty still gripping the country. UK exports were also lower.

The United States

US equities saw another volatile week, finishing lower overall. US-China trade tensions still loom over US stock markets, with the move in the Chinese currency adding further weight.

Sectors were mixed with real estate names outperforming, while energy names lagged on the week. A move lower in oil prices after the International Energy Agency (IEA) cut its oil demand outlook certainly didn’t help the energy sector. The IEA stated oil demand is at its weakest level since 2008.

Meanwhile, the US 10-year bond rallied, with yields dropping as low as 1.6% for the first time since 2016 on Wednesday.

Asia Pacific

Shares in the Asia Pacific region closed generally lower in a volatile week driven by trade rhetoric. Markets in Hong Kong and mainland China underperformed, unsurprisingly feeling the pressure of the ongoing trade spat with the United States.

Central banks in the region were also in focus as New Zealand, India, Thailand and Philippines all proceeded with interest rate cuts. New Zealand’s 0.5% cut was more aggressive than the consensus 0.25% forecast, while the Bank of Thailand’s rate cut was first in more than four years. The dovish move from the central banks also played into the lower-yield environment, exacerbating concerns over global growth.

Away from the headline-grabbing US/China tensions, a number of other political situations are bubbling away in the region:

Pakistan-India: Last week saw a dangerous flare-up in Kashmir, with India scrapping the region’s special status. Pakistan was enraged, formally suspending trade relations with its neighbour.

Hong Kong-China: Protests in Hong Kong saw no respite, with latest developments pointing to potential of Chinese military intervention, further weighing on markets.

South Korea-Japan: Relations somewhat improved week-on-week after Japan approved shipments to South Korea (after previously imposing restrictions on sales of three chemicals crucial to South Korea’s chip and display makers). In response, Seoul held off on removing Japan from its trade “white list”. Tensions remain, but this is an incremental positive. South Korean shares still finished the week in the red, however, as North Korea carried out its fourth missile test in the space of two weeks in protest against planned joint US/South Korea military exercises.

Week Ahead

Economic Data

• United States: Consumer price index (CPI) data (Tuesday); Retail sales
• Europe: UK labour market data (Tuesday), Euro area and Germany GDP (Wednesday); CPI (Wednesday), retail sales (Thursday)
• Asia: We have some notable Chinese macro data due this week industrial production and retail sales due on Wednesday. In Japan, we have producer price index (PPI) data tomorrow and industrial production on Wednesday.

Politics

• Events in Hong Kong will be a focus as the protests continue to grip the city.
• In Europe, focus will be on Italy and for any sign of when parliament might convene to hold a vote of no confidence in the government. Elsewhere, UK assets appear remain at the mercy of the next headline on Brexit.
• In Argentina, the populist opposition leader won the country’s primary election by a much larger margin than expected, with Alberto Fernandez taking 47% of the ballot, compared with incumbent Mauricio Macri’s 33%. Given that result, focus will likely be on Argentinian assets as we kick off this week. The next round of voting will take place in October.

Monetary Policy

• No major central bank decisions this week, but any Fed speaker commentary will receive greater scrutiny given the broader back drop of President Trump’s attacks on the Fed.

Insight from Our Investment Professionals

Our View as US-China Trade Tensions Deepen

US-China trade tensions escalated in early August as US President Trump announced new tariffs on Chinese goods, and in turn, China announced it would stop purchasing US agricultural products. Amid an already-slowing Chinese economy, many investors were rattled. Franklin Templeton Emerging Markets Equity’s Sukumar Rajah and Jason Zhu weigh in on the situation and explain why China’s economy may be better able to absorb the trade issues than some observers fear. Read More.

Trade Tensions Flare: Where Do We Go from Here?

Market volatility has been on the rise as US-China trade tensions continue to flare and recent central bank activity has created more questions than answers. As such, many investors have been on edge. Franklin Templeton Multi-Asset Solutions CIO Ed Perks, and Gene Podkaminer, Head of Multi-Asset Research Strategies, present the team’s latest thoughts on where the global economy is headed—and how investors should think about risk today. They say the persistent uncertainty calls for a cautious and nimble stance. Read More.

Adrift: Has Monetary Policy Become Unanchored?

In light of the Federal Reserve’s recent interest-rate cut, our Fixed Income CIO Sonal Desai takes a look at how US central bank thinking seems to have changed, and whether there’s a risk of having interest rates too close to zero. She argues deflation risks are overblown and looser monetary policy will lead to increased financial market distortions. Read More.

Impact Investing in Practice: Social Infrastructure

To understand how impact management can be applied in practice, our Franklin Real Asset Advisors team, in collaboration with consulting firm Tideline, took an example from the real estate sector and considered the specific demands of social infrastructure. The third post of this three-part series explores why social infrastructure can be seen as a natural fit for most impact investors. Read More.

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