Notes from the Trading Desk – Europe

Global equities found some support last week heading into month-end, with many moving parts in the political world. In Europe, we saw party political posturing in the United Kingdom and Italy, while trade rhetoric continued between the United States and China ahead of new tariffs. Cyclical stocks underpinned global equity strength with growth sectors outperforming. The dollar gained strength as the week went on, hitting its strongest level since May 2017 ahead of a long weekend in the United States.

The Digest

A Little More Prorogation, A Little Less Action

It was a tumultuous week for UK politics: On Wednesday, the Queen agreed to the UK government’s request to prorogue the UK Parliament from September 10 until October 14.

This effectively means parliament will be suspended ahead of a new session which will start in mid-October.

While this action does fall within the usual operation of the government, the timing is controversial given the Brexit deadline at the end of October.

As an example, House of Commons Speaker, John Bercow, who does not traditionally comment on political announcements, described the move as a “constitutional outrage”.

The government has said that the five-week suspension in September and October would still allow time to debate Brexit. However, critics have accused prime minister Boris Johnson of trying to remove parliament as an obstacle to Brexit.

A suspension would mean anti-Brexit MPs would have less time to push through measures to avoid a no-deal Brexit.

While the latest developments would seem to increase the risk of a no-deal departure, there is also an argument that Johnson would have better chance of obtaining concessions from the European Union (EU) if no-deal looks like a more credible threat.

Meanwhile, expectations for a general election in the coming months (or even weeks) have increased. The Conservative Party has taken a lead in many opinion polls since Johnson took control.

Market Reaction

The starkest reaction to the prorogation news was in the foreign exchange market: sterling sold-off against the US dollar, amid heightened expectations of a hard Brexit.

The moves in equity markets were predictable: weakness in the pound helped the exporter-heavy FTSE100 share index outperform at stages last week.

Given the amount of noise, we feel the moves in equity markets have not been extreme overall in recent weeks.

EU Reaction

Over the weekend, the EU’s chief negotiator Michel Barnier rejected Johnson’s bid to have the Irish backstop scrapped.

Barnier claimed the backstop itself was the “maximum amount of flexibility that the EU can offer”. While this is no surprise, it does undo the perceived more-conciliatory language used by Emmanuel Macron and Angela Merkel a week ago.

This Week

UK members of parliament (MPs) return from their summer recess on Tuesday this week.

Anti-Brexit MPs are expected to hold an emergency debate in parliament to try to force an extension to the current Brexit deadline.

If they can’t achieve their aim by Friday they will have to start again when parliament resumes on October 14.

The coming week promises to be pivotal in the Brexit process.

How anti-Brexit MPs fare in forcing Johnson to seek a Brexit extension could shape markets not only in the UK but across Europe this week.

If they fail to take control, we’d expect to see both sterling and the euro slide. However, markets could find some support if MPs’ action make a hard Brexit less likely.

Salvini Side-lined

In Italy, the Five Star Movement and the centre-left Democratic Party agreed to form a new government led by Prime Minister Giuseppe Conte. Crucially for markets, this removes the immediate risk of fresh elections and the uncertainty that would bring.

The new agreement ends days of negotiations over cabinet posts and comes just a week after Conte was ousted from his position when Lega leader Matteo Salvini triggered the dissolution of the previous government.

We recognise there is little love lost between the new coalition partners. Questions have already been asked about how long this government will last.

Italian politics will be an interesting place in the coming months as investors monitor how well these unlikely partners can work together. If the new coalition proves unworkable then we could see new elections before the end of its term in 2022.

One of the next steps for the new government will be to select ministers. Given the importance of the upcoming budget, all eyes are on who the next Minister of Finance will be. The new budget needs to be presented to the Italian parliament by September 30 and to the European Commission by October 15. The new coalition government is expected to respect EU deficit rules.

Italian assets have been supported by the news of the new coalition. Italian stocks outperformed broader European equities. Italian bonds were also in demand with bond yields dipping despite already being at record lows. The spread between Italian government bonds and the German Bund narrowed last week.

Last Week

Europe

European equities performed well into month-end, led higher by Italian equities. Greek equities also outperformed, as a new centre-right government is set to lift capital controls from the beginning of September, bringing to an end four years of restrictions on transfers.

Elsewhere, UK assets lagged on the fresh Brexit uncertainty.

In terms of sector movers, month-end positioning appeared to drive performance, with recent laggards seeing a bounce.

The best performing sectors last week were basic resources and autos. The laggards were the pharmaceuticals and banks.

Over the weekend, there were regional elections in the German states of Saxony and Brandenburg. The far-right party, AfD, made significant gains in the polls, but not to the extent many expected and it failed to win either region.

In Brandenburg, the Social Democratic Party (SPD) won the largest share of the vote and in Saxony the Christian Democratic Union (CDU) prevailed.

This result takes some pressure of the ruling CDU/SPD coalition government. If the SPD had lost Brandenburg, the pressure to pull out of the government would have increased.

European investors are keenly awaiting the European Central Bank (ECB) meeting on September 12 as many expect the announcement of fresh easing measures. However, these expectations were tempered last week following hawkish remarks by some officials. Bundesbank chief Jens Weidmann and Dutch central banker Klaas Knot argued large scale stimulus was not warranted yet.

United States

US equities managed to snap their four-week losing streak, with improving trade sentiment and month-end rebalancing supportive.

Looking at performance across asset classes throughout August, we see a clear risk-off tone, with traditional safe havens such as gold, the yen, and bonds all outperforming equities.

As we came into month-end last week, investors looked to the month’s underperformers for opportunities and this helped all three major equity indices gain on the week. Last week’s rally was not enough to reverse the previous week’s losses, however.

The ongoing US/China trade war and central bank rhetoric dominated headlines in what was another noisy week.

There appeared to be a conciliatory tone at the start of the week after President Donald Trump said he had a call with China over the weekend to restart trade talks.

Despite initially denying this, China did say it was discussing the next round of in-person talks, scheduled for this month.

Importantly, officials from China indicated that they would not retaliate against Trump’s latest tariff increase and the Commerce Ministry said that it opposed an escalation of the situation.

The more positive tone helped to support equities last week, but the bigger picture was little changed. China reiterated that it still has ample means to retaliate and over the weekend, new tariffs were imposed by China.

Trump’s latest round of tariffs also came into effect over the weekend, affecting roughly $110 billion of Chinese imports, ranging from footwear and clothing to technology products.

We can expect plenty more noise to come.

The impact on US macro was clear last week as consumer sentiment fell sharply in August, dropping the most since 2012 and hitting its lowest level since Trump became president.

Data points in the coming weeks will be in focus, with Friday’s nonfarm payrolls high on the agenda.

Asia Pacific

It was a mixed picture for Asian equity markets last week. Australia and South Korea saw modest gains, while Hong Kong equities lagged.

The yuan continued to weaken against the US dollar marking its biggest monthly fall in over 25 years.

Japanese equities were flat on the week. Japanese Prime Minister Shinzo Abe and President Trump reportedly agreed in principle a trade deal that would reduce Tokyo’s tariffs on US agricultural goods, also delaying the threat of additional levies on Japanese auto exports to the United States.

The Bank of Korea left interest rates unchanged at 1.5% at its August meeting last week.

Week Ahead

On the political front the big themes will clearly be Brexit, trade, and Italian politics. On the macro front, US nonfarm payrolls on Friday will be in focus as always. The jobs market has remained one of the bright spots for the US economy and the release will be crucial as we approach the latest Federal Open Market Committee (FOMC) interest rate decision. German macro will also be in focus as investors look for signs that second-quarter weakness has persisted.

Macro:

• US: Nonfarm payrolls (Friday) and factory orders (Thursday).
• Europe: Euro area retail sales and UK purchasing manager indexes (PMIs) (Wednesday), Germany manufacturing (Thursday), Euro area gross domestic product (GDP) and German industrial production (Friday)
• APAC: China Caixin Manufacturing PMIs on Monday, China Caixin Services PMIs on Wednesday.

Politics

• UK Parliament returns from summer recess on Tuesday and it is set to be another dramatic week on the Brexit front.
• Trade wars likely to continue with the imposition of new tariffs from both the US and China over the weekend.
• Italy’s latest proposed government will present a list of key ministers and a new government program to the Italian president this week. Five Star Movement will also vote on whether to proceed with the proposed coalition with the Democrats.

Monetary Policy

• We hear from a number of Fed speakers, with much scrutiny expected ahead of the September 18
• We also hear from a number of ECB members.

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of  September 2, 2019, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton. 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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