Notes from the Trading Desk – Europe

The Digest

It was a strong start to September for global equities as trade optimism and hope for central bank stimulus led to risk-on rotation. Italy’s equity market was the clear outperformer in Europe amid some long-awaited political stability for the country. All three major US benchmark equity indices were higher, and China outperformed in the Asia-Pacific (APAC) region.

Brexit

Clearly, the focus for us in coming days and weeks is going to be UK politics. There was a LOT of noise last week.

The key point now is when and not if we get a general election. We are watching Prime Minister Boris Johnson, who did not want such a thing, and is now desperate to push through an election. On the other hand, we have Labour Party Leader Jeremy Corbyn, who had been consistently asking for an election, looking to avoid one.

What Happened Last Week?

On Tuesday of last week, UK members of parliament (MPs) aiming to prevent a hard-Brexit on 31 October voted in favour of taking control of the parliamentary schedule. The vote was won by a 27-vote margin and included 21 Conservative MPs.

This was the group’s first step towards passing legislation that would force Johnson to delay Brexit, following Conservative defections earlier in the day which saw Johnson lose his government’s ruling majority.

Reacting to the loss, Johnson in effect cast 21 of his MPs out of government. It seems the prime minister had not anticipated the level of rebellion seen from his own MPs when increasing his hard-line rhetoric. This has proven the last straw for some MPs, with Johnson’s own brother resigning as a conservative MP last week. We also saw Work and Pensions Secretary Amber Rudd leave over the weekend, calling the move to kick out these 21 members an act of “political vandalism”.

Johnson faced yet another defeat on Wednesday after the House of Commons rejected the PM’s call for an early general election on 15 October. The legislation, known as the “Benn bill”, passed through both the House of Commons and the House of Lords and is expected to achieve “royal assent”, which means it becomes law. The bill, put forward by the so-called “rebel alliance”, aims to avoid a no-deal Brexit by forcing Johnson to ask for an extension from the European Union (EU) if no deal is reached by the 19 October. Of course, this is dependent on the EU approving an extension.

The market reaction to the proposed legislation was interesting, with sterling having its best week in some time as we saw the risk of a no-deal at the end of October fall. The increased hopes of avoiding a hard-Brexit also helped UK equity inflows.

The domestic-leaning FTSE 250 Index closed last week up 1.61%, outperforming the exporter-heavy FTSE 100 Index, which gained a more muted 1.04%.¹   There was high volatility in UK bonds, with the 10-year yield falling as low as 0.35% at the beginning of the week, before spiking up to 0.65% on Thursday on the early success of the Benn bill.

What Next?

This week, MPs will be asked to vote again on whether they support a general election to take place on 15 October, but Johnson seems unlikely to get the two-thirds majority he needs as the Labour party is not expected to support an election this early. The opposition party instead wants to delay this until after the Benn bill has taken effect (19 October), or even later until November, when a no-deal crash out on the 31^st of October has been fully avoided.

With Johnson having said he would rather be “dead in a ditch” than ask for an extension, his hopes lie on either winning a general election before 19 October (which looks unlikely, as discussed), or finding some kind of loop-hole in the bill. Otherwise, Johnson’s options seem to be to either go against his word or to break the law. Another would be resignation. That outcome, given his loss of his majority, would hand power straight to Jeremy Corbyn.

There is also speculation Johnson may send the letter requesting an extension to the EU, but alongside this, send some sort of document making it clear that this is not actually what he wants and not what he believes best for the United Kingdom, hoping the EU will reject the request.

In addition, Johnson’s move means that parliament is set to be suspended for five weeks, ahead of a Queen’s speech on 14 October.

In early trade this week, we’ve seen the pound rally versus the US dollar from an initially soggy open after the latest comments from Johnson in Dublin. Johnson conceded that no deal would be a bad outcome for both sides. He said that it would amount to a “failure of statecraft”, and politicians would be “responsible”.

Despite recent rhetoric from Johnson himself, his MPs (both surviving and kicked out)—and the EU hinting otherwise—he insisted he is still determined to get a Brexit deal. Better UK data this morning also helped lift market sentiment a bit.

Last Week

European markets were higher across the board last week, with major indices recovering much of August’s lost ground.

Looking at sectors, we saw rotation out of defensives and into cyclicals amid a rise in expectations of stimulus from the Federal Reserve at its next meeting on 18 September and the European Central Bank on 12 September. Automotive stocks had their best week in months, while financial services and banks also had a strong showing last week. The REITs, utilities and telecommunications sectors were the week’s losers. The risk-on tone sent European government bond yields up by over 10 basis points²  , whilst the Italian BTP-German Bund yield spread tightened.

Recent ECB member commentary has been on the hawkish side, pushing back on ECB President Mario Draghi’s more dovish slant back in July. However, German economic data continued to disappoint last week, heightening concerns about an economic slowdown. Factory production and orders both disappointed in another sign of the impact of trade disputes.

A heavy fall in industrial orders from companies outside the euro area drove the data disappointment. In addition, the Economy Ministry said that no fundamental improvement in momentum is in sight for coming months.

Draghi has just two meetings left whilst he is in charge, so some are expecting him to “over-deliver” on accommodative policy, especially given speculation that policy review will see the goalposts shift to a higher inflation target.

Incoming ECB President Christine Lagarde confirmed that the central bank should re-examine its framework. Lagarde also believes inflation is too low and that monetary policy should remain accommodative. Expectations are for an interest-rate cut, with the potential for new bond purchases, although the market is split on the size of the expected rate cut.

In Italy, yields hit record lows recently as President Mattarella approved the new coalition government between the anti-establishment Five-Star Party and centre-left Democratic Party, with a confidence vote to take place early this week. Fiscal challenges remain, but the new coalition is expected to be less combative when it comes to the EU.

Rome is expected to submit its 2020 draft budget to the European Commission in October. How long the coalition lasts after this point is open to speculation, but we have some short-term stability and investors seem to have found some comfort.

United States

Last week, US equities continued with their bounce after the previous week had seen indices snap a four-week losing streak and the dollar lost some ground. Positivity around trade and some developments in Hong Kong were supportive of sentiment.

On Thursday, China announced that Vice President Liu He will travel to the United States for high-level trade talks in early October. These talks were originally planned for September, but both sides reportedly struggled to agree on a date. This announcement came after what was reported to be a positive phone call between Liu, US Trade Representative Robert Lighthizer, and Treasury Secretary Steven Mnuchin.

Whilst clearly supportive last week, there remains scepticism over a deal. And, there is still another tariff increase, which is planned to take effect on the 1^st of October before the planned visit. So, we would remain cautious about getting too excited about these talks.

On the macro front, there were mixed takeaways. Friday’s August employment report was the key focus. The non-farm payrolls number came in lower than expected (130,000 versus consensus expectations of 16,000), despite an impressive boost in temporary workers. The previous month’s number was also revised lower. The knee-jerk reaction saw equities move lower, but this plays into President Trump’s call for interest-rate cuts, and in our view, means there are even greater odds for dovish action from the Fed on 18 September.

APAC

The MSCI APAC Index closed last week up 2.0%, its third straight weekly gain.³  Mainland China and Hong Kong both outperformed on fresh stimulus and political developments. Hong Kong’s Hang Seng Index got a boost mid-week after Chief Executive Carrie Lam formally withdrew the controversial extradition bill that had sparked the three-month long protests there. Demonstrators feel that this is too little too late, however, and are still pushing for other demands, including Lam’s resignation.

The government in mainland China announced more stimulus measures, including a 50 basis point cut in the reserve requirement ratio for all banks, which took effect after Friday’s close. Ahead of the move, the State Council referred to an “increasingly severe external environment”, a sentiment that was echoed by Liu. This got lost in the noise, however, as the October talks with the United States were scheduled.

Japanese equities also managed to close the week higher, despite some escalation in their trade dispute with South Korea, who removed Japan from their so-called “white-list” of trading partners. For its part, the Japanese Ministry of Economy, Trade and Industry labelled the decision as “arbitrary retaliation”.

Week Ahead

In Europe, all eyes are on Thursday’s ECB meeting, with an interest-rate cut expected, and the potential for further action. We think there is potential for disappointment if the central bank doesn’t go as far as some are hoping.

We can likely expect another deluge of headlines surrounding UK politics, with the vote on an early general election the initial focus. On the macro front, US inflation data on Thursday will be in focus ahead of next week’s Federal Open Market Committee meeting.

As we kicked off this week, we saw the latest gross domestic product data from the United Kingdom come in better than expected as services returned to growth, easing recession fears. We get euro area industrial production data on Thursday morning, ahead of the ECB meeting.

Macro Data Reports Coming Up

United States: Small business optimism (Tues); PPI (Weds); CPI (Thurs); Retail Sales & University of Michigan Sentiment (Fri).

Europe: UK manufacturing production, industrial production, trade balance, GDP (Mon); UK Labour market, Italy industrial production, France industrial production; Germany CPI, Euro area industrial production (Thurs); Euro area trade balance (Fri).

Asia: China CPI and PPI (Tues)

Insight from Our Investment Professionals

European Political Developments: A Lesson in Unexpected Consequences

Even the most dedicated news-junkie may struggle to keep up with the pace of political shenanigans in Europe in recent weeks. Two countries in which the news has been especially fast-moving are Italy and the United Kingdom. Our Head of European Fixed Income David Zahn notes some peculiar similarities in the way events have unfolded. Read More.

Pinpointing Fixed Income Credit Risks

In this excerpt from the latest Franklin Templeton Thinks, Franklin Templeton Fixed Income Group examines how machine learning techniques can measure the risks of consumer and home loans—helping pinpoint credit risks they think are worth taking. They review digital loans, a relatively new asset class, and explain why quantitative approaches may be more applicable to some fixed income sectors than others. Read More.

What We Think Could Drive European Markets in the Coming Months

As European investors and market practitioners return from their summer vacations and prepare for the final third of 2019, our Head of European Fixed Income David Zahn highlights the issues he thinks will drive markets in the coming months. Here’s what he views as the most important issues for global investors following developments in Europe. Read More.

Changes to the Emerging Markets Club: China (A Shares), Argentina and Saudi Arabia

There have been some noteworthy recent changes in the composition of two broad emerging market indexes that have investors taking notice. Domestic Chinese equities now have a greater presence in both the MSCI and FTSE Emerging Markets Indexes—with more shares still to be added. Meanwhile, Argentina and Saudi Arabia also saw status upgrades. Our Dina Ting and Louis Hsu discuss the significance of these changes for these countries, and for investors. Read More.

For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn.

Important Legal Information

This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of  9 September 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.

Nothing in this document may be relied upon as investment advice or an investment recommendation.The companies named herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FT affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

What Are the Risks?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Past performance is not an indicator or guarantee of future performance.

Links to External Sites

Franklin Templeton Investments is not responsible for the content of external websites.

The inclusion of a link to an external website should not be understood to be an endorsement of that website or the site’s owners (or their products/services).

Links can take you to third-party sites/media with information and services not reviewed or endorsed by us. We urge you to review the privacy, security, terms of use, and other policies of each site you visit as we have no control over, and assume no responsibility or liability for them.

1. The FTSE 100 Index is a capitalisation-weighted index of the 100 largest companies listed on the London Stock Exchange. The FTSE 250 Index is a capitalisation-weighted index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange. Indices are unmanaged and one cannot invest in an index. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.

2. A basis point is a unit of measurement. One basis point is equal to 0.01%.

3. The MSCI AC Asia Pacific Index captures large- and mid-cap representation across five developed markets countries and nine emerging markets countries in the Asia Pacific region. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.