Notes From the Trading Desk – Europe

Last week proved to be positive for global equities as sentiment improved not only around the chances of a trade deal between the United States and China, but also on Brexit. Despite being light on detail, rhetoric was supportive over the potential for progress on both and markets reacted well. In terms of sector moves, sentiment was very much risk-on, with growth sectors outperforming and defensives lagging on the week.

The Digest

Brexit Progress At Last?

Last week eventually provided some much-needed relief for sterling and UK equities, as hopes rose that the United Kingdom and European Union (EU) might finally be moving closer to a Brexit deal.

Interestingly, the tone throughout much of the week had been one of pessimism as reports came through that EU leaders were very doubtful about the chances of a deal.

On Thursday, feedback from a meeting between UK Prime Minister Boris Johnson and Irish Prime Minister Leo Varadkar drove the biggest positive change in sentiment we have seen since the referendum. Varadkar said Johnson could secure a deal, with both parties saying that they could now see a “pathway” to an agreement

Before Thursday, the market had been pricing in a further extension to Article 50, rather than a deal. So markets were naturally buoyed on Friday as optimism grew around a possible compromise and the potential end to the political uncertainty.

Sterling closed up 3.6% versus the dollar on Friday from midday on Thursday, touching US$1.27 for the first time since June.

While the exporter-heavy FTSE 100 Index was up just 1.3% last week, the more domestically focused FTSE 250 Index was up 2.9% on the week. The UK banks especially benefitted.

Despite the market’s optimism, details were light by market close on Friday and it was difficult to see the basis on which there should be such a stark change in market sentiment. Therefore, Friday’s market moves were a great illustration of how underweight the market is on UK exposure.

It’s important to note that both sides are aware that there is still a significant amount of work to be done if a deal is to be worked out and signed off at this week’s summit of EU leaders. One European official said that talks on Monday of this week would be “one last chance” to work through the sticking point. Otherwise, they risk failing to agree a deal by the start of the summit.

The timeline:

• Thursday, October 17: Two-day EU summit, the last scheduled meeting before the October 31 Brexit deadline. We expect to see a constant flow of headlines in the lead-up.
• Saturday, October 19: The Benn Act forces Boris Johnson to ask for an extension if there is no deal approved. There is also a special sitting of parliament.
• Thursday October 31: The day on which the UK must leave the EU should no extension be granted.

We also saw some further evidence of the impact the dragged-out process is having on the UK economy.

Productivity in the second quarter contracted at the fastest pace in five years, lagging well behind the Organization for Economic Cooperation and Development (OECD) average.

Elsewhere, London’s initial public offering (IPO) market suffered its quietest quarter in 10 years, with most observers citing political and economic uncertainty as the catalysts. Just four UK companies listed on stock markets in the third quarter. We also saw a number of domestic UK companies issue profit warnings last week; all of the companies cited Brexit and the accompanying uncertainty as reasons.

US/China Breakthrough On Trade Too?

Hopes of a US/China trade breakthrough coincided with the positivity around Brexit last week. Headlines throughout the start of the week had been numerous and mixed, but on Thursday and Friday sentiment got a boost as negotiations resumed in Washington.

Both sides signalled they were cautiously optimistic in securing a partial deal that could lead to a temporary truce on tariffs. On Friday afternoon, US President Donald Trump said the two sides had reached a “phase one deal”. This saw all major US indices close the week higher.

As part of the tentative deal, there were reports that China was willing to increase purchases of US agricultural products by US$10 billion annually in order to stave off tariffs.

We then saw subsequent headlines that the United States was looking at rolling out a previously agreed currency pact as part of an early harvest deal that could also see a suspension of a tariff increase next week.

In addition, the Trump administration was said to be planning to issue licences allowing some American companies to supply non-sensitive goods to the Chinese telecom giant Huawei.

While all of this helped to boost sentiment towards the end of the week, it is important to note that commentary from China remained cautious.

Neither the Chinese Ministry of Commerce nor Chinese state media referred to the outcome as a “deal”. Instead, they noted only that progress had been made in numerous areas. China also failed to make any mention of the US’s promise not to raise tariffs, or Beijing’s commitment to boost agricultural purchases.

For his part, Trump said the phase one deal would be formalised in writing in the next several weeks, and he may be able to sign the agreement with President Xi Jinping at next month’s Asia-Pacific Economic Cooperation (APEC) Summit in Chile (November 16-17).

Reports early this week have suggested China wants more talks before signing Trump’s phase one deal. As a result, equity markets fell back in early trading on Monday of this week before making a partial recovery. Time will tell if this sets the tone for what is expected to be a noisy week with regards to trade headlines.

The US Federal Reserve (Fed) Steps In

With markets higher on the back of the Brexit progress and the improvement in US/Chinese trade negotiations, the Fed added fuel to the rally by announcing US$60 billion worth of monthly Treasury bill purchases until the second quarter 2020 in order to get a grip on money market rates. Fed Chair Jerome Powell (pictured) stressed that this action should not be confused with quantitative easing, but the development was taken well by markets nonetheless.

All of this saw risk-on sector and style rotation. Within equities, cyclical stocks markedly outperformed defensives and we saw selling in momentum-style names moving into value stocks in both the United States and Europe. In Europe, basic resources, banks and technology were the winners, while food & beverages, media and health care closed the week lower. The reflation trade was back in play, with US bond yields jumping as minutes from the most recent Federal Open Market Committee (FOMC) meeting also played into this dynamic.

Last Week

Europe

In Europe, the main focus last week was on Brexit, and broad market moves reflected this. Stocks in much of Europe closed the week higher, with Germany outperforming among the major indices.

Better industrial production data for August further supported equities in Germany. Improved sentiment around a US-China trade deal and the news of tax changes in China, which may help sales of German cars, also helped the autos sector.

Turkey was the notable underperformer in the region, as political uncertainty rose after Turkey’s military moved into Northern Syria. This is not expected to move markets in itself. However, Trump’s assertion that he will “destroy and obliterate” Turkey’s economy if it were to breach red lines with regards to the US’s Kurdish allies prompted some caution among investors.

Any economic downturn could have a dramatic impact on Turkey’s risk profile and cost of capital prompting investors to cut exposure to the country last week. The Turkish Lira also suffered.

Last week’s European Central Bank (ECB) meeting proved largely underwhelming. There was a somewhat hawkish slant to commentary.

In the general election in Poland over the weekend, the nationalist Law and Justice party looks set for victory. Early indications suggested the current ruling party was due to take a majority of seats once again in the Polish parliament. The newly formed centre-right Civic Coalition party looks set to take up the role of opposition.

Americas

US equities were better across the board last week amid improving trade sentiment and the Fed’s Treasury bill-buying announcement.

FOMC minutes on Wednesday were in focus and reinforced the divide among voting members when it came to the September interest-rate cut. However, the minutes did little to move the needle, and policymakers are concerned that the market is expecting more rate cuts than the committee is willing to give.

Powell reiterated that the US economy is in good shape, although the headwind to growth from trade policy was mentioned 16 times in the FOMC discussion of the outlook. The majority of FOMC members who voted for last month’s interest-rate cut cited trade, slowing global growth, low inflation and risk management as drivers for the move. Notably, US inflation data came in softer than expected last week.

Asia   

Equities in the Asia-Pacific region also took part in last week’s rally, with trade the clear focus. China outperformed.  Outside of the US/China headlines, Japan and the United States signed a limited trade deal which covers agriculture as well as digital products and services. Along with a weaker yen given the risk-off tone, this pushed Japanese stocks up on the week.

Australian equities also managed to advance despite weaker data showing that consumer confidence fell to a four-year low, even with the three recent interest-rate cuts from the Reserve Bank of Australia (RBA).

Week Ahead

It promises to be an interesting week with plenty of potential for market-moving macro headlines around the same themes as last week. In addition, investors will be eyeing the start of the third-quarter earnings season.

Politics

• Investor attention will likely centre on the Brexit-focused EU summit on Thursday and Friday. We expect a flow of headlines through the start of the week before more substantial insights at the end of the week on the potential for a deal or the length of any extension.

Monetary Policy

• US Fed speakers are expected on Tuesday, Wednesday and Thursday with the Fed releasing its Beige Book report on Wednesday.
• ECB speakers are due on Monday, Wednesday and Thursday ahead of the ECB’s  release of current account data on Friday.

Macro

• In Europe: eurozone industrial production on Monday; UK jobs on Tuesday, eurozone car registrations and trade balance and UK inflation data on Wednesday; UK retail sales on Thursday.
• In the United States: retail sales and business inventories on Wednesday; housing starts on Thursday.
• In Asia: Chinese inflation data on Tuesday; Chinese gross domestic product (GDP), industrial production and retail sales and Japanese consumer price index (CPI) on Friday.

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