Notes from the Trading Desk – Europe

The Digest

The start of last week in Europe saw a continuation of rotation into value (led by the financials, automobiles, and oils), whilst the recent leading sector, health care, was the underperformer on the week. Rotation paused for breath in Europe on Thursday, however, with some weaker earnings in the value space (e.g., RDS), but strength in the US growth names (Tesla, Facebook, Microsoft). We also saw some central bank disappointment.

Despite a selloff following Thursday’s European Central Bank (ECB) meeting, European equities had made enough gains at the start of the week for the STOXX Europe 600 Index to close up 2.4%.¹ With this, the recent recovery had put global stocks on target for their best month since the financial crisis more than a decade ago. That said, the European equity market is the clear laggard globally, with a less-cohesive response to the COVID-19 pandemic than the US Federal Reserve (the Fed).  Tensions between European Union (EU) members states did not help matters.

Earnings warnings from the outperforming US technology sector on the potential impact of the coronavirus and weak data showing the eurozone’s economy is in an historic fall dented investor sentiment ahead of the weekend. Both the US S&P 500 Index and the UK FTSE 100 Index (one of the only markets open on Friday in Europe given the 1 May holiday) closed lower. As we kick off this week, we have seen some dire macro data from Europe and Asia, but more importantly, geopolitical tensions are on the rise as the US increases their aggressive approach towards China on the origins of the coronavirus.

COVID-19 Updates

Over the weekend, US President Donald Trump pledged a “very conclusive” report on the outbreak, saying that he thought China has made a “horrible mistake”. Whilst this rhetoric is perhaps not a surprise from Trump, US Secretary of State Mike Pompeo weighed in to say that “enormous evidence” exists that the coronavirus began in a laboratory in Wuhan, China, and he accused the government in Beijing of covering up what happened. It was reported that US officials are exploring options to either punish China through tariffs or have the United States in some way financially compensated for losses leading from the pandemic. Last week, there were also new rules put in place by the US Bureau of Industry and Security and the Department of Commerce which seek to re-order global supply chains, moving more control to the United States.

China and Japan remain on market holiday on Monday 4 May, so we expect some level of negative market reaction when markets reopen there on Tuesday. There is currently a lot of rhetoric and speculation, but the geopolitical risk of this approach from the United States cannot be understated.

Over the weekend, the US government raised its death toll forecast dramatically, from 60,000 to 100,000. As certain states move towards easing lockdowns, governor of the state of Mississippi, Tate Reeves, has admitted he would backtrack on plans to partially end the state’s coronavirus lockdown after seeing its largest single-day increase in both cases and deaths on Friday.

US earnings season has highlighted the economic impact of the virus, as the weakest quarter in more than a decade continues. The balancing act of reopening economic activity too early and stemming the catastrophic economic impact of COVID-19 is clearly one of the most controversial and difficult decisions facing global leaders. There were reports last week that in China, three-fifths of new coronavirus cases didn’t show any symptoms, suggesting that large numbers of people are likely to be out in the community spreading the virus without knowing it.

Turning our attention to Europe, the weekend saw new death-toll lows in France, Italy and Spain. As some countries continue to move forward in easing measures given a continued decline in cases and deaths, the United Kingdom remains in lockdown. On Thursday, UK Prime Minister Boris Johnson gave his first briefing since contracting the virus and announced that the United Kingdom is past the peak, with cases now declining. Still, the United Kingdom now has the second-highest death toll in Europe (after incorporating non-hospital deaths) and the government is yet to deliver on testing targets. The UK government is set to review its measures this week, with possible post-lockdown workplace rules released over the weekend.

Starting today on, Italy will further relax its measures after almost two months of strict lockdown. People will be allowed to move around within designated regions, and face masks will be required on all public transport. Mainland Spain will enter its first phase of transition next week, and France’s phased end to lockdown is set to begin on 11 May.

Germany began easing measures last month, helped by an intense focus on testing, and schools are set to reopen for exam-year students on 4 May. This week, German Chancellor Angela Merkel gave playgrounds, museums, zoos and places of worship the green light to reopen. However, she warned that there was risk of triggering a second wave if people did not adhere to social distancing measures.

ECB: Further Easing for Banks Not Enough for Markets to Push on

The ECB conducted its policy meeting last Thursday. Quantitative easing (QE) measures and interest rates remained unchanged (as expected), but in a constructive policy surprise, targeted longer-term refinancing operations (TLTRO) terms were eased further. The extra cut means banks can now borrow at lower terms from the ECB before lending to firms, often with government guarantees. And, if they need to deposit the money back with the ECB, the rate is -0.5%.

The ECB also signalled that whilst the QE program size was maintained, it is prepared to increase it if needed. This should have been supportive, particularly for the banks, but it seems that the market may have been hoping for the Pandemic Emergency Purchase Program (PEPP) to be upsized (it was held at €750 billion). With that, we saw banks lose gains from earlier in the week, drifting lower along with broader markets. The sector closed Thursday down 4.5%, whilst the STOXX Europe 600 Index was off just over 2%. It seems that investors feel the central bank is talking a good game, but struggling to match that with actions.

German Court to Rule on ECB Bond Purchases

Importantly, on the subject of the PEPP, the German Constitutional Court is due to rule this week on whether the ECB’s QE programme introduced in 2016 violated the country’s constitution. A group of Germans filed a lawsuit after the ECB announced its regular program to buy public bonds as of March 2016, and in 2018 the European Court of Justice (ECJ) voted in favour of the ECB. However, in hearings last July, the German court expressed some sympathy for the claims that the ECB had overstepped its mandate and infringed the prohibition of monetary financing.

A ruling against the ECB from the German court, though unlikely, would raise a political crisis and also have the potential to curtail the ECB’s flexible use of the current PEPP (though not identical to the original QE program known as the Public Sector Purchase Programme (PPSP). This may impact the market’s perception of how effectively the ECB can respond to the current situation.

Whilst the German court has no jurisdiction over the ECB, if the court rules against the ECB purchases of public-sector bonds, it could, in turn, order the Bundesbank to abstain from such purchases. This is a highly unlikely outcome but is still worth flagging as a potential risk to the political situation and the efficacy of the ECB’s programmes.

Germany has accounted for half of all state aid the European Commission has approved during the coronavirus.

Capital Raising and Profit Warnings

We continue to see capital-raising exercises and placings in Europe, with the breadth and depth of demand for these deals still strong from what we hear and based on how they are trading post-deal. As you would expect, buyback activity in Europe as virtually non-existent, with many banks reporting only a handful of live buybacks.

Focusing on the United Kingdom, more than 20% of listed companies issued a profit warning in the first quarter of 2020, compared with 17% in the full year of 2008, according to a report by consultants Ernst & Young. The economic crisis triggered by the COVID-19 pandemic has pushed up the number of profit warnings in the country, with 301 issued in the quarter ending 31 March, almost as many as the whole of the previous year, the report stated.

Week in Review

Europe

European markets traded broadly higher last week, missing the market selloff on Friday due to the Labour Day holiday. Of the key markets, it was only the United Kingdom and Denmark that were open on Friday to bear the weakness stemming from the potential re-escalation in trade tensions between the United States and China. However, as mentioned, markets were buoyed overall throughout last week by the very gradual easing of lockdown measures across some of the key markets in Europe. In terms of sectors, it was the year’s underperformers which lead the way last week. Automobiles were a significant outperformer, with banks not far behind. Health care, which had been a leader, was down by the end of week. Earnings season is also now in full swing in the first quarter (Q1) of 2020 and the key story was in the energy space, with Royal Dutch Shell cutting its dividend for the first time since World War II.

Data continues to be very weak in Europe. Eurozone Gross Domestic Product (GDP) came in line with expectations, down 3.8% on the quarter. French Q1 GDP missed, down 5.8% vs. a 4% drop expected. In terms of fiscal year (FY) GDP estimates, the ECB predicts that eurozone GDP will shrink approximately 5% to 12% this year, with a speedy rebound anticipated in 2021.² Meanwhile, Germany has updated its FY GDP forecasts, anticipating GDP to fall 6.3% in 2020. Finally, Spanish retail sales in March were also grim, down 14.1% on the year.

It was another interesting week for oil markets, but this time the focus was on corporate updates in Europe, rather than commodity prices per se. Royal Dutch Shell cut its dividend by two-thirds, a deeper and earlier cut than the market had anticipated. Equinor also cut its dividend by two-thirds, whilst BP and ENI kept their dividend policies unchanged—for now. In terms of oil prices last week, Brent crude oil rallied, with June futures back above US$25 amid news that many countries were starting to gently ease lockdown measures. Meanwhile, West Texas Intermediate (WTI) oil prices also moved higher, with June futures touching US$20 on Monday 4 May for the first time since prices collapsed at the start of last week.

United States

US equities paused for breath last week, with the S&P 500 Index trading slightly lower on the week after a month of strong gains. April saw US equities’ biggest monthly rally since 1987, gaining 12.7% over the month, to leave the S&P 500 Index “only” down 12% so far in 2020.³

US markets then saw losses on Friday as earnings in tech heavyweights (e.g., Amazon) prompted profit taking. Following its earnings update, Amazon shares traded lower on Friday. As we have discussed before, the narrow concentration of the recovery in US equities is the most extreme it has ever been, with just a handful of tech names driving much of the move. Without the gains in the tech names, US equities’ performance would have been starkly lower, and it is not too surprising to see some profit taking on Friday in Amazon.

In terms of macro data last week, real GDP declined at a higher annual rate in Q1 than expectations. Focus this week will turn to Friday’s April monthly employment report, where the market expectations are for a staggering decline of over 21 million in employment.

Last Wednesday’s Fed meeting saw no major surprises from Chairman Jerome Powell. The Fed kept policy on hold at its April meeting and maintained commitments to keep interest rates near zero while continuing asset purchases. Powell stressed that the Fed would continue to act “forcefully, proactively and aggressively” until the recovery was well under way, and that it was prepared to do more, if needed, “to the limit of its powers”.

In terms of outlook, the Fed stated it was concerned about the significant strain on financial markets and impaired flow of credit to the economy. With that, it expressed concern about “considerable risks” to the economic outlook over the “medium term”. In the press conference following the policy meeting, Powell defined the “medium term” to be at least over the next year. On how long rates will remain this low, Powell did not give a timeline, but reaffirmed the central bank’s commitment to keep rates low for as long as needed to be confident that the economy is on a solid footing.

Asia Pacific (APAC)

Asian equities fared well last week, also missing the weakness late in the week that hit other regions, because much of the continent closed on Friday for holidays. China, Hong Kong, South Korea and many other markets were closed on Friday for Labour Day. In terms of sectors in Asia, it was the year’s laggard—energy—which led the way last week. As was the case in Europe, health care finished lower.

In Hong Kong, it is interesting to note that no local cases have been reported for two weeks, and life appears to be gradually returning to some kind of normalcy. Today, civil servants are returning to their offices after weeks of working from home. The government is also set to relax some social-distancing measures, and gyms and cinemas might be allowed to reopen this week, according to local media. No lockdown has been put in place in the city of seven million, but it has become compulsory for restaurants to check customers’ temperatures before allowing them in, as well as providing hand sanitizers. Most staff will wear masks and gloves to serve customers.

While Asia appears to have been spared the worst of the COVID-19 pandemic, it is worth keeping an eye on increasing number of cases in a few hotspots, including Singapore.

Macroeconomic data in Asia was weak again last week. South Korean exports fell by 24.3% in April, their biggest fall since May 2009. Meanwhile, manufacturing data was particularly weak for April, with both China’s and Japan’s purchasing managers indices (PMIs) coming in lower than expectations. Finally, in Japan, one media outlet surveyed economists, who predicted the country’s GDP will shrink by 22% in the second quarter 2020, which would mark the biggest quarter-over-quarter hit to GDP since World War II.⁴

Week Ahead

PMI data from Europe was bleak on Monday 4 May as the impact of the virus is being felt. Outside of that, the main macro focus this week will be Friday’s US April employment report; some commentators are suggesting it could be the most severe one-month contraction ever.  All eyes will be on COVID-19 developments across the region, with particular focus on new case and death figures from those regions easing lockdowns. Any developments on the US’ stance towards China will be key. Also on Friday, euro-area finance ministers meet to discuss the European Commission’s proposed recovery fund. It’s a big week for the United Kingdom, with the Bank of England’s (BoE) Monetary Policy Report on Thursday, and updates expected on the country’s lockdown measures.

Equity markets in both the United Kingdom and Denmark will be closed this Friday.

Monday 4 May – China, Japan and Thailand markets closed for holidays

• Economic/Political: EC President Ursula Von der Leyen hosts a virtual summit meeting wherein world leaders will discuss raising US$8 billion to accelerate the development of a coronavirus vaccine; ECB survey of professional forecasters
• Data: Global manufacturing PMI

Tuesday 5 May  – China, Japan and South Korea markets closed for holidays

• Economic/Political: German court rules on legality of QE; Reserve Bank of Australia monetary policy meeting.
• Data: UK new car registrations, UK services PMI, US services PMI, US ISM non-manufacturing

Wednesday 6 May – markets closed in Japan for holiday

• Economic/Political: Chile and Brazil central bank meetings
• Data: Global services & composite PMI; German factory orders; eurozone retail sales

Thursday 7 May

• Economic/Political: BoE interest-rate announcement and new Governor Andrew Bailey holds press conference; Norges Bank interest-rate announcement; EC economic forecast; Istat releases economic note
• Data: Germany industrial production (IP); France IP; Italy retail sales, US initial jobless claims, Japan PMI services

Friday 8 May – United Kingdom and Denmark markets closed for holiday

• Economic/Political: Italy’s Sovereign debt to be rated by Moody’s and DBRS; euro-area finance ministers meet to discuss the EC’s proposed recovery fund.
• Data: Germany trade balance; Spain IP; US monthly employment report (April)

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3. Indices are unmanaged and one cannot invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.

4. There is no assurance that any estimate, forecast or projection will be realised.