Notes from Franklin Templeton's Trading Desk

by Franklin Templeton Investments

The Digest

Politics and rotation into value proved the key talking points in a week that saw the Stoxx Europe 600 Index close up 2.1% and the S&P 500 Index up 3.85%.¹ The year-to-date (YTD) losers were the winners last week, with the travel and leisure sector in Europe up 8.8%. Banks (+4.9%) and oil and gas (+5.0%) stocks also outperformed, with European equities largely taking their direction from the United States. Last week, fresh US stimulus hopes helped extend the week’s rally both in Europe and the United States, although those hopes were dashed a bit over the weekend. It was a quieter week for the Asia Pacific (APAC) region, with China’s equity market mostly closed for Golden Week holidays. Still, the MSCI APAC Index closed up 3.4%.²

US Election

The US presidential election remains a key investor focus in Europe. Democratic nominee Joe Biden continues to lead in the polls; however, President Donald Trump’s comeback in the 2016 election proves that there is still scope for uncertainty over the final result. There is also risk of a contested result, which would imply prolonged equity market uncertainty. Voter turnout will be critical to the election’s outcome, as will any legal challenges to mail-in/absentee ballots.

Since the start of September, European equity markets have outperformed their US counterparts, and some observers are predicting that any US dollar weakness in the lead-up to or in the aftermath of a Biden victory would likely see this trend continue.

Interestingly, we also saw a rally in the Chinese renminbi toward the end of last week. The currency jumped 1.5% vs. US dollar on Friday (its biggest move in 15 years), as hopes for an easing of tensions under a Biden win boosted the currency, alongside positive macro data that showed demand for Chinese assets had risen. We would note that the rally has faded today after the central bank stepped in, announcing that lenders would no longer have to hold reserves when buying forex (FX) forward contracts, essentially making it cheaper to bet against the renminbi. Even with this intervention, it feels to us like this dynamic has further to run.

US Polls Play into Rotation Dynamic

There was a lot of discussion around rotation last week as value outperformed momentum, with Europe really taking its lead from the United States. Looking at growth vs. value globally, it’s worth noting that the spread between the two style factors still looks extremely stretched, in our view. The YTD performance spread is at its largest-ever level, even exceeding the runup to the 2000 bubble, with technology outperforming energy/banks approximately 45%/50% at this point. Alongside this stretched positioning, we are also seeing a shift in sentiment around the US election and potential stimulus, implying that the unwind has potential to run.

US politics is an interesting theme playing into the rotation dynamic. It’s all about positioning, as expectations for a Biden win seem to be increasing. Investors are repricing the probability of a Democratic win, which seems to be less about risk on versus risk off for markets, and more about “rotation-on”. That is, if Biden wins, there is an argument that rotation into value will accelerate.

More influence from the Democrats is likely to lead to a shift in government stimulus. Under a “blue wave” scenario (Biden win, Democratic control of the House and Senate), we would expect a sizable stimulus package, with the focus of that stimulus on struggling industries,  smaller companies and individuals, rather than aiming at elevating asset and index prices (as seen through the Trump administration). This sort of thinking fed into the outperformance of cyclicals and small- and mid-capitalisation stocks last week (particularly in the United States), as these areas would be more likely to benefit from state aid. The small-cap Russell 2000 Index gained 6.4% last week, while the big-tech NYFANG Index was up 3.6%.

The Democratic approach to stimulus is not likely to be as supportive to the technology space, and there is also potential for increased regulatory scrutiny. We have seen reports that funds used to making both bullish and bearish bets on equities have been trimming their net exposure to the FANG cohorts and there’s been a shift in the zeitgeist towards industrials, materials, and financials heading into next year. We’ve already seen a rebound in industrials since mid-May (as hopes for a global recovery and further stimulus increased), with US industrials in particular outperforming the technology space and broader market.

In Europe, a number of positive earnings pre-releases supported cyclicals, particularly from those companies exposed to goods transportation. This suggests that estimates are perhaps too low going into earnings season, meaning we could see some impressive upside surprises.

Despite all of the above, uncertainty remains around the US election, COVID-19 and Brexit, so the conviction behind last week’s move in Europe was subdued. The rotation has not been so much about investors seeking out value aggressively, but more about buying the beaten-up underperformers for fear-of-missing-out (FOMO) on the recovery.

For example, the best-performing European index on Thursday of last week was Spain, but volume was the lowest it has been since August. It was the “most-shorted” stocks that rallied aggressively, with quality/defensive/momentum underperforming on a relative basis. The YTD “COVID-winners” and work-from-home stocks were particularly weak on Thursday.

In Europe, travel and leisure stocks were top performers, followed by banks. Whilst the positioning unwind and “FOMO” argument does explain a lot of the rotation dynamic, travel and leisure was one of the spaces where there was actually some volume behind the move, with punchy moves particularly in the airlines. It looks like news in the space could improve in the coming months, as international travel in Asia and domestic travel in the United States is already starting to improve.

There were also positive headlines regarding UK Travel Corridors last week, with the Department for Transport announcing that people from England would be able to travel to five Greek islands, including Santorini and Zante, after localised coronavirus outbreaks were brought under control.

Before we move on from US politics and positioning, it’s worth noting that another beneficiary of the Biden trade is the Environmental, Social and Corporate Governance (ESG) space, with a more progressive climate plan than Trump. In Europe, we also had increases to wind generation targets for the United Kingdom and Spain last week, leading to continued buying in ESG-related stocks.

Week in Review

Europe

European equities traded higher across the board last week and saw buying in some of the more beaten-up sectors. As noted above, investors were buying the YTD underperformers in Europe last week, which drove overall index moves.

The Spanish IBEX Index led the way last week, up 2.9%, given the moves in travel and leisure and banks. The UK FTSE 100 Index was the relative underperformer last week, given some strength in the sterling versus the US dollar, but still managed to finish the week up 1.9%. Specifically on the sector moves, it was the year’s three YTD underperformers which came out top of the pile last week. As noted, travel and leisure and the banks were better off on the week, whilst oil and gas stocks made up the top three in terms of performers.

The tone around the chances of a Brexit deal being agreed upon in the coming weeks and months turned more optimistic again last week. Despite that optimism, it is now certain that these negotiations will continue beyond the EU Summit on 15 October. Reports last week suggested the European Union (EU) would ignore this soft deadline the United Kingdom set to have a deal, and that negotiations would continue into November. Whilst it is clear that differences remain in the negotiations (around level playing field, fisheries and governance), the recent rhetoric has  suggested chances of a deal have improved.

The UK’s chief Brexit negotiator David Frost said a deal is “eminently achievable”, whilst EU sources were quoted as saying a deal was getting “closer and closer”. Sterling closed up 0.9% last week versus the US dollar. There were further talks over the weekend between UK Prime Minister Boris Johnson and French President Emmanuel Macron (on Saturday)  and between Johnson and Chancellor of Germany Angela Merkel (on Sunday). The two-day EU Summit will commence on 15 October, where Brexit will be high on the list of agenda items.

Central banks were in focus last week in Europe. Last week, the European Central Bank (ECB) released its minutes from September’s Governing Council meeting. The key message was one of support from the central bank, and the minutes noted “broad agreement among members that there was no room for complacency.”

ECB President Christine Lagarde also pointed to the need for sufficient stimulus to allow the ECB to reach its goal on inflation. Headline inflation slipped back further in September to -0.2% and the latest projections predict inflation of just 1.3% on average in 2022. The minutes note that the ECB would be ready to “adjust all of its instruments” if necessary in working towards a target of “close to 2% inflation”.

The ECB is still expected to add to stimulus, with an increase in the pace of its asset purchases under the Pandemic Emergency Purchase Programme (PEPP) expected to be the next move. The latest minutes also note that “further cuts in policy rates and changes to the conditions of the targeted longer-term refinancing operations (TLTROS) were also part of the toolkit”, whilst Lagarde has also spoken openly about the willingness to cut deposit rates further.

A potential Bank of England (BoE) move to negative deposit rates has been a point of discussion in previous weeks as the UK economy struggles through a second wave of COVID-19 infections. There were headlines in the UK press over the weekend which suggest some of the country’s top banking officials have held talks in recent weeks, noting their preparedness for the central bank to impose negative rates for the first time ever. It would certainly not be a surprise given the UK economic recovery seems to be floundering. UK gross domestic product (GDP) growth for August came in at a disappointing +2.1%, versus +4.6% expected.

United States

Last week saw some impressive gains in US equity markets as investors started to price in a reduced risk of a contested election result). On the week, the S&P 500 Index gained 3.8%, the Dow Jones Industrial Index was up 3.3% and the NASDAQ Index was up 4.5%. The rotation into value names discussed earlier was evident in the performance of the small-cap Russell 2000 index, which traded up 6.4% last week. The index is seeing notable outperformance over the mega-caps so far this month.

From a sector perspective, materials and energy were strongest (a recovery in crude-oil prices adding a boost to the latter).

Fiscal stimulus impasse continues: aside from the election campaign, another major focus for markets was the ongoing fiscal stimulus talks between the Democrats and Republicans. We seemed to lurch from one headline to the next on this issue. At the start of the week, Trump was stressing the need for a deal, only to tweet on Tuesday the talks were over— and he then offered a piecemeal deal. However, by the end of the week, focus was back onto the main talks between the Democrats and Republicans.

Treasury Secretary Steven Mnuchin is believed to have offered US $1.8 trillion in stimulus, which was rejected by House Speaker Nancy Pelosi on Sunday, who described the latest proposal as “wholly insufficient” (she is said to be holding out for a US $2.2 trillion deal). White House Economic Advisor Larry Kudlow commented yesterday that the “bid and the offer is narrowing somewhat” between the two sides.

US Federal Reserve (Fed) officials have urged the two sides to agree a stimulus package, with Fed Chair Jerome Powell stating last week that it was important the government did not deliver “too little support”. The September Fed minutes were released last week and also highlighted their eagerness for a fiscal stimulus package. The minutes noted “Many participants noted that their economic outlook assumed additional fiscal support and that if future fiscal support was significantly smaller or arrived significantly later than they expected, the pace of the recovery could be slower than anticipated”.

Finally, Boston Fed Bank President Eric Rosengren was quoted in the Financial Times as saying: “We definitely need it and the sooner we get significant fiscal stimulus, the better”.³

Time is running out ahead of the election, and a deal will remain a key focus for investors this week, as it is still uncertain if we will see an agreement prior to the election. Markets should embrace a sizable deal—if and when we get one.

Asia Pacific

The MSCI Asia Pacific Index managed to close last week up 3.4%, with China closed for most of it. Australian equities outperformed in the region, up 5.4%, given the strength in the miners and supportive policy announcements. The Shanghai Composite was closed for most of the week due to Golden Week, but still managed to finish up 1.7% following a move higher on Friday. Sector performance was mixed in Asia, with the YTD underperformers failing to catch a bid to the same extent as they did in Europe and the United States. The materials led the way, up 4.7% on the week, closely followed by technology stocks, up 4.5%. The defensives were among the underperformers.

The Reserve Bank of Australia (RBA) left policy rates unchanged last week, but the tone was dovish overall, with the central bank expected to cut interest rates from 0.25% in November. Later in the week, the RBA warned of rising business and household defaults. Greater focus was on the government’s budget announcements on6 October. Tax cuts/incentives, infrastructure investment, deregulation and wage subsidies were all part of the latest package announced, totalling AU $507 billion. Lingering COVID-19 cases in the state of Victoria are still preventing the reopening of Melbourne, and the impact of shutdowns was clear as Australian services activity contracted sharply last month.

In terms of data elsewhere, China announced services data on the market’s reopening on 9 October following Golden Week. Activity quickened following a pickup in new orders. Japan household spending and real wages fell last month, but in line with expectations.

Week Ahead

US Earnings: Next week marks the start of US corporate earnings season. The big banks will lead the parade starting with JP Morgan and Citigroup on 13 October, Bank of America, Goldman and Wells on 14 October. Morgan Stanley will report on 15 October.

BREXIT: Informal talks continue this week ahead of Johnson’s 15 October deadline for a deal. This is ahead of the two-day summit in Brussels where EU leaders are due to discuss Brexit, climate change, COVID-19 and relations with Africa. But there remains a hardline rhetoric, even if as expected that talks continue after 15 October on the grounds that enough progress has been made.

COVID-19: The United Kingdom may announce tougher COVID-19 restrictions on the north of England. The government’s pandemic policies are facing growing opposition from local officials and from Conservative Party lawmakers. We expect to hear from Boris Johnson on this issue.

EU Council Meeting 15th – 16th October: EU leaders will meet in Brussels to discuss the epidemiological situation, relations with the United Kingdom, as well as climate change and relations with Africa.

MACRO: UK labour report today, US inflation also today. Thursday: China producer price index (PPI) and inflation data. Friday: euro area inflation and US retail sales/industrial production.

Market holidays

Monday: Bond markets will be closed in the United States and Canada for the US Columbus Day holiday and Canada’s Thanksgiving Day, respectively.

Calendar

Monday 12 October

• Economic/Political: BOE’s Haskel, Bailey speak
• Data: Japan: (August) machine order

Tuesday 13 October

• Data: Germany: (October) ZEW survey, (September) wholesale prices; UK: (September) claimant count, (September) jobless claims, (August) ILO UR; US: (September) consumer price index (CPI); China: (September) trade balance

Wednesday 14 October

• Economic/Political: ECB’s Lane, Villeroy speak; BOE’s Andy Haldane speaks; Fed’s Clarida, Kaplan, Randal Quarles speak
• Data: Eurozone: (August) industrial production (IP); US: (Oct 9) MBA mortgage applications

Thursday 15 October

• Economic/Political: BoE’s Cunliffe speaks; EU Council meeting; US Presidential Debate
• Data: France: (August) industrial orders; US: (October 10) initial jobless claims, (October) Empire Manufacturing, (September) import prices, (October) Philly Fed

Friday 16 October

• Economic/Political: EU Council meeting; UK’s Sovereign debt to be rated by Moody’s; France Sovereign Debt to be rated by DBRS
• Data: Eurozone: (September) New car registrations, (August) trade balance; US: (September) retail sales, (September) industrial production

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1. 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 a guarantee of future results.

2. Ibid.

3. Source: The Financial Times, “Fed’s Powell is chief cheerleader for fiscal stimulus”, 11 October 2020.

This post was first published at the official blog of Franklin Templeton Investments.