Notes from the Trading Desk

The Digest

After a relatively stable start to last week, it was a rough day on Thursday when the Stoxx Europe 600 Index finished down 2.1%, and European equities closed the week lower despite an attempt at recovering some ground on Friday. Equities in the United States outperformed, with the S&P 500 Index making a modest 0.2% gain on the week, whilst markets in the Asia Pacific (APAC) region were mixed, with the MSCI Asia Pacific Index down 0.4%.¹

The downward trend in Europe last Thursday had a number of catalysts, but the main (and very real) concern was the increase in European COVID-19 cases and subsequent action from the individual governments. The continued uncertainty over Brexit also weighed on sentiment, and delays over the US stimulus bill remained unhelpful for risk assets in general. In addition, third-quarter earnings season kicked off in the United States and failed to support the markets—despite some upside surprises from US banks.

Europe’s Second COVID-19 Wave in Focus

Sharp increases in COVID-19 cases and many fresh restrictions across the region spooked European markets. The United Kingdom and France in particular saw a sharp rise in new cases, whilst in Germany, Czech Republic and Poland, daily cases hit record levels. Overall, hospitalisation levels are still much lower than the first wave of the virus in the spring, but they are steadily rising and health care systems are under strain in regions where cases are surging.

To combat the rise in new cases, European governments put in place fresh measures to slow the spread, but at the same time, are eager to avoid going back to the full lockdown we saw in March. Crucially, outside of the hospitality industry, workplaces and schools have remained open.

Of note last week:

• France: residents of Paris and eight other major cities will be confined to their homes between 9 pm and 6 am for four weeks.
• United Kingdom: a new three-tiered system was announced in England, with Liverpool immediately placed into Tier 3, with the most severe restrictions. In addition, Northern Ireland entered a two-week lockdown and pubs remain closed in most of Scotland.
• Germany: Chancellor Angela Merkel’s Chief of Staff, Helge Braun, stated: “At the moment the numbers are actually increasing everywhere and increasing numbers mean that we are not doing enough at the moment to keep the infection under control”.
• Elsewhere, a number of other countries are adding further restrictions, including Spain, Holland and the Czech Republic.

Notably, the political unity we saw in March has long since gone. In the United Kingdom, the political opposition party, Labour, has been a harsh critic of the government’s recent efforts on stabilising COVID-19 cases, and in Spain and Germany there have been disputes between central and local governments.

The impact of all these COVID-19 developments will be a key focus for third-quarter earnings, which kick off in earnest this week. Last Friday we saw the impact in hospitality, with UK pub chain Wetherspoons trading -12% after reporting its first loss since 1984.

Shaky European Outlook

As the COVID-19 backdrop has worsened, the European economic situation has also continued to show signs of deterioration. It looks like the best of the initial “recovery” may be behind us. Official industrial production (IP) data has been soft, consumer price index inflation (CPI) prints have been dismal, and the new restrictions will only create further headwinds for gross domestic product (GDP) recovery.

The bond market is a key indicator of investor expectations and on Thursday, German bond yields fell to seven-month lows, with the 10-year bund breaking through its only post-pandemic support level. With this move lower, we are seeing fresh divergence between US Treasury yields and European government bond yields, with the gap between the US 10-year Treasury and 10-year bund hitting the widest level in years.

The European Central Bank (ECB) does have a heavy presence in bond markets, which should help keep bunds well bid, but this move is extreme and reflects a drop off in the growth outlook for the region. It’s also worth noting that the yield compression is present across all durations, flattening the curve. With this and the divergence with the United States, the outlook has began to look quite bearish for Europe. Banks are particularly vulnerable and were last week’s underperformers on the equity side. It’s worth noting that the US market outperformed European markets last week, with the most apparent difference in performance unsurprisingly last Thursday.

Brexit Negotiations Sour

Brexit negotiations were in focus last week as UK Prime Minister Boris Johnson’s “deadline” passed without a deal. Things came to a head on Friday after Boris Johnson suggested that the United Kingdom should get ready for an “Australia-Style” deal. This essentially means no deal, and World Trade Organization (WTO) rules would prevail. Johnson blamed the European Union’s (EU) approach and said it was time for businesses to prepare for this outcome, as it appeared the EU had abandoned the idea of a free trade deal.

These headlines initially hit UK sterling and domestic stocks, which saw a knee-jerk move lower, but then managed to stabilise. Investors were left unsure of quite how to take in the latest developments, which seemed to many like posturing and applying pressure. UK sterling had traded better early last week against the US dollar on the back of positive murmurs that Germany was pushing France to relax their stance on fisheries.

Despite headlines that the EU expects trade talks to continue in London in the days ahead, Johnson said the EU should “only come to us if there is some fundamental change of approach”. Johnson’s spokesperson later hardened the language, saying that the EU had in effect ended talks by failing to compromise.

Any likelihood of continuing Brexit talks this week hangs in the balance, depending on what concessions the EU is willing to offer in order to restart negotiations. News this morning that the UK government is shying away from actually ending negotiations helped boost sterling. The latest headlines suggest the UK government is considering watering down some of the Internal Markets Bill in an attempt to get an agreement with the EU.

Negotiations will now most likely continue with a new deadline of the end October. The EU has said a deal needs to stand by the middle of November in order to have time for all the required ratification, though it’s always possible to stretch deadlines. As we are unlikely to get any decisive news over the next few days, the market’s Brexit and sterling focus might temporarily fade once again. Odds of a deal seem to be less than 50%, according to some reports we’ve read.

Week in Review

Europe

Last Thursday’s selloff saw European equities close the week slightly lower, with a number of catalysts weighing on sentiment. Spain’s market was the underperformer as year-to-date (YTD) losers suffered most in the decline on Thursday. It’s worth noting that in Europe, value still underperformed, failing to benefit from a “fear-of-missing-out”(FOMO) and “buy the losers’” mentality as we have seen in previous such moves of late. When looking at sectors, oil and gas, travel and leisure, and banks and insurers were the week’s losers.

Automobiles were a bright spot, rallying on Friday after a standout earnings release from Daimler boosted sentiment. Earnings season kicks off in earnest this week in Europe, with hopes that we should see a rebound in third-quarter numbers tied to the economic recovery seen during the period. Last week saw a continuation of positive pre-announcements and upgrades, particularly in the cyclical stocks. This has led to discussion around whether the recovery will now be priced into earnings.

United States

US equities saw muted gains last week despite continued COVID-19 concerns. The S&P 500 Index closed up 0.2% and the Dow Jones Industrial Average was up 0.1%, whilst the NASDAQ was ahead once again, up 1.1% on the week and now up 35.7% YTD. The upcoming US presidential election as well as the ongoing impasse over stimulus continues to gain much of the attention stateside. Sector performance was somewhat mixed last week. Industrials led the way, up 1.1% on the week, followed by communication services, up 0.9%, and utilities and technology, both up 0.8%. Real estate investment trusts (REITs) struggled, down 2.3% on the week, whilst the weakness in energy stocks also continued.

Polling for the upcoming election suggests a gradual increase in support for Democratic nominee Joe Biden over current US President Donald Trump, with some suggesting Biden holds a double-digit lead. A Democratic majority of Congress and the presidency (a “blue wave”) is now being priced into the markets, but there is still uncertainty surrounding the risk of a contested result and questions over whether the Democrats will actually be able to take back enough Senate seats from the Republicans to achieve a majority.

We have heard from a number of different investment banks over the last few months regarding the implications of a Biden victory for US equities. A Biden victory appears likely to cause a rotation in US stock markets, along with easing trade tensions, a potentially weaker dollar and higher bond yields.

On the stimulus front, last week Trump said he was open to increasing the US$1.8 trillion bill he had been championing in the past. Whilst it was reported that House Speaker Nancy Pelosi and Treasury Secretary Steven Mnuchin were again discussing potential deals, the chances of something being agreed upon in the short term remain slim.

Senate Majority leader Mitch McConnell said that his US$500 billion package was “appropriate” and that he would be rejecting calls for higher levels of stimulus. The uncertainty over whether the Democrats can take the Senate as well as the White House in the November elections calls into question exactly how much stimulus is likely to materialise in the near term.

Earnings season is underway in the United States, with JP Morgan and Citibank beating expectations on revenues and earnings. Details on interest margins, which remained challenging, tapered investor sentiment somewhat. Despite the positive developments, most banks were met with selling pressure, mostly due to the uncertainty of the economic outlook going forward. Reports show the majority of companies which reported earnings last week saw better-than-expected results, with the majority of those beats coming from consumer staples and health care. This week, of the momentum stocks which have been so strong this year, Netflix and Snap report after the close on Tuesday, whilst Tesla reports after the close on Wednesday.

Asia Pacific

Asian equities finished lower overall following the selloff on Thursday, with the MSCI Asia Pacific Index down 0.4% last the week. The Shanghai Composite Index outperformed, up 2%, returning to a full week following the “Golden Week” holiday period. Similar to Europe and the United States, sector performance was mixed. Communication services stocks were generally better off, along with  financials  and consumer discretionary. Energy and health care stocks lagged.

Chinese equities saw a strong start last week after policymakers removed rules which made shorting the yuan expensive, done in a bid to stem the currency’s appreciation. Equity markets held onto strength for the rest of the week after the country reported an unexpected surge in exports and imports, whilst car sales were reported to have risen for the sixth straight month.

Trade tensions with the United States still rumble on, as Trump reiterated his desire to have China fund a US stimulus bill in the midst of the COVID-19 pandemic. The United States also made moves this week to add Ant Group (owned by the Chinese Ali Baba Group) to a trade blacklist, and there are also ongoing attempts to overturn a court-ordered injunction over its ban of TikTok.

While Europe and the United States are still seeing COVID-19 cases increase, they continue to trend lower in Asia overall. New daily cases in South Korea fell below 50, and restrictions eased last week. There were reports that Hong Kong and Singapore would be establishing travel bubbles, whilst the Australian state of Victoria eased restrictions over the weekend.

Week Ahead

This week it will be the familiar themes of continuing Brexit negotiations and COVID-19 cases and restrictions that should give European markets direction. In addition, third-quarter earnings season heats up. It’s a similar story in the United States, with politics, stimulus and earnings likely to drive markets.

Calendar: Week Ahead

Monetary Policy

Monday 19 October

ECB’s Christine Lagarde Speaks

Tuesday 20 October

US Federal Reserve (Fed’s) Charles Evans and John Williams speak

Wednesday 21 October

Fed releases its survey of the nation’s economic conditions (commonly known as the Beige Book); Fed’s Loretta Mester speaks

Macro Data

Monday 19 October

Europe: German producer price index (PPI); UK house prices

United States: NAHB Housing

Asia: Japan trade balance; China gross domestic product (GDP), IP, retail sales

Tuesday 20 October

Europe: German PPI

Wednesday 21 October

Europe: UK CPI, retail price index (RPI) and PPI

Thursday 22 October

Europe: Eurozone consumer confidence

United States: Initial jobless claims, existing homes

Friday 23 October

Europe: UK retail sales and consumer confidence, Eurozone/German/French composite, services and manufacturing Purchasing Managers’ Index (PMI)

United States: Services and composite PMI

Asia: Japan Jibun Bank PMIs, Japan CPI

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