Notes from the Trading Desk—Europe

The Digest

Last week saw stabilisation in European government bond yields, which in turn, led to rotation back into some of the more recent losers, and defensive stocks. Alongside this, the reopening trade was firmly in play. All sectors closed the week higher and the STOXX Europe 600 Index gained 3.5%, making back last week’s losses and more. Whilst yields stabilised in Europe, in the United States they continued to push higher, with the 10-year Treasury yield gaining 5.9 basis points (bps)¹ to 1.626%, breaking new 52-week highs. The S&P 500 Index closed the week up 2.8%, with all sectors in the green. The Asia and Pacific (APAC) region underperformed, with the MSCI APAC Index only gaining 0.9% on the week.²

The recent value surge paused for breath in Europe, with the value basket the worst weekly performer, whilst the stay-at-home basket outperformed. This is more due to its defensive nature, however, as the retail sector was also higher on reopening hopes. There were quite a few moving parts behind sector dispersion.

Telecommunications and utilities were two of last week’s best-performing sectors given their defensive tilt, also joined by travel and leisure on the reopening theme. Construction and materials benefitted from US stimulus. Real estate, and basic resources sectors were relative underperformers as part of the value consolidation.

Meanwhile, automobiles and miners lagged last Thursday especially, with the market rotating out of China-exposed names as concerns over tightening of stimulus measure there weighed on sentiment. The banks and financial services also put in more muted performances, selling off on Thursday as yields tightened after the European Central Bank (ECB) signalled it was uncomfortable with the recent rise in yields.

The UK equity market was the underperformer in the region, despite the success of the vaccine rollout so far. Regional divergence reflected index sector skews; value and basic resources weighed on the UK FTSE 100 Index, whilst Italy’s utilities exposure saw the FTSE MIB Index outperform, alongside further stimulus announcements with new Prime Minister Mario Draghi taking charge.

The FTSE 250 Index fared better than the FTSE 100 Index, with its re-opening ‘brick and mortar’ skew. Whilst the European value trade may have paused for breath last week, the divergence between global growth and value stocks remains at historically elevated levels, suggesting that the rotation still has the potential to run further.

Looking at US sectors, there were again a number of moving parts. The best-performing sectors were consumer discretionary (reopening hopes) and utilities (bounce for renewables after recent weakness). The cyclical materials and industrials spaces were also strong amid the passing of the US$1.9 trillion stimulus package. Energy was a relative underperformer, with WTI crude oil pausing for breath on higher US inventories and (again) China’s move to curb its exuberant stimulus provisions.

From a factor perspective, US momentum was higher last week vs. US value, although this does not do justice to some of the whipsaw moves we saw through the week.

ECB Ramps Up Pandemic Emergency Purchase Programme (PEPP) Purchases

Last Thursday, we heard from the ECB, and the central bank made it clear it was uneasy about the recent rise in yields and would proactively accelerate its quantitative easing (QE) purchases ‘at a significantly higher pace than during the first months of this year’. Since the start of the year, the ECB has adopted an estimated €18 billion-per-week rate. We can expect more detail on exactly what ‘significantly higher’ means in coming days, but it’s important to note that the central bank stressed that the size of the program will not be increased, just the speed.

The announcement had the desired effect, with European government bond yields moving lower and the bond market feeling more orderly. The spread between the German 10-year bund and Italian 10-year BTP also tightened and the euro traded up over 40 basis points (bps) despite the dovish tone.

The macro picture was not dramatically different from what the central bank was forecasting late last year, but subdued inflation was a focus for many. The last quarter of 2020 was not as bad as feared, but 2021 has started on a weaker footing; the ECB is now expecting gross domestic product (GDP) to decline by 0.4% in the first quarter vs. the fourth quarter. Notably, strong growth is still expected during the second and third quarter, with the recovery just delayed somewhat.

Looking further out, GDP at the end of 2023 is forecast to be about 0.5% higher than previously assumed. The ECB reflected this by nudging its core inflation forecast higher for 2023 (from 1.2% to 1.3%). Compared to ‘normal times’, however, this is still 0.3-0.5% lower than what the ECB would forecast for core inflation three years out. This implies that the macro backdrop has not improved significantly enough to warrant the recent rise in yields. The magnitude of the recovery will need to surprise to the upside for several consecutive quarters in order for inflation forecasts to move high enough to justify accepting significantly higher borrowing costs.

Of course, there remains some tension within the governing council, with disagreement on the tolerance for higher yields. With this, the situation remains fragile and will inevitably need to be revisited later this year.

Week in Review

United States

Last week saw a strong performance from US equity indices, with the S&P 500 Index testing highs again, up2.9% on the week, while the Dow Jones Industrial Average was up 4.1% and the Nasdaq up 3.1%. Familiar themes drove market performance, with bond yields, stimulus, reflation/reopening and central bank policy dominating market narrative. A notable feature through the week was aggressive sector and factor rotation that ebbed and flowed from day to day. The US 10-year Treasury yield edged to new 52-week highs, up 5.9bps at 1.63% on the week.

We also saw significant rotation out of bonds and into equities.

Stimulus: With the US$1.9 trillion stimulus package signed off by President Joe Biden last week, we saw focus turn to the impact of this on the US economy and markets. Of note, US$402 billion will be distributed to individuals in US$1,400 cheques that are now being sent out. Some of this will likely be invested in the markets in coming weeks. We have already seen some retail favorites pushing higher, with Bitcoin trading at new all times highs above US$60,000, TESLA bouncing back to trade +16% last week, and the Goldman Sachs Retail Basket +6.4% on the week.³ Some of this was likely be pre-positioning in anticipation of the stimulus impact—the power of retail investing cannot be underestimated.

Another debate around the stimulus is its impact on US inflation. However, US Treasury Secretary Janet Yellen played down this risk, stating price pressure remains subdued: ‘I think there’s a small risk and I think it’s manageable’. In addition, some economists don’t see the fiscal package causing runaway inflation, as some individuals may not spend their stimulus cheques right away, but elect to put the money into savings instead.

Federal Reserve (Fed) Policy: This Wednesday’s Fed meeting will be a significant event for markets. While there was no fresh Fed commentary last week as it was in the comment blackout period ahead of the meeting, there was much speculation around what to expect. No change to interest rates is expected, but we get updated economic projections from the Fed, which could have an impact on its ‘dot plot’, i.e., the path of future interest-rate increases. We could see market volatility, and moves in Treasury yields will be closely watched. Many see a US 10-year yield of 1.75% as problematic for equities (particularly ‘bond proxy’ yield plays).

Recall the Fed’s current wording on its rate policy is it ‘expects it will be appropriate to maintain this target range until…and inflation has risen to two percent and is on track to moderately exceed two percent for some time’. Market expectations (based on a survey of economists) project two quarter-point hikes in 2023.

Europe

European stocks closing last week up 3.5%, with equity markets continuing to take direction from global credit markets for now. As mentioned, bond yields moved lower, and it was some of the year-to-date winners which lost out as defensives outperformed.

Despite the moves in equity markets last week, the reopening of economies around Europe remains at a precarious stage. Infection rates in the eurozone are on the increase, albeit stabilising in Germany, France and the Netherlands, and continuing to fall in Spain. In Italy, there has been a notable rise in new cases over the last month and Prime Minister Mario Draghi stated that Italy was facing a ‘new wave’, which has led to the announcement of stricter lockdown measures around the country. Any region registering over 250 cases per 100,000 inhabitants will be placed in the strictest lockdown with bars, restaurants and schools closing. During the Easter holidays, all of Italy will be placed in automatic shutdown.

The picture continues to improve in the United Kingdom, with infection rates continuing to fall despite test intensity hitting new highs. Hospitalisations are also falling in the United Kingdom as the country forges on with its vaccination programme.

Last week, questions were raised in Europe about possible side effects of the Astrazeneca vaccine. Many countries around Europe suspended the use of the vaccine after reports some recipients experienced blood clots. The decision to suspend the use of the vaccine was a precautionary one, whilst the World Health Organisation (WHO) and Astrazeneca claimed there was no link. With the concerns over the slow vaccine rollout and its impact on growth prospects, Europe only saw muted equity inflows versus other regions globally.

German politics received some focus over the weekend following two state elections. Support for Chancellor Angela Merkel’s centre-right Christian Democratic Union (CDU) party fell to historic lows, with a number of drivers. A kickback scandal in the CDU/Christlich-Soziale Union (CSU) parliamentary faction in Berlin, discontent over slow vaccination progress, and criticism over the management of lockdowns amidst rising infections have all seemingly curtailed support for the conservatives. Now questions have been raised around whether or not this sets the tone for the federal elections due in September this year.

The CDU/CSU remain the favourites; however, the results of the state elections have increased conversations on alternatives. Armin Laschet was appointed new leader of the CDU, but his rival Markus Söder from the CSU is more popular with voters, so may be a more suitable candidate to replace Angela Merkel as chancellor later this year. Whilst the poor performance in the state elections cannot be attributed necessarily to Laschet, the first two months have been far from smooth, and he may decide it is appropriate to step aside for Söder.

Brexit was back in focus last week with the release of export/import data. The report showed a dramatic impact on UK exports to the European Union (EU), down 40% month-on-month in January. Imports from the EU also fell dramatically, down 28.8%. Whilst some of the drop was likely due to stockpiling effects ahead of January switching and pandemic-related restrictions, the report is a worrying sign.

Whilst the overall goods trade balance with the EU slightly improved in January, this is no consolation given the sizeable loss of business caused by the sudden collapse in UK-EU commerce. Although trade should rebound somewhat in February and March, the latest report shows that UK-EU trade may remain below pre-Brexit levels for a long time to come. Some observers say this could change with improved administration on the implementation of the new UK-EU border.

APAC

Asian equities were mixed last week, with the MSCI Asia Pacific Index managing to close the week up 0.9%. Sector performance in Asia was relatively mixed. Like in the United States and Europe, utilities were market leaders, while industrials and materials were also higher. Energy stocks and communications services were the only two sectors that declined last week.

Chinese equities fell for a third straight week, with the Shanghai Composite closing the week down 1.4% after an early slump due to concerns about the imminent curbing of stimulus. Stockpiles of iron ore at Chinese ports have risen to their highest level since May 2019, which could signal slowing production; iron ore prices fell by 4.6% on the week. Other data was more positive, as Chinese January-February exports surged, jumping 61% in US-dollar terms. The surge, while skewed because of the comparison to a locked down economy from last year, reflects strong global demand and was well above expectations. Imports also grew, climbing 22.2% in the first two months of the year from a year earlier.

The Hang Seng Index also lagged on the week, down 1.2%. Investor demand has been hit again after China’s national legislature approved electoral changes that would put pro-Beijing loyalists firmly in charge of Hong Kong.

US-China relations were back in focus after a top Chinese diplomat urged the United States to stop ‘crossing lines and playing with fire’ on Taiwan, as part of a broad series of warnings to President Biden against meddling in Beijing’s affairs. China Foreign Minister Wang Yi said there was ‘no room for compromise or concessions’ in China’s claim to sovereignty over Taiwan.

Week Ahead

Monetary policy decisions dominate this week’s calendar, with the Fed centre-stage on Wednesday. We also hear from policymakers in the United Kingdom, Japan, Norway and Russia. Looking at data releases, a second reading of the euro-area consumer price index (CPI) will be in focus, along with Tuesday’s German ZEW reading. Outside of this, the WHO is scheduled to release a report on the origins of COVID-19 this week.

Monday 15 March 

• Eurogroup & Ecofin meeting (Monday and Tuesday)
• Key speakers: ECB’s Mario Centeno

Tuesday 16 March

• France CPI
• Italy CPI EU harmonised
• Germany ZEW financial market survey (March)
• US manufacturing production

Wednesday 17 March

• Eurozone EU27 new car registrations
• Spain trade balance
• Eurozone CPI & construction output
• EU Commission unveils its proposal for vaccine passports
• The Netherlands holds a general election for the 150-seat lower house of parliament
• International Energy Agency’s monthly oil market report
• US Federal Open Market Committee meeting and projections

Thursday 18 March

• Italy trade balance total
• Eurozone trade balance
• UK Bank of England policy meeting and interest-rate decision
• Policy meetings/rate decisions: Norway, Indonesia, Taiwan, Norway, Turkey, Egypt
• Key speakers: ECB’s de Luis Guindos and Isabel Schnabel; BoE’s Andy Haldane and Jon Cunliffe
• US jobless claims

Friday 19 March

• Germany
• UK public finances
• Bank of Japan monetary policy decision; Governor Haruhiko Kuroda briefing
• Russia rate decision
• The US China Economic and Security Review Commission presents its annual report to Congress on the national security implications of the economic relationship between the US and China

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1. One basis point is equal to 0.01%.

2. 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.

3. Ibid.