Notes from the Trading Desk – Europe

The Digest

Equity markets traded lower last week after a slight hawkish tilt in tone from the Federal Reserve (Fed) had a clear impact on investor sentiment. With that, reflation beneficiaries pared year-to-date gains and growth names performed well into the end of the week. The MSCI World Index traded down1.9%, the STOXX Europe 600 Index down 1.2%, S&P 500 Index down 1.9% and the MSCI Asia Pacific Index down1.1%.¹

Focus on the Fed

The primary focus for investors last week was the Fed meeting and the market impact thereafter. As expected, the Fed kept rates unchanged, but did give new guidance for their expected path of rate hikes (the “dot plot”) and revised their inflation expectations. The Fed members shifted the median dot to show two hikes in 2023 (from zero in March) and the wider dot plot saw seven participants expecting the first hike in 2022. Inflation forecasts also changed, with an expected 3.4% vs. 2.5% prior in 2021, but they see it moderating with fiscal year 2022 remaining at 2.0%, and there was only a minor uptick in 2023 to 2.2% versus 2.1%.

Regarding the Fed’s US$120 billion a month emergency asset purchasing programme, Chair Jerome Powell stated the bank was “talking about talking about tapering”. So, no change to policy but the first steps in the carefully choreographed road to the Fed’s scaling back of quantitative easing.

It’s worth noting Powell did caveat this meeting by stating the Fed’s forecasts need to be taken with a “big pinch of salt” due to remaining economic uncertainties.

Later in the week, comments from St Louis Fed Chair James Bullard doubled down on the Fed’s change in tone, stating Powell officially opened taper discussions this week and that higher inflation could potentially justify interest-rate hikes as early as 2022.

Although it was only a mild change in tone from the Fed overall, given how crowded and consensual many positions in the market have become, the change in tone was enough to spark some interesting market moves.

In bond markets, we saw signs longer-term inflation expectations declining, as evidenced by the tighter spread between the US two-year and 30-year yields.

Given that, we saw profit taking in reflation beneficiaries, due to the message that the Fed was willing to be more proactive on inflation. In addition, the Fed reiterated its view that the current inflationary pressures are transitory and will fade. Powell cited the example of lumber prices, which rocketed earlier in the year on pent-up demand, only for it give up most of the gains in the past month. This added further pressure to reflationary trades. The fall in yields helped to lift growth stocks vs. value. Elsewhere, the US dollar rallied 1.8% which added further pressure to commodity stocks, who also suffered from the Fed’s views that inflation was transitory. In Europe, reflation names were notable underperformers, the Goldman Sachs EU Reflation basket traded down 4% on the week.

As an example of how crowded some of these reflation trades have become, last week’s Bank of America Fund Manager survey illustrated how commodities and banks were consensus longs. In addition, long commodities overtook long Bitcoin as the most “crowded trade”.

So, reflation trades ran out of steam somewhat, but it is important to keep the moves in context. Many of these sectors have had extraordinary moves, for example the Goldman Sachs EU Reflation names are still up 61% over the past year, so a pause for breath is healthy in our opinion.

What next: Looking ahead, we have a number of Fed speakers this week, including Jerome Powell at Congress, whose commentary will be closely watched. Thereafter, the next few US monthly payroll numbers will be important for steering Fed policy, with the Jackson Hole central banker summit in August still viewed as a possible point for the Fed to comment on tapering plans.

The Week in Review

Europe

After weeks of steadily grinding higher to new highs, European equites paused for breath last week as the ripple effect from the Fed meeting impacted. Ahead of the meeting, Europe has seen nine consecutive days of setting new all-time highs, its longest run since 1999, so some would argue a pullback was overdue. With much focus on inflation being transitory, reflation names saw aggressive profit taking, with basic resources trading down 7.8% (stronger US dollar weighing as well), automobiles down 4% and the banks down 3.3%. In that context, defensives outperformed. With bond yields tightening, we saw yield proxies such as health care and utilities outperforming.

Unsurprisingly, the defensive-heavy Swiss exchange was the best performing, up 0.8%, whilst the FTSE MIB Index, with its large financials weightings, lagged (down 1.9%).

Fund flow data (up to last Wednesday) showed continued interest in European equities.

Looking at European Central Bank (ECB) policy, Chief Economist Philip Lane last week commented it was unnecessary and premature to talk about the end of the pandemic emergency purchase programme (PEPP).² In contrast, the head of Germany’s central bank, Jens Weidmann, said the PEPP scheme should come to an end in “the coming year”. On inflation, he also said it was temporary, stating, “the sharp rise in prices in Germany is temporary” and there was no evidence of “stubbornly excessive inflation”.³

United States

Last week started off quiet but switched into volatility overdrive after the Federal Open Market Committee (FOMC) meeting, with the VIX rallying 32% through the week and touching 21% late on Friday.⁴ The S&P 500 Index closed the week down 1.9%. The Dow Jones underperformed over the week, down 3.4%, whilst the Nasdaq outperformed, up 0.4%, with technology outperforming over the week.

The reflation trade was unwound on the back of the much more hawkish FOMC projection for the path of US interest rates. As such, it was not a good week for cyclicals, which were sent into a tailspin on Thursday. Materials finished the week down 6.3% with financials (down 6.2%) and energy (down 5.2%) not far behind.. Technology was the only sector to finish the week better off, albeit only slightly.

US 10-year Treasury yields rallied, back above 1.55% on Thursday. The dollar closed the week up 1.84%, with the US Dollar Index back above 92 for the first time since mid-April, which added further pressure to commodity stocks. The quarterly options and futures expiry on Friday added another dynamic to markets, with an estimated US$2.2 trillion of expiries globally.

Away from the FOMC, hopes for a bipartisan infrastructure deal  are still alive, but  are complicated by a lack of details, especially around funding and pushback from progressives. More moderate Democrats are not keen to support the recently floated US$6 trillion figure for a much broader package. A bipartisan infrastructure plan costing a little over US$1 trillion, only about a fourth of what President Joe Biden initially proposed, has been gaining support in the US Senate, but disputes still continue over how it should be funded.

Macroeconomic data was a little mixed last week. Retail sales in May were down 0.7%, missing expectations, and the Empire Manufacturing Index also missed, coming in at 17.4 with new orders, prices paid and prices received all slipping. Producer Price Index (PPI) headlines were strong (largest 12 month increase on record), but the details which pass through to Personal Consumption Expenditures (PCE) inflation are more mixed. Air fares actually fell in May, down 1.3%, whilst health care costs were stable.

Asia and Pacific

Asian stocks fell last week, with the MSCI Asia Pacific Index down 1.1%, also driven by the hawkish Fed release. The same themes we saw play out in Europe and the United States were evident in Asia too. Materials lagged, down 4.2%, whilst utilities (down 3.7%) and energy (down 2.5%) followed close behind. As in the United States, technology was the only sector to finish in the green, up 0.1%.

Chinese equities underperformed last week, down 1.8%, not helped by all economic data missing estimates. May retail sales grew 12.4% vs a consensus estimate of 14% growth. Industrial production grew 8.8% and fixed assets (ex-rural) grew 15.4%.

The Financial Times reported that China has approved record amounts of investment to flow out of the country through an official scheme, as authorities liberalise the local financial system against a backdrop of a rallying renminbi.⁵ A cumulative US$147 billion of approvals have been added to the nation’s qualified domestic institutional investor scheme, which allows investors to access assets outside mainland China through banks and other institutions. The move to allow more capital to leave the country came as policymakers have increasingly voiced concerns over high asset prices, as well as a rally in the currency.

In Japan, Prime Minister Suga survived a no-confidence motion late last Tuesday. While this was previously flagged as a possible catalyst for an early election, expectations of a dissolution of parliament in September have solidified. Also, macro sentiment was supportive with the G7 backing the Olympics to be held “in a safe and secure” manner as a symbol of global unity in overcoming COVID-19.

The Week Ahead

Monday 21 June

• ECB President Christine Lagarde addresses the European Parliament.
• UK: Rightmove house prices month-on-month (MoM).
• US: This week sees a virtual conference with several Fed members and starts on Monday and continues on Tuesday. Expect lots of headlines and more colour around last week’s hawkish statement.
• US: Chicago Fed National Activity Index.

Tuesday 22 June

• Eurozone: consumer confidence.
• US: existing home sales MoM; Richmond Fed Manufacturing Index.
• US: Jerome Powell testifies at a House Subcommittee hearing on the Fed’s pandemic emergency lending and its asset purchase programmes.

Wednesday 23 June

• France: Markit France Manufacturing PMI; Markit France Services PMI; Markit France Composite PMI.
• Germany: Markit/BME Germany Manufacturing PMI; Markit Germany Services PMI; Markit/BME Germany Composite PMI.
• Eurozone: Markit Eurozone Manufacturing PMI; Markit Eurozone Services PMI; Markit Eurozone Composite PMI.
• UK: Markit UK PMI Manufacturing SA; Markit/CIPS UK Services PMI; Markit/CIPS UK Composite PMI.
• US: current account balance; Markit US Manufacturing PMI; Markit US Services PMI; Markit US Composite PMI; new home sales; new home sales MoM.

Thursday 24 June

• France: business confidence; manufacturing confidence.
• Spain: Gross domestic product (GDP) quarter-on-quarter (QoQ); GDP year-on-year (YoY).
• Eurozone: ECB publishes economic bulletin.
• Germany: IFO expectations; IFO current assessment; IFO business climate.
• UK: Bank of England (BoE) bank rate/corporate bond target/gilt purchase target.
• US: advance goods trade balance; durable goods orders; durables (ex-transportation); capital goods orders nondefense (ex-air); GDP annualised QoQ; personal consumption; GDP Price Index; Core PCE QoQ; initial jobless claims; continuing claims; Kansas City Fed manufacturing activity.
• Stress tests: The Fed releases the results of the latest US bank stress tests.

Friday 25 June     

• UK: GfK consumer confidence.
• Germany: GfK consumer confidence.
• Italy: consumer confidence index; manufacturing confidence; economic sentiment.
• UK: CBI Retailing Reported Sales; CBI total distribution, reported sales.
• US: personal income; personal spending; real personal spending; PCE deflator and PCE core deflator YoY; University of Michigan sentiment and current conditions.

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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. Source: Reuters, “ECB’s Lane says early to discuss end of emergency bond buys”, 17 June 2021.

3. Source: Reuters, “ECB’s Weidmann sees normalisation of monetary policy in 2022”, 17 June 2021.

4. The CBOE Market Volatility Index measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. 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 performance.

5 Source: Financial Times, “China approves highest-ever outflows for mainland investors”, 15 June, 2021.