Notes from the Trading Desk – Europe

The Digest

Markets were expected to be quiet last week as US investors took Thanksgiving vacations, but news of the COVID-19 variant that emerged in South Africa (named Omicron) shook sentiment on Friday, prompting sharp declines. With that, we saw some significant weekly moves; the MSCI World Index was down 2.7%, the European Stoxx 600 Index was down 4.5% (its worst weekly performance since 2020), the S&P 500 Index down 2.2% and the MSCI Asia Pacific Index continued with its underperformance, down 2.9%.¹

Omicron Variant Threat Spooks Investors

Equity markets plunged last Friday on the Omicron (B.1.1.529) COVID-19 variant headlines, as there were concerns it has a high number of mutations in the spike protein (reducing vaccines’ ability to recognise and fight it off) and the variant is more transmissible than the previous Delta variant. The Financial Times reported that early PCR results suggest 90% of 1,100 new cases last Wednesday in the Gauteng region of South Africa (Johannesburg) were caused by the new variant.² The rapid spread of new cases prompted the United Kingdom into action, with travel bans on six African countries. The UK Health Security Agency said it was the “most worrying” variant yet.

Since this news broke, a growing number of countries have confirmed cases of Omicron and further travel restrictions are being put in place; Japan announced it was closing its borders to foreign travelers once again. Regarding the virus, it is reported that some South African health officials suggested “no unusual symptoms have been reported following infection with the B.1.1.529 variant and as with other variants some individuals are asymptomatic”. It is also reassuring Moderna is trading up 10% pre-market after saying that a vaccine will be ready early next year.

However, details at this stage remain light and it thought it could take around two weeks for scientists to fully understand Omicron.

Market Reaction

Asian markets were the first to fall sharply last Friday, with Hong Kong’s Hang Seng Index down 2.7% and Japan’s Nikkei Index down 2.5%, the worst-performing markets in that region. Europe followed suit, with the European Stoxx 600 Index seeing its worst weekly performance since October 2020, with the index finishing down 4.5% and every single subsector down on the week. The European Volatility Index rose 63%.

Nerves regarding the COVID-19 situation in Europe were already brittle, given the rising cases in many countries and fresh lockdown measures being enforced or discussed, so Friday’s news prompted a further sharp unwind in the travel and leisure space; “stay at home” stocks held up well, down just 0.5% Friday, while “reopening” stocks slumped 9.4%. In addition, banks and oil and gas also lagged as the recent rotation into value comes to a halt. West Texas Intermediate crude oil fell 13% Friday on fears fresh travel restrictions may dent demand for crude oil. No surprise to see defensive sectors outperform in such a risk-off environment, with utilities and health care outperforming.

The risk-off theme was clear across asset classes, with the US 10-year Treasury yield tightening by around 15 basis points (bps) to 1.47%,³ one of the yield’s sharpest declines in recent times. In the foreign exchange markets, the Japanese yen and Swiss franc strengthened, and elsewhere, credit spreads also widened as the news hit corporate default swaps.

While we saw some extreme moves, it is important to note that a huge number of market participants were on holiday due to the US Thanksgiving break last week. While it is hard to quantify the impact, it is likely that volatility was exacerbated because many US market participants were out. However, European market volumes were high, as Friday saw the third-highest daily volume of the year in the Stoxx 600 Index. Of note, there was a clear unwind of crowded trades.

The dust seems to be settling a bit on Friday’s moves, and markets have steadied somewhat in early trade this week. In Asia, we saw muted moves lower with Hong Kong’s equity market down 1%, South Korea’s down 0.9% and Shanghai market in China unchanged on the day. Japan was the laggard, down 1.6% on the news of the travel ban. The European Stoxx 600 Index held up well, with some respite for the hardest-hit names, including travel and leisure. The US 10-year Treasury yield widened to 1.53%.

Looking ahead, it will be important to watch how this latest COVID news feeds into central bank thinking, with money markets already repriced the timeline for potential rate hikes further out.

The Week in Review

Europe

European equities experienced their worst one-day move of the year to close last week down 4.5%. We saw classic “risk off” trade, as the market digested the news of the latest Omicron variant. Bonds caught a bid, the Japanese yen and Swiss franc were stronger, and commodities were lower.

The detail regarding the mutation of the virus was fairly vague, but that didn’t stop investors from becoming spooked by the headlines. The lack of market participants and US market closures due to the Thanksgiving holiday likely exacerbated the moves. Right now, we don’t know what this mutation means for vaccine effectiveness or transmissibility.

Investors in Europe were already on tenterhooks these past few weeks following the rise in cases around Europe, so it did not take much for sentiment to be shaken further. Volatility spiked in Europe on Friday, with the European Volatility Index (V2X) up 63% on the day and passed 30 for the first time since January. Note, the index peaked >80 back in March 2020.⁴

We saw a clear rotation out of cyclicals last week as investors flocked to safety. Another clear theme, for obvious reasons, was selling of the reopening trade. The “going out” basket closed lower as travel and leisure names were particularly hard hit. Concerns around international travel deteriorated further with the news of the new COVID-19 variant, causing European airlines to extend losses. Bank stocks also suffered. Defensive names including utilities and telecommunications, along with food and beverage, were unsurprisingly the “winners” last week—albeit all still with mile losses overall. Friday was also the worst day year-to-date for oil prices. Brent crude oil was down 10.3% on the day at Friday’s equity market close (down 6.6% on the week).

Looking to politics, there are a couple of interest dynamics in Europe to keep an eye on.

German Politics: The Social Democratic Party (SPD), Free Democratic Party (FDP) and the Greens unveiled the new government coalition. They now must get the approval of their party members and then it is likely they will take power around 9 December. Former Finance Minister Olaf Scholz (SPD) will replace Angela Merkel as Chancellor; FDP leader Christian Lindner will be finance minister; and the Greens leader, Annalena Baerbock, will be foreign minister.

One area that will be interesting is foreign policy, with Baerbock already taking a tougher stance on both China and Russia. She stated German foreign policy should be “guided by human rights and values” and “We have to stop (equating) German interests with German economic interests”. Perhaps something to watch for those companies with significant Chinese exposure.

UK Politics: After a few torrid weeks for Prime Minister Boris Johnson (party scandal, migrant crisis, European Union loggerheads on Northern Ireland, the now infamous Confederation of British Industry speech incident, etc.) support for the Conservative party in the polls has waned somewhat. Last week, we highlighted cautious UK investor sentiment, (Bank of America Survey, UK equity fund outflows) and whilst it’s too soon to read too much into the polling, if it continues it will be interesting to see how this impacts investors’ view on the United Kingdom.

United States

Given the Thanksgiving holiday last Thursday and half day on Friday, it was a quieter week for US markets in terms of newsflow. Friday’s Omicron variant selloff was the main talking point. Last week, the S&P 500 Index traded down 2.2%. As in Europe, the defensive stocks held up fairly well, with mild losses in utilities and consumer staples and communications services and consumer discretionary faring a bit worse.

Earlier in the week, US President Joe Biden reaffirmed current Federal Reserve (Fed) President Jerome Powell for another term, with Lael Brainard nominated as vice chair. The news prompted some sharp moves in the bond markets, with the US 10-year yield widening to 1.62% last Monday.

Some believe that Powell will now have greater flexibility to become more hawkish, as Brainard—who was in the running for the Fed leadership role—is seen as more dovish. With the move in yields, we did see growth/tech names underperform earlier last week. It remains to be seen how the latest COVID news will impact policymakers—and markets—going forward.

Looking at Fedspeak, there appears to be more noise around a potential acceleration in the tapering of the Fed’s asset purchasing programme. Atlanta Fed Chief Raphael Bostic had argued in favour of a faster pace of tightening to give the Federal Open Market Committee more optionality. In addition, the Fed meeting minutes released last week said the Fed stressed the need to be flexible as it winds down its US$120 billion-a-month bond-buying programme. However, how the recent COVID-19 news flow feeds into this will be something to watch.

Finally, it is worth noting that given the moves on Friday, the CNN Fear & Greed investor sentiment Index⁵ has plunged firmly into “Fear” territory. The change in sentiment looks extreme and, if we get any reassuring headlines regarding the Omicron variant, expect a sharp bounce back.

Asia and Pacific

What we thought might be quieter week in Asia (US holidays, Japan was closed on Tuesday) turned out to be rather busier than expected, as the new COVID-19 Omicron variant headlines spooked the market at the end of the week and the old theme of China vs. United States continued.

China: Chinese markets weakened slightly last week amid US-China tensions and rising economic pressures that raised expectations for supportive government measures. The yield on China’s 10-year government bond fell to 2.881% from the prior week’s 2.946% as investors sought safe-haven assets.

Relations with the United States remained tense over the status of Taiwan and trade issues. The US Commerce Department issued a trade blacklist naming a dozen Chinese companies that it said supported the military modernisation of the People’s Liberation Army. In response, a Chinese official said the United States should not expect China’s military to compromise regarding Taiwan.

On the economic front, Premier Li Keqiang said that China should step up efforts to stabilise employment, financing, and other key areas and that the government was studying policies on tax and fee cuts, along with some reforms, to support businesses.

Hong Kong: Stocks traded down this week with internet and health care dragging the market lower, with focus on the Hang Seng Index and Hang Sang Composite Index quarterly review results. Internet names were weak due to news around “data tax” against platform developers and tighten regulations via tax on “flux economy” participants.

According to an official, the recent detection of three imported cases of COVID-19 caused by the Omicron variant in Hong Kong won’t affect the city’s reopening plans with mainland China.

South Korea: The KOSPI Index traded higher last week, with large-capitalisation stocks taking the lead (especially the semiconductors) on the back of strong earnings reported by US competitors MICRON, NVIDIA, etc. The Bank of Korea raised its benchmark rate by 25 basis points,⁶ but this was well flagged and so no material impact on the markets.

Japan: Japanese equities held up for much of the shortened week, only to succumb late last week amid worries about the pace of economic recovery in light of the new COVID variant. The Nikkei 225 Index fell below 29,000, shedding 3.3%.

Looking at macro data, flash data showed the Japan Composite Purchasing Managers’ Index (PMI) rose to 52.5 in November—a 37-month high—from 50.7 in October, buoyed by loosening coronavirus restrictions at that time, and soaring vaccination rates. Similarly, the Japan Services PMI hit a 26-month high of 52.1 in November, up from 50.7 the previous month. Japan’s Manufacturing PMI rose to 54.2 in November, up from 53.2 in October.

The Week Ahead

Unfortunately, we are back to watching the latest COVID-19 headlines when following market sentiment. However, Fed policy will be worth watching too as Powell speaks this week. The October US employment report is also a focal point. In Europe, inflation data will be in focus as we get Consumer Price Index (CPI) data.

Monday 29 November  

• Spain CPI
• UK net consumer credit
• Eurozone consumer confidence
• Germany CPI
• Italy Producer Price Index (PPI)
• US pending home sales

Tuesday 30 November    

• UK nationwide house price survey
• France gross domestic product (GDP), CPI and consumer spending
• Germany unemployment change
• Spain current account balance
• Italy GDP
• Eurozone CPI

Wednesday 1 December

• Switzerland CPI
• Germany PMI manufacturing
• Italy PMI manufacturing, budget balance
• UK PMI manufacturing
• US PMI Manufacturing, MBA mortgage applications, ADP employment change, Institute for Supply Management (ISM) manufacturing

Thursday 2 December      

• Spain unemployment change
• Italy unemployment rate
• US challenger layoffs
• US jobless claims

Friday 3 December      

• France manufacturing and industrial production
• Eurozone retail sales
• Germany PMI Services/composite
• Italy PMI services/composite
• UK PMI services/composite
• US non-farm payrolls & unemployment rate

Views You Can Use

UK Equities: Attractive Relative Valuations, Despite Relatively Unattractive Macro Signals

While UK equities have faced a number of headwinds in 2021, there are reasons to be optimistic about the year ahead, according to Ben Russon and Will Bradwell of our Franklin UK Equity team. They discuss the economic recovery from COVID-19, inflation, the state of the consumer and why stock valuations look attractive. Read more. 

Inflation Insulation: Navigating the Nuances of Inflationary and Rising-Rate Environments

Moderate inflation can be good, especially for some value stocks. Christian Correa breaks down why investors should not be afraid of the current inflationary or rising rate environments and explains how they can actually help some businesses and areas of the equity market. Read more. 

Japan: A New Quiver of Arrows?

With a new Prime Minister taking the helm in Japan, what does the future hold? Franklin Templeton Investment Solutions’ Gene Podkaminer and members of the research team take a look at both local and global trends influencing Japan—and why investors should pay more attention to the country. Read more.

PODCAST: High Time for High Yield?

In our latest “Talking Markets” podcast, Bill Zox and John McClain, portfolio managers with Brandywine Global, join Amer Hasan to discuss how current market and economic conditions could benefit high yield investors, the opportunities and risks right now, and why the asset class is often overlooked or misunderstood. Read more.

Quick Thoughts: What Our Managers Think: Do Growth or Value Stocks Have the Upper Hand?

While “growth” and “value” have typically been seen as distinct styles, that type of thinking continues to evolve, according to our investment professionals. For Stephen Dover, Head of Franklin Templeton Investment Institute, the real issue is how to invest where you are best rewarded. Read more.

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.  Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

What Are the Risks?

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.  Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

Past performance is not an indicator or guarantee of future performance. There is no assurance that any estimate, forecast or projection will be realised.

Links to External Sites

Franklin Templeton is not responsible for the content of external websites.

The inclusion of a link to an external website should not be understood to be an endorsement of that website or the site’s owners (or their products/services).

Links can take you to third-party sites/media with information and services not reviewed or endorsed by us. We urge you to review the privacy, security, terms of use, and other policies of each site you visit as we have no control over, and assume no responsibility or liability for them.

____________________________

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

2. Source: Financial Times,’ What we know about Omicron variant that has sparked global alarm’, 26 November 2021.

3. One basis point is equal to 0.01%.

4. The Euro STOXX 50 Volatility Index (V2TX) measures implied volatility of near term EuroStoxx 50 options, which are traded on the Eurex exchange. 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. CNN’s Fear & Greed Index tracks seven indicators of investor sentiment. 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.

6. One basis point is equal to 0.01%.