Notes from the Trading Desk – Europe

The Digest

Last week saw some extreme moves in equity markets as investors digested several central bank announcements, most notably the Federal Reserve (Fed) meeting on Wednesday. Last Thursday saw a sharp selloff in global equities, as fears around central bank policy errors regarding a stagflation environment weighed on sentiment. The ongoing COVID-19 lockdown in China and the Russia-Ukrainian war heightened investor uncertainty. In that context, all markets traded lower last week, with the MSCI World Index down 1.2% (down 14% year-to-date), the STOXX Europe 600 Index down 4.5%, the S&P 500 Index down 0.2% and the MSCI Asia Pacific Index down 2.7%.¹

Central Banks in Focus

Fed: Last Wednesday’s announcement was largely in line with market expectations, as the Fed increased interest rates by 50 basis points (bps), taking the fed funds rate to 1% (as expected). The US central bank also set out plans to reduce its balance sheet. This was the first time it had raised rates by 50 bps since 2000, and the first time since 2006 rates were raised in back-to-back meetings. The Fed now aims to get back to its “neutral interest rate” between 2% and 3%, although Chair Jerome Powell said a neutral rate was “not something we can identify with any precision”.²

Regarding the Fed’s US$9 trillion balance sheet, it announced quantitative tightening at US$47.5 billion runoff (marginally higher than consensus) starting on 1 June (marginally later than expected, likely offsetting the faster initial pace) rising to US$97.5 billion after three months (broadly in line with expectations).

Looking ahead, Powell said 50 bp rate increases would be “on the table for the next couple of meetings” but, when asked about a larger increase, he said the Federal Open Market Committee (FOMC) was not “actively considering” a 75 bp rate hike.

US markets initially focused on the comment to rule out future 75 bp hikes as dovish and, last Wednesday saw a knee-jerk 3% rally in the S&P 500 Index, only for it to reverse the following day as investors appeared to shift focus to the overall hawkish path ahead in a difficult economic context. On the economic outlook, the Fed feels that the US economy is strong enough to withstand the measures it is taking. However, US Treasury Secretary Janet Yellen said Powell would need to be “skillful and also lucky” to see the US economy have a soft landing.

Bank of England (BoE): Following on from the Fed rate increase last Wednesday, the BoE announced its interest-rate decision on Thursday. Consensus was for a 25 bp rate hike and the BoE didn’t disappoint, raising the benchmark rate by 25 bps to 1%—the fourth consecutive rate rise. Interestingly, six monetary policy committee members voted for 25 bps and the remaining three for 50 bps, giving the announcement a slightly hawkish feel (compared to the FOMC, which many thought had a slightly dovish feel to it). In the press release, there was some (depressing) commentary warning of growing recession risk, and the BoE also forecast inflation to hit 10% by the end of the year (the highest rate since 1982).

However, some have been questioning the BoE’s (very bearish) gross domestic product (GDP) projections, which are at odds with the Bloomberg consensus and, importantly, the United Kingdom’s own Office for Budget Responsibility (OBR). Maybe the BoE is being overly (or ”conservatively”) pessimistic, or maybe the market consensus is being overly optimistic. Either way, it seems there is a very rocky road ahead and we are at the mercy of geopolitical and pandemic developments.

European Central Bank (ECB): The focus will now turn to the next ECB meeting on 9 June.  The change in rhetoric from ECB members has been notable, with a much more hawkish stance. Last week, Austrian Central Bank Governor and ECB Governing Council member Robert Holzmann said the ECB planned to discuss an interest-rate rise at its June meeting and will “probably do it.”³ The market now is factoring in three ECB rate hikes this year.

The Week in Review

Europe

Last week global equities made new year-to-date lows, so unsurprisingly it was a tough week for European equities. The STOXX Europe 600 Index declined 4.5% on the week. Clear headwinds included central banks raising rates into stagflation and a gloomy outlook from the BoE, causing growth and consumer stocks to buckle. Once again, the dispersion between sectors was extreme, with energy remaining one of the few hideouts, up 3.2% last week amid higher crude oil prices and positive earnings reports. Consumer products (particularly luxury goods) and real estate slumped.

It was another big week for corporate earnings, with the energy space the clear beneficiary of some good numbers (e.g., BP and Shell). In contrast, the market was unforgiving on any earnings misses, particularly so with consumer stocks (e.g., Adidas).

Once again, we saw outflows from European equities, continuing the streak.

In Ukraine, the Russian advance in the east made marginal gains, and with no mention of peace talks anymore, a long, drawn-out campaign into the summer seems probable. The impact of this on commodity and food prices is clear. Of note, fertilizer prices are now at all-time highs. In addition, the impact on supply chains was highlighted when German car manufacturer Volkswagen stated it had “sold out” of electric cars for 2022 after supply chain bottlenecks hit production.

Looking to other asset classes, European credit continues to show signs of stress amid fears over the region’s economic outlook. In addition, since 2020 the ECB has backstopped credit markets with its asset purchasing programme; as it is set to conclude in the second half of 2022, there are serious concerns over the impact of its disappearance from the market.

One of the big stories last week was the slump of the UK sterling, which fell 2.5% last week. The gloomy BoE message triggered the move, as downside risks to growth continue to rise even as the UK Consumer Prices Index (CPI) is expected to rise above 10%.

European government bond yields continue to sharply widen, with the German 10-year bund going from negative territory in March, up to 1.13%. Peripheral yields have also widened, with the spread between 10-year BTPs and bunds crossing 200 bps. This will be a concern for authorities in Italy, as its economy is heavily exposed to Russian energy imports.

Macro data for the region was mixed last week. Eurozone Purchasing Managers’ Index (PMI) manufacturing data was a little better than estimated at 55.5, but new orders had the lowest reading since June 2020. German year-over-year March factory orders also dropped far more than expected. The consumer has also been under pressure, with retail sales in Germany falling unexpectedly in March.

United States

The S&P 500 Index closed last week down 0.2% to record its fifth consecutive weekly loss, its worst run since 2011. The tech-heavy Nasdaq Index also fell 1.3%, now with five straight weeks of >1% declines. Risk-off sentiment was clear when we look at fund flow data, which showed continued US equity outflows. Focus for the week was on the Fed announcement, which initially sparked a rally in equity markets with a couple of dovish signals. The deterioration in macro datapoints was cited as the reason behind the subsequent selloff in global equities, as data out of China and Europe disappointed. Despite the dramatic moves last week, there was no sharp rise in the VIX Index, which closed at 30.19.⁴

Meanwhile, the April US employment report was roughly in line with expectations, with 428,000 jobs added. However, there were a couple of misses within the report. There was a decline in household employment and labour-force participation, which raised concerns on the future growth of the jobs market.

US equities were very mixed at a sector level last week. Energy closed the week with strong gains helped by the rally in oil prices on the prospect of a European Union (EU) embargo on Russian oil, as well good earnings. Utilities and communication services also fared relatively well last week. At the other end, real estate investment trusts (REITs) underperformed, closing the week lower with interest rates on the rise and as US Treasury yields moved higher. Consumer discretionary stocks were also weak, with retailers under pressure. The Goldman Sachs Non-Profitable Technology Index traded down on the week as well.

Meanwhile, earnings season remained in full force, with nearly 90% of the S&P’s market cap having reported first-quarter earnings. So far, we are seeing more companies beating expectations than missing. Value and growth stocks are delivering similar revenue growth as in the first quarter; however, value stocks are delivering stronger earnings-per-share (EPS) growth. Within the United States, more globally oriented companies are delivering faster earnings growth than their more domestically oriented peers.

In terms of credit markets, the US 10-year Treasury bond crossed 3%, rising to levels last seen in November 2018. Global credit markets remain under pressure, driven by fears of slowing economic growth, faster inflation and subsequent interest rate rises. Last week was the fifth consecutive week of losses for credit markets, the longest losing streak in more than three months.

ASIA-Pacific

Although markets in China and Japan were closed for most of last week amid holidays, the week was marked by declines.

China’s market reopened on Thursday and declined on Friday. The government’s strict zero-COVID policy continues to hit economic growth, jobs and the entire supply chain. As a guide to how impactful the restrictions have been, spending over China’s five-day Labour Day holiday plummeted 43% from a year earlier to CNY 64.7 billion, or roughly US$9.8 billion.⁵ This follows the Caixin and official purchasing managers’ surveys, which showed manufacturing and services contracted at a significant rate in April.

US-China relations continue to be stretched, as US regulators added more than 80 companies to an expanding list of firms that face possible expulsion from American exchanges because of Beijing’s refusal to allow access to the businesses’ financial audits. Also, investors continue to be wary of possible sanctions on China over their tacit support of Russia, with Chinese regulators holding emergency meetings with domestic and foreign banks to discuss how they could protect the country’s overseas assets from US-led sanctions.

Later in the week, the market sold off as the government reaffirmed its commitment to a zero-COVID strategy, and amid the Fed’s rate hike and bearish BoE outlook.

Yields on Chinese government bonds declined after the People’s Bank of China said it would use incremental policy tools to support steady economic growth and stabilize employment and prices. The CNY weakened slightly against the US dollar from the prior week as corporates rushed to hedge after the currency slumped 4% in April, its steepest monthly drop since foreign exchange reforms in 1994.⁶

Japan’s market closed the week up 0.58% despite the holidays and the volatility induced by the Fed’s decision to implement the first 50 bps raise since 2000. The yield on the 10-year government bond rose to 0.24%, from 0.21% at the end of the previous week. The yen finished the period slightly weaker, at around JPY130.51 vs. the US dollar, continuing to hover at a two-decade low.

Elsewhere, in Australia the Reserve Bank of Australia raised rates by 25 bps to 35 bps last Tuesday, and short-dated bonds traded off hard as a result.

The Week Ahead

In Europe, focus ahead will be on the German ZEW economics expectations survey, the UK Sterling and Eurozone Industrial Production (IP) reports. Rhetoric from the ECB will continue to be a focal point ahead of its June meeting. Elsewhere, US and Chinese Inflation data on Wednesday will be closely watched.

In terms of politics, commentary around the proposed EU ban on Russian oil imports will be important to track, given the potential economic impact.

Monday 9 May   

• UK BRC sales LFL
• French trade balance

Tuesday 10 May

• Germany ZEW Expectations Survey
• Italian IP

Wednesday 11 May

• German CPI
• US CPI
• China CPI

Thursday 12 May

• UK GDP
• UK imports and exports
• US Producer Price Index (PPI)

Friday 13 May

• French CPI
• Spanish CPI
• Euro area Industrial Production

Views You Can Use

Peering Around the (Yield) Curve

The US Treasury yield curve momentarily inverted. Franklin Templeton Investment Solutions investigates what this implies for recession risk, growth momentum, and equity prices. Read more.

Europe Outlook: A French Economic Evolution

Franklin Mutual Series’ Katrina Dudley sees President Emmanuel Macron’s re-election as a positive for the French economy and regional equity markets over the longer term. Read more. 

Middle Eastern Resilience: Improving Economic Activity and Defensive Characteristics

The Middle East and North Africa (MENA) region has been resilient despite ongoing geopolitical uncertainty and rising inflation, according to Franklin Templeton’s Dino Kronfol and Salah Shamma. While Ukraine and Russia are remote from the region and linkages are not direct nor easy to identify, they give their views on how local economies are faring amid the volatility. Read more. 

Technology Investing: Volatility, Valuations and Opportunity

Despite increased volatility due to the Russia-Ukraine war and rising interest rates, Franklin Equity Group’s Jonathan Curtis sees compelling opportunities within high-quality technology companies in an increasingly digital world. Read more.

Should Investors “Buy the Dip” in a Time of Geopolitical Crisis?

Many market pundits have advocated a strategy of “buying the dip” after significant selloffs, but does it always make sense to do so? Franklin Templeton Investment Solutions’ Gene Podkaminer and Miles Sampson explore market reactions to geopolitical events and caution against celebrating the success of this strategy too soon. Read more.

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.

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.

_______________

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: Financial Times, “Federal Reserve Implements First Half-point Interest Rate Rise Since 2000”, 4 May 2022.

3. Source: “ECB to Discuss Rate Hike in June, Probably Act, Holzmann Says,”

Bloomberg. 5 May 2022.

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 results.

5. Source: “China sees spending, travel tumble during COVID-hit Labour Day holiday,” Reuters, 5 May 2022.

6. Source; Bloomberg.