Notes from the Trading Desk – U.S. 10-yr Yields Tighten in a Normal 'Risk-Off' Way

by Franklin Templeton Investments blog, Franklin Templeton Investments

The Digest

Last week global equity markets struggled for any clear direction as investors fretted about economic growth. Regionally, performance was very mixed. The S&P 500 Index closed the week down 3%, the STOXX Europe 600 Index closed down 0.6%, whilst the MSCI Asia Pacific Index outperformed, closing the week up 2.8%.1 Investors focused on consumer sentiment last week as corporates made clear the true impact of inflation on the consumer. Household savings have been dented of late and that has started to feed through to retailers—last week served as a wake-up call for the retail space. The ongoing war in Ukraine as well as China’s zero-COVID-19 policy also continued to weigh on global growth estimates. We are now through most of the current earnings season with 95% of the companies in the S&P 500 and 86% of the STOXX Europe 600 done reporting. Overall, earnings have surprised to the upside, by 10.5% in Europe and 5% in the United States. Outperformance in Europe was mainly driven by the energy space. Yet, market sentiment remains very negative given the latest inflation data, more hawkish central banks and growth fears. The CNN Fear and Greed Index remained in Extreme Fear territory last week.2 The latest Fund Managers Survey showed very high cash levels.

Inflation concerns bring on growth fears

Inflation has been a hot topic for markets for months now and there was no change last week. Eurozone Consumer Price Index (CPI) surged to 7.4% in April. Oil and gas prices reached new peaks after Russia’s invasion of Ukraine and, we believe that inflation will likely stay close to current levels until the fourth quarter. In the United Kingdom, April’s inflation accelerated to 9% year-over-year (Y/Y), a 40-year high. Rising energy costs drove last month’s jump also. April’s number was actually a touch lighter than market expectations and in line with Bank of England expectations. The latest reading will keep the cost-of-living crisis front and centre for UK politics. Germany’s April Producer Price Index (PPI) report, which measures price change from the perspective of the seller, rose 33.5% Y/Y, the biggest increase since it was first measured in 1949. Also, last week, the European Commission increased their inflation forecast for fiscal year 2022 to 6.1% from 3.5% previously.

The impact of inflation on the consumer became clearer last week following poor earnings for large US retailers. Merchandise retailer, Target said that they saw a trading down from brand to private label and that discretionary spending was suffering. With that, the stock closed down significantly last week as investors fretted about the continued squeeze on consumers and the impact on future growth. It was a similar story for Walmart, Kohls and Ross. In Europe, Richemont warned of margin weakness and closed the week down substantially. Richemont’s report pointed to revenue weakness in Asia Pacific.

All these news added to concerns around global growth. With that, we saw a number of US banks slash their growth forecasts. JPMorgan cut their US gross domestic product (GDP) forecasts for this year, with second half of 2022 growth now expected to be 2.4% vs 3.0% previously. Goldman Sachs also cut their growth forecasts. They now expect the economy to grow 2.4% in 2022 and 1.6% in 2023, down from 2.6% and 2.2% previously.3 Also, the latest Fund Managers Survey showed that global growth optimism was at record lows.

Despite last week’s renewed fears on growth, the Federal Reserve (Fed) commentary was notably hawkish once again. Fed Chair Jerome Powell said that the Fed would not hesitate to raise rates until there is “clear and convincing evidence that inflation pressures are abating and prices are coming down”. Powell also noted that the labour market is “extremely strong” and consumer spending is healthy, implying the Fed feels that the US consumer can tolerate higher prices for a while longer. Chicago’s Charles Evans noted that forthcoming hikes were needed for tightening financial conditions “as well as for demonstrating our commitment to restraining inflation”. Philadelphia’s Partick Harker said the US economy could withstand a “methodical tightening”. As it stands, Fed fund futures are pricing in rates of 2.75% by the end of the year.

There was plenty of rhetoric from the European Central Bank (ECB) policymakers last week. Firstly, Pablo Hernandez de Cos said that the ECB would likely decide at its next meeting to end its stimulus programme in July and raise interest rates “very soon” after that. Luis de Guindos said that that the ECB needs to move gradually and cautiously, whilst Georg Muller had noted that “gradual” meant rate hikes of 25 basis points (bps)4. The market expects a rate hike in July. Ignazio Visco said that a rate hike in June is “certainly” out of the question and that July is “perhaps” the right time to start hiking rates. Meanwhile, Joachim Nagel said that a July hike is possible and that more hikes could follow in quick succession. As it stands, the market expects three 25 bps rate hikes in 2022, with the first fully expected to come at the July meeting.

The Week in Review

Europe

Last week was another volatile one for European equity markets. Despite the continued push-and-pull in markets, the STOXX Europe 600 Index closed the week down just 55 bps following a late sell-off. Albeit, volumes were poor—last week’s moves lower were on the lowest volume week of the year in Euro STOXX 50 cash. European equities have seen extensive outflows year-to-date. Macroeconomic data was in focus again last week as investors debated what the latest reports mean for future inflation and subsequent rate shifts. With that, sentiment has been very cautious of late and we believe we are at the mercy of a bear squeeze on any positive news. Markets did rally on Tuesday on more supportive headlines out of Asia on Chinese technology stocks and as the COVID-19 situation appeared to be easing there too. However, this rally was short-lived as European equities gave up all their gains and more on Wednesday and Thursday as markets struggled for their next move in either direction.

In terms of sectors in Europe, renewables were notably strong last week, following some mergers and acquisitions headlines in the space. Basic resources also outperformed in Europe, making up for recent losses. Utilities also performed better last week. Increasing concerns of consumers getting squeezed is evident when we look at the week’s laggards: Food and beverage, personal and household goods, and retail stocks. Sentiment was hit further as UK Consumer Confidence reported its lowest level since 1974.

United States

It was another tough week for US equities with the S&P 500 down 3.0% and the NASDAQ Composite Index down 4.5% as fears over central bank policy error, stagflation and global economic slowdown stalked markets. For the S&P 500, the decline makes it a seventh week of declines for the index, something that has not happened since 2001, and only happened four times prior to this run. On Friday, the S&P 500 briefly fell into bear market territory, down 20% from its January peak, but the index recovered ground later that same day.

Looking at weekly sector performance, energy names rose significantly, while consumer staples and consumer discretionary names fell, following high-profile profit warnings in the space.

In terms of macroeconomic data, two sentiment surveys came in weaker than expected with the May Empire State Manufacturing Survey falling 36 bps to -11.6 and the May Philadelphia Manufacturing Business Outlook Survey falling 15 bps to 2.6. However, the April US Retail Sales data was better than expected—albeit this reading did lose its significance given the corporate warnings in the space.

Looking at other asset classes, US bonds saw yields tighten in a ”risk-off” environment with the 10-year Treasury yield at 2.78%, down 14 bps. The US dollar (USD) actually saw some respite after weeks of strengthening, with the USD spot down 1.3% with some putting this down to the suggestion we are at peak Fed hawkishness. Interestingly, US credit markets appeared calmer than European credit, with no signs of panic yet in high-yield or investment-grade spreads.

Asia Pacific

Asian equities outperformed global peers with the MSCI Asia Pacific Index seeing a 2.8% rise last week. Hopes that China would step up its support for the economy and ease the crackdown on tech stocks helped improve sentiment.

Hong Kong stocks rose 4.1% after Vice Premier Liu He said the government will support the development of digital economy companies and their public listings. On the back of this, the Hang Seng TECH index gained 6.0% on hopes that China may be ready to ease up on a year-long clampdown on tech giants.

In China, the Shanghai Composite Index rose 2% with talk of a phased reopening of shops in Shanghai. On Friday, the People’s Bank of China (PBOC) lowered the five-year loan prime rate to 4.45% from 4.60%, exceeding expectations for a move of between 5 bps and 10 bps, which should help disposable income for the middle class and counter weak loan demand.

Over the weekend, US President Joe Biden was in the region and helped sentiment further by stating he will review US tariffs on Chinese imports. He noted: “We did not impose any of those tariffs—they were imposed by the last administration”. However, he also stated that the US will defend Taiwan in any attack from China.

The economic picture remains challenging in China. April macroeconomic data released last week were weak, with Industrial Production down 2.9% and Retails Sales down 11.1%.

In Australia we saw a change of government following the election victory of Australian Labor Party leader Anthony Albanese, replacing the current Liberal-National government. There are eight seats left to be counted, with Labor requiring two more seats to hold a majority by itself in the House of Representatives. There was a muted reaction from Australian equities, with the Australian Stock Market Index rising a mere 0.1%.

The Week Ahead

Holidays:            

  • Wednesday 25 May: Sweden (half day)
  • Thursday 26 May: Denmark, Finland, Norway, Sweden, Switzerland
  • Friday 27 May: Denmark

 Key Events:

  • Monday 23 May: Germany IFO Survey
  • Tuesday 24 May: Euro area and UK flash composite Purchasing Managers’ Index (PMI)
  • Wednesday 25 May: US Federal Open Market Committee (FOMC) minutes
  • Thursday 26 May: US GDP and Jobless Claims
  • Friday 27 May: Month-end US pension rebalance

Monday 23 May 

  • Germany IFO Survey
  • Sweden Public Employment Service (PES) weekly Unemployment

 Tuesday 24 May

  • Euro area flash composite PMI Survey
  • UK flash composite PMI Survey
  • US S&P/Markit Manufacturing PMI

 Wednesday 25 May

  • Sweden Unemployment Rate and PPI
  • Germany GDP and Government Spending
  • Norway Unemployment Rate
  • France Consumer Confidence
  • US Durable Goods
  • US FOMC minutes

 Thursday 26 May

  • Italy Consumer Confidence Index
  • Italy Industrial Sales
  • US GDP and Jobless Claims

 Friday 27 May

  • Sweden Retail Sales
  • Spain Retail Sales
  • US Personal Income

Views You Can Use

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China: Separating Myth from Reality

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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. 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.

3. Bloomberg.

4. One basis point is equal to 0.01%.

This post was first published at the official blog of Franklin Templeton Investments.

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