Notes from the Trading Desk – Europe

Market Rundown

Global markets were mostly higher last week, with the US S&P 500 Index making new record highs, while equities in Hong Kong underperformed, both globally and in the Asia-Pacific (APAC) region, amid the continuation of protests in the city.

The Digest

The biggest macro-focused event last week was Thursday’s European Central Bank (ECB) policy update and ECB President Mario Draghi’s subsequent press conference. The central bank left interest rates on hold (as was widely expected), but takeaways were mixed. The level of concern over an economic slowdown and tempering of dovish language during the press conference outweighed hopes for fresh stimulus, even as the message was “all options are open”.

The announcement began with a bang as the policy statement laid out a clear easing bias and stressed the symmetric nature of the inflation target. However, in the press conference, Draghi was non-committal about any specific policy measure and ambiguous on the growth outlook. Markets are now pricing in an 85% probability of a 10 basis-point cut to the ECB’s deposit rate, priced for the 12^th of September.¹ The current rate is -0.40%.

Expectations for a more dovish tone at last week’s meeting (or even an early rate cut) had been elevated ahead of the event, driven by more disappointing macro data releases and the dovish communique from the US Federal Reserve (Fed). German IFO Business Climate Index fell to its weakest level in six years, and the eagerly anticipated PMI data from the euro zone was poor, with the region falling further into contraction.

With this backdrop, markets eased later in the day, and the euro had a volatile reaction. European government bond yields slid, with the German 10-year Bund yield hitting a record low of -0.42% as Draghi shot down hopes of quantitative easing in the press conference and displayed a lack of urgency and detail on the next stages of easing. As such, bank stocks subsequently faded.

Meanwhile, global bonds currently appear to be on pace for a record year of inflows, coinciding with record-high prices, and at present this shows no sign of slowing.

There were some words of caution from UBS CEO Sergio Ermotti on Bloomberg television last week. “I’d be very, very careful about growing further the balance sheet of central banks… We are at risk of creating an asset bubble,” he said.

BlackRock CEO Larry Fink also weighed in, saying on CNBC that “If the ECB is really going to try to re-stimulate the economy in Europe, they are going to have to buy equities.”

It has been seven years since Draghi’s “whatever it takes” speech. Our interesting snippet of the week is that if you had bought a basket of Greek bonds at the lows in 2012, you would have made a 1,000% return on your investment now.² In fact, the Greek 10-year yield is now below the US 10-year Treasury.

It’s another big week for central banks, with the Fed expected to cut rates on Wednesday and the Bank of England (BoE) decision following on Thursday.

A New Leader for the United Kingdom: UK/Brexit Update

Boris Johnson was sworn in as prime minister on Wednesday of last week after winning 66% of the vote from Conservative party members. The early reaction in foreign exchange markets suggests investors are wary. Johnson signaled his hardline determination to deliver Brexit by removing more than half of the existing cabinet and ensuring his own cabinet included pro-Leave veterans and right-wing proponents of a free market.

The pound hit its lowest level vs. the US dollar since 2017 and lost almost 1% on the week after EU negotiator Michel Barnier sent a strongly worded email to EU diplomats. He described Johnson’s first appearance in parliament as “combative,” and called his demand to scrap the backstop “unacceptable”.

New Chancellor of the Exchequer Sajid Javid will this week give details of increased funding for preparations for no-deal Brexit, after Michael Gove, the minister in charge of no-deal preparations, said such an exit was a “very real prospect”. Johnson has set up a six-strong Brexit “war cabinet” that will meet for the first time this week, and then every following day, to ensure the country leaves the EU on October 31.

Kicking off this week, the pound was lower again on July 29, after the Confederation of British Industry (CBI) warned the UK government that neither the United Kingdom nor the EU are ready for a no-deal departure. Sterling has now hit levels not touched since mid-March 2017. In addition, a Whitehall report from the Institute for Government warned that there is “no such thing as a managed no deal” and the hard Brexiters predictions of a “clean break” from the EU will not materialise.

It is set to be an interesting week as we learn more about Johnson’s intentions for both domestic and international policy.

Last Week

Europe

European equity markets closed last week higher overall as trade optimism helped override a lacklustre response to the ECB on Thursday. Markets in France and Germany outperformed, whilst the United Kingdom and Spain lagged.

The Spanish political situation remains a concern after acting Prime Minister Pedro Sanchez failed to form a new government, losing both parliamentary votes last week. The risk of elections then rose further after coalition talks between the Sanchez’s Socialists and the Podemos party broke down. Sanchez is determined to avoid a new general election, but his efforts so far have gone unrewarded and a coalition remains elusive.

In Italy, Deputy Prime Minister and leader of The League party Matteo Salvini pledged his commitment to the current coalition despite pressure to ditch its Five-Star partners. Last week Salvini called for new tax cuts that could lead to another clash with the EU, which also has the potential to spark further tension between the coalition leaders.

Both of these situations feel precarious and in our view, are likely to generate more headlines in the coming days.

United States

US equities ended the week at fresh all-time highs thanks to strong corporate earnings and anticipation of Fed easing ahead this week. Investor focus is squarely on Wednesday’s Fed meeting, with the market seeing an 82% chance of a 25 basis-point rate cut and an 18% chance of a 50 basis-point cut.³

With the Fed now in blackout period ahead of the meeting, there were no further clues from Fed speaker commentary last week.

Last week, the White House and Congress agreed to a budget and debt ceiling deal, which the markets took as positive. This agreement suspends the US borrowing limit for two years, thus removing the uncertainty of debt ceilings being regularly tested, along with potential government shutdowns.

There was some news regarding US/China trade talks. Chinese and US negotiators have agreed to meet in Shanghai this week to restart the discussions of trade relations between the two countries.

In terms of macro data, the US second-quarter gross domestic product (GDP) growth was reported at 2.1%, which topped expectations. The news did see the odds of a 50 bps interest-rate cut from the Fed this week edge lower.

Asia-Pacific

Last week was mixed for Asian equities as Australian equities outperformed, whilst South Korean and Hong Kong equities fell.

In China, the news of fresh trade talks between United States and China helped mainland Chinese equities. We did have some disappointing Chinese June Industrial profits data, providing further evidence any positive news on trade will be welcome.

Protests in Hong Kong remain a focus, with fresh violence over the weekend pressuring the Hang Seng Index in early trade this week.

Elsewhere in the region, a spat between South Korea and Japan has dominated headlines. A mix of concerns are weighing on sentiment, including worries that Japan will toughen restrictions on trade with its neighbour and the US potentially excluding South Korea from the list of countries receiving the benefits of developing-nation status. It has been reported that Japanese Prime Minister Shinzo Abe plans to not meet with South Korean President Moon Jae-in at the UN General Assembly in NYC in September. Also, early July data on Korean exports signalled an eighth straight month of decline amid weaker global demand.

In Australia, we saw further dovish commentary from the Reserve Bank of Australia (RBA), as Governor Philip Lowe said he’s ready to ease policy further if back-to-back cuts fail to revive growth. He said households should expect “an extended period” of low rates. Recall the RBA cut rates in June and July to record low of 1%.

Week Ahead

Second-quarter corporate earnings season continues in earnest, with releases likely to drive the larger market moves. It’s also another busy week for central banks, as we hear from the Bank of Japan on Tuesday, the Fed on Wednesday, and the BoE on Thursday. Political developments in Spain and Italy will garner particular attention and the United Kingdom will also be in focus as Boris Johnson begins to settle into his role. On the macro front, the monthly US employment report on Friday will be key.

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of July 29, 2019, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton. Because market and economic conditions are often subject to rapid change, the analysis and opinions provided may change without notice. An assessment of a particular country, market, region, security, investment or strategy is not intended as an investment recommendation, nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. This article does not provide a complete analysis of every material fact regarding any country, region, market, industry or security.

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1.Source: Bloomberg, Eurozone Overnight Index Swaps. A basis point is a unit of measurement. One basis point is equal to 0.01%. There is no assurance that any estimate, forecast or projection will be realised.

2. For illustrative purposes only. Past performance is not an indicator or guarantee of future results.

3. Source: CME Group, based on Fed funds futures. There is no assurance that any estimate, forecast or projection will be realised.