Notes from the Trading Desk – Europe

Market Rundown

Last week, the US Federal Reserve (Fed) was in focus for the first half of the week, whilst trade rhetoric from the United States and China dominated headlines and drove markets towards the end of the week. The S&P 500 Index fell every day in its worst week year-to-date (-3.1%).¹ Hong Kong was the worst hit among the major equity markets given the added pressures of the ongoing protests.

The Digest

Fed Up with Trade Spats

Expectations were high coming into last week, as the S&P 500 Index had closed the prior week at a record high and meetings in Shanghai planned between US and China trade representatives were looming. We were initially disappointed as progress failed to materialise and the talks ended early. President Donald Trump then announced via Twitter on Thursday that he plans to impose a 10% tariff on the remaining US $300 billion of US imports from China on September 1. Trump said: “We thought we had a deal with China three months ago, but sadly, China decided to renegotiate the deal prior to signing. More recently, China agreed to buy agricultural product from the US in large quantities, but did not do so.”

Trump also mentioned that at some point tariffs could rise to above 25%. In response, China announced it will take countermeasures if the United States insists on these new tariffs.

The comments weighed heavily on global equities last week, and we also saw the US dollar sell off, whilst a global bond rally saw yields slide. The US 10-year Treasury yield hit its lowest level since November 2016 and saw its biggest weekly drop since June 2012.

Weaker US macro data had already pushed yields lower, and this accelerated after the 10-year yield broke below 2%. Further dovish European Central Bank (ECB) speculation and a deterioration in euro area macro also played into the dynamic.

Meanwhile, the German 10-year bund yield made a new low of -0.50%, and the German yield curve out to 30 years hit a negative yield at one point, in unprecedented territory.

In Europe, the trade-sensitive automobile and basic resources stocks were the worst hit, whilst the defensive real estate sector was the only space to not end Friday in the red. Crude oil suffered its worst day in over three years as tensions rose, with West Texas Intermediate (WTI) crude oil down 7.9% on Thursday, although it did recover some ground on Friday and managed to stem losses to just 1% on the week.

There is speculation that this latest move from Trump was, at least in part, motivated by a desire to attack the Fed following its less-dovish-than-hoped-for interest rate cut of 25 basis points (bps) last week.² Expectations were elevated going into the Fed’s July 31 meeting and its announcement disappointed markets, even after Fed speakers had tried to push back against the market pricing of aggressive easing ahead of the pre-meeting blackout period.

The real kicker weighing on sentiment was Fed Chair Jerome Powell’s comment that the move was a “Mid-cycle adjustment”, saying that “When you think about rate-cutting cycles, they go on for a long time. We don’t see that. You would do that if you saw real economic weakness and needed to cut a lot,” which suggested this was not the start of an easing cycle many had hoped.

The market is now pricing in a second 25 bps cut by October.³ Boston Fed Bank President Eric Rosengren is one of the Fed voting members who dissented last week, preferring not to cut rates. In his statement, he gave a number of economic data points as evidence, and interestingly, there has been some speculation the only thing that would change his mind would be a dramatic move in equity markets. This view gives further weight to the speculation that Trump’s escalation of tensions and the inevitable impact on equities is designed to send a message to the Fed.

Over the weekend, trade rhetoric has toughened further from both sides. China is now looking to scale back agriculture purchases from the United States and, more importantly, allowed the yuan to break 7.00 per USD for the first time since 2008 in what has been called by some as a “clear escalation” of the trade war.

In our view, such a move will likely aggravate Trump, who already views the yuan as too weak versus the dollar.

As we kicked off this week, equities closed lower across the board in the Asia Pacific (APAC) region and it’s has been a similar story in Europe on Monday, August 5. Government bonds have extended their rally, with sentiment remaining decidedly “risk-off”. The German 10-year bund has hit a new record low of -0.53%. Alongside this, the safe-haven yen has strengthened substantially.

It looks set to be a tumultuous week of headlines from both sides.

UK/Brexit

We can’t not talk about Brexit and UK politics after the pound made new record lows versus the US dollar, closing last week down 1.8% as the chances of a no-deal Brexit continue to rise.

The move versus the euro was also notable, breaking below 1.10 and ending last week down 1.6%. With the risk-off move to safe havens and selloff in the currency, it’s worth noting that gold has now hit a new all-time high in sterling.

This has left the exporter-heavy FTSE 100 Index as a relative outperformer, albeit still losing ground last week.

Last week, the anti-Brexit Liberal Democrats won a by-election in Brecon and Radnorshire, reducing Prime Minister Boris Johnson’s House of Commons majority to a single seat and making his balancing act even more difficult as he seeks to deliver Brexit by October 31.

Boris’s top aide, Dominic Cummings, warned members of parliament (MPs) that it was too late to stop a no-deal Brexit, saying that a no-confidence vote would not halt an exit on October 31, adding that a general election would lead to a Tory majority. Losses for Sterling have extended further this morning after fresh reports that Cummings is considering a fresh path to a technical ‘no deal’ Brexit.

Over the weekend, newspapers focused on the impact of the situation on the UK economy. Based on the quarterly business confidence monitor from the Institute of Chartered Accountants in England and Wales, confidence has now turned negative in every sector of the economy and every region in England and Wales.

In addition to this, the city of London now has 1/3 fewer jobs than in 2018, with the collapse in confidence also seeing 28% fewer professionals looking for jobs, according to a report in the Sunday Telegraph.

We heard from the Bank of England (BoE) on Thursday. Interest rates were left unchanged, as expected, with the vote unanimous. There was some disappointment as the central bank failed to produce any dedicated forecasts under a no-deal Brexit scenario, continuing to assume a smooth Brexit as their central scenario and keeping its tightening bias.

The odds of a hard-Brexit have been on the rise since Boris Johnson’s win, as discussed, so for some this feels like an oversight. The BoE also cut its growth forecasts, which applied further pressure to the pound.

Last Week

Europe

European equities experienced their second-worst week of 2019 last week with all EU markets lower.

Equities struggled, with the Fed announcement failing to match overall market dovishness, along with Trump downplaying the chances of a deal between the United States and China and poorer European macro data reports. All sectors traded lower, with a defensive tilt to moves as food and beverage, health care and telecommunications were among the outperformers. Basic resources stocks were down over 8% in Europe last week, weighed down by trade concerns and with metals trading lower.

As noted, the FTSE 500 Index was the relative outperformer versus the other major indices. A weaker pound supported the exporter-heavy UK equity index, along with the BoE’s decision to  keep rates on hold but lower its fiscal year 2019 growth forecast.

Softer macro data also gripped European equities, with weaker gross domestic product (GDP) and consumer price index (CPI) reports whilst manufacturing data took a dip.

Eurozone second-quarter GDP slowed to +0.2% on the quarter, down from +0.4% in the first quarter.

French GDP also missed estimates. Eurozone CPIs came in at +0.9% (behind expectations) and below the first quarter’s 1.1% pace. Whilst manufacturing purchasing manager indices (PMIs) came in slightly ahead of expectations, the eurozone release did show the steepest decline in operating decisions since December 2012 as new orders saw their second largest fall on record. Whilst not unexpected, the latest reports do represent a continuation of the weaker macro theme we have seen persist in Europe for some time now with a shortage of signs of any possible turnaround.

The United States

US equity markets were weaker across the board last week, with an escalation in trade rhetoric and some disappointment at the Fed’s dovish cut weighing on sentiment, as discussed. It was just the bond-proxy defensive sectors of real estate investment trusts (REITs) and utilities that managed to end the week in the green, given the lower-rate backdrop. Consumer discretionary, information technology, and banks were hit the hardest. Technology stocks were having a good week before the additional tariffs came into play, but ended lower on the week.

Macro data was disappointing, with the Institute for Supply Management prices-paid component slipping to 45.1, which highlighted the weak inflation outlook.

Friday’s June non-farm payroll figures were in line with expectations, but suggest that the labour market may be losing steam after the previous month’s figure was revised lower to 193,000 versus 224,000 prior, and the three-month average is sitting at its lowest level since September 2017.

Asia Pacific

Clearly, much of the focus last week fell on the trade war situation, and indices were lower across the board.

Australia managed to outperform—albeit with a loss—whilst mainland Chinese equities were harder hit. Hong Kong’s market underperformed dramatically, down 5.6% as protests continue to escalate and the situation turns increasingly violent. Millions of demonstrators have flocked to the streets to protest against the now-suspended bill that proposed extradition of suspected criminals to China.

The business confidence survey for the city fell to its lowest level since January 2016, citing the impact of the political unrest. We also saw the release of a very poor PMI print from the city as Hong Kong prepared for its first general strike in 50 years. This situation shows no sign of resolving any time soon.

In addition to the unrest and the US/China escalation, Japan’s trade spat with South Korea intensified as the government voted to remove South Korea from a “white list” of trusted trade partners. In turn, South Korea promised to remove Japan from its “white list”, and both equity markets closed lower last  week.

Week Ahead

On the political front, we would anticipate more headlines from China and the United States on trade. Brexit/UK politics also remains high on the agenda, as do protests in Hong Kong.

Looking at macro data, we get European PMIs, which will give some insight into how Europe started the second half of the year. These reports will be of particular interest given the recent evidence of a slowdown.

UK second-quarter GDP is due out on Friday and is likely to show the impact of the unwind of Brexit stockpiling and car factory shutdowns. China releases trade data on Thursday, which will be a big event given the pressure from US tariffs and as observers look to the release as an indicator of global growth.

The Reserve Bank of Australia  meets on Tuesday It appears the central bank seems likely to leave rates on hold, but leave the door open for further easing.

Corporate earnings will remain a key focus.

Economic Data

• Europe: services and composite PMIs on Monday; German manufacturing orders on Tuesday; and German trade balance on Friday.
• US: ISM non-manufacturing and composite PMIs on Monday; and wholesale trade report on Thursday.
• Asia and Pacific: Chinese services and composite PMIs on Monday; Japanese employment survey on Tuesday; Chinese FX reserves on Wednesday; Chinese trade balance on Thursday; Chinese CPIs on Friday.

Politics

• We expect US-China trade headlines to persist whilst we continue to monitor for any developments on the Brexit front.

Monetary Policy

• The Fed’s Bullard and Evans speak on Tuesday and Wednesday respectively.
• The ECB publishes its economic bulletin on Thursday.

Insight from Our Investment Professionals

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For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn.

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of August 5, 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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