Notes from the Trading Desk – Europe

Last week saw some remarkable moves in global equity markets, with the extreme rotation from momentum/growth stocks into value stocks catching many off guard. Broader market sentiment was positive as there was a more constructive tone around the US/China trade dispute. Meanwhile, the European Central Bank (ECB) announced fresh quantitative easing (QE) and a cut interest rates.

The Digest

Rotation Pain Trade

The key theme for equity markets last week was the extreme rotation out of recent winners into what had been the laggards. That showed up in the switch out of momentum names with expensive valuations, such as technology and food & beverages, into so-called “cheap” value sectors such as banks and European autos.

The rotation had started in the previous week, but accelerated dramatically on Monday. In the United States, value names saw their biggest one-day move since 2000.

The moves eased a little mid-week, but picked up again once again into the end of last week. Banks and basic resources were the main beneficiaries, while food & beverage was the worst-performing sector. Some commentators referred to this rotation as the “Momentum Crash”.

Potential Causes

There has been much debate around the causes of these extreme moves. We think a combination of factors triggered the initial moves, and then the unwinding of extreme positioning exacerbated the situation.

• Bond Yields Widen: Government bond yields have widened sharply in recent weeks, driving demand for bank stocks. The inversion of the US Treasury yield curve weighed on markets and sentiment over the summer, so the beaten-up share prices of banks caught a bid on the easing of this headwind.
• US-China Trade Talks: The tone from both the United States and China softened last week, with further tariffs on Chinese imports delayed from October 1 to October 15 and discussion about fresh talks taking place between the two sides. In addition, some argued the departure of US National Security Advisor John Bolton (an arch-hawk) from US President Donald Trump’s administration may lead to a less confrontational White House.
• European Politics: Improved sentiment in Europe, with an Italian election avoided and the odds of a hard Brexit falling, will have prompted buying in unloved European names such as Italian banks.
• ECB Easing: An interest-rate cut and fresh QE measures from the ECB should be broadly supportive for European equities. In addition, the ECB announced measures to support European banks, with the aim of protecting them from negative interest rates. Importantly, ECB President Mario Draghi also pushed European Union (EU) member states to take action and introduce fiscal stimulus, prompting further speculation about Germany launching supportive fiscal measures.
• Extreme Positioning: The positioning in these sectors was so extreme that once these moves started, they became self-fulfilling.

Will It Continue?

There has been much discussion around whether this unwind will continue. It does feel to us as if a lot of positions were unwound in the past two weeks, so it may continue but not with the violent moves we saw last week.

The likely next market catalyst with be the US Federal Reserve meeting on Wednesday of this week. Events in the Middle East will also be a focus.

Crude in Focus on Heightened Middle East Tensions

Oil prices are in focus at the start of this week after a drone strike on a Saudi Arabian oil facility on Saturday.

Houthi rebels in Yemen claimed responsibility for the attacks; however, the United States is blaming Iran.

US Secretary of State Mike Pompeo accused Iran of “an unprecedented attack on the world’s energy supply”. Iran has denied being responsible for the attacks.

The focus in the near term will be on the timescale of the production resumption; the depletion in Saudi oil reserves and whether another OPEC (Organization of the Petroleum Exporting Countries) nation releases reserves to limit the impact on supply; and the read-through for any increase in geopolitical risk in the region and the heightened focus on the fragility of oil production in a region plagued by political uncertainty.

Last Week

Europe

European equities extended their strong September performance as risk appetite returned, with all major indices making gains.

The macro picture in Germany continues to be a concern, however, with data on Thursday showing that Germany led a July fall in industrial output for the eurozone. The pressure on Germany’s gross domestic product (GDP) is a theme we have been watching for some time and we think it will have fed into the ECB’s actions last week.

The ECB meeting was the main event for European investors last week, but outside of that focus fell on the political landscape, with the United Kingdom, Italy, and Spain all generating headlines.

Brexit

A brief update of the week’s events:

• On Monday night, UK Parliament was suspended until the October 14. Importantly, however, the highest Scottish Court ruled last week that UK Prime Minister Boris Johnson’s suspension of Parliament was illegal. We now await a ruling from the UK Supreme Court on this.
• Also on Monday, Johnson faced another defeat in Parliament as he lost a vote calling for a general election. Opposition groups want to prevent a no-deal Brexit before holding an election. As a result, we cannot see an election until November at the earliest.
• Johnson is now trying to negotiate a deal with the EU, having said at a press conference that he would overwhelmingly prefer to get an agreement than a no-deal Brexit.
• If he has no deal by October 19, Parliament has now ruled that Johnson must request an extension to Article 50 from the EU. This is something he has insisted he will not do. This situation is extremely fluid and even with Parliament suspended, the headlines will keep coming thick and fast.

The market seems to feel chances of a no-deal Brexit have fallen with these developments. The pound had another strong week. The exporter-heavy FTSE 100 Index put in a decent performance despite the strength in the pound, but the domestically exposed FTSE 250 Index was the outperformer, in a demonstration of the improved domestic sentiment.¹  

Better macro data also helped, with an improving employment picture and better industrial production. Wage growth accelerated to its fastest pace since mid-2008 and the employment rate rose to a record high.

Johnson is holding talks with European Commission President Jean-Claude Juncker this week, the first time the two will negotiate face-to-face, and so we can expect more headlines soon and more volatility in the pound alongside that. Sterling volatility is currently at the level of some emerging market currencies and this dynamic shows no sign of abating any time soon.

The Bank of England holds a monetary policy meeting and interest-rate decision this week. While we expect no change in rates, any potential commentary on the economic outlook given the political situation will be in focus.

Italy

As expected, Italian Prime Minister Giuseppe Conte triumphed in parliamentary confidence votes last week, giving his newly formed coalition a mandate.

This provides relief in the short term as Italy looks to pass its budget. However, we did also see headlines last week suggesting that the new coalition government plans to hike the 2020 deficit target to around 2.3% of GDP vs. 2.04% this year, likely driven by the anti-establishment Five Star party.The current 2020 deficit target goal is at 2.1%.

This move of the deficit target goal risks reigniting tensions with the EU; this had been a contentious issue for the previous Italian government.

Spain

As Italy finds some short-term stability, Spain is moving in the other direction as the country faces the prospect of its fourth election in as many years. Talks between the caretaker Socialist government, led by acting Prime Minister Pedro Sanchez and the radical leftwing Podemos party, broke down early last week, with no current plans to resume.

The country will go to the polls on the November 10, unless Sanchez can win a parliamentary vote on forming a new government by the September 23. Recent polls look encouraging for Sanchez, suggesting that he could improve on his party’s April result where it won 29% of the vote.

Spanish equities held their ground last week, but we can expect rhetoric will heat up in coming days.

Americas

US equities were higher overall last week, with a significant unwind at play.

The ECB meeting was in focus last week as investors took stock of another dovish central bank announcement ahead of this week’s US Federal Open Market Committee Meeting. The US dollar finished the week lower after spiking on Thursday on the back of the ECB rate cut. In sectors, cyclicals and value stocks led the way.

There was a clear thawing in trade tension rhetoric last week. At the start of the week, it was reported that China would recommence purchases of US agricultural goods. This was followed later by reports that President Trump was considering delaying the imposing of tariffs on Chinese imports proposed for December 15.

On Friday, markets were buoyed by news that Trump would consider some kind of interim deal with China that would include commitments on intellectual property and agricultural purchases from China.

Finally, on Friday, China noted that it was encouraging companies to purchase US agricultural goods like soybeans and pork and that these products would be exempt from additional tariffs on US goods.

Asia   

The APAC region was no exception to the strength we saw in global equities last week, benefiting from improved trade relations.

Japan was the outperformer, as a weaker yen offered a boost on the back of the easing tensions. A meeting between Bank of Japan Governor Haruhiko Kuroda and Prime Minister Shinzo Abe offered additional support. This came amid speculation that the central bank may look to adopt further easing policies at its next meeting, following the lead of global peers.

Trade rhetoric gave a boost to both mainland and offshore Chinese equities, despite more protests being planned in Hong Kong and talk that China will likely take more control over firms in Hong Kong.

Meanwhile, South Korea filed a World Trade Organization  (WTO) complaint against Japan’s export curbs on three materials used in semiconductor chip manufacturing, but this failed to weigh on equities on either side of the spat.

Australia was the regional underperformer, posting only modest gains as the Australian dollar rallied after consumer confidence for the region fell in September.

Week Ahead

Monetary policy with be the main focus this week, with a number of major central banks meeting.

Macro

• Tuesday: US industrial production
• Wednesday: UK August inflation data
• Thursday: UK retail sales
• Friday: Japanese consumer price index (CPI), eurozone consumer confidence

Politics

• Middle East: Tension in the region will be a key focus early in the week, as markets watch to see the response to the Saudi refinery attack.
• US/China: Investors will hope the recent softening in the US/China rhetoric continues.
• Brexit: UK Prime Minister Johnson is in Luxembourg to meet EU officials for talks.
• Spain: Watch for news on fresh elections.

Central Banks

• US Fed meeting (Wednesday): An interest-rate cut is expected, but some suggest it could be 50 basis points (bps), rather than the general consensus for 25 bps currently.²   Watch for commentary on the Fed’s “dot plot,” which is a visual projection of future interest-rate moves.
• BoJ (Thursday): Expectations are high for a dovish BoJ stance.
• BoE (Thursday):  Expectation is for a unanimous vote to keep rates on hold, as the BoE would thus keep its powder dry until there is more clarity around Brexit.

Insight from Our Investment Professionals

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1. The FTSE 100 Index is a capitalisation-weighted index of the 100 largest companies listed on the London Stock Exchange. The FTSE 250 Index is a capitalisation-weighted index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange. 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 guarantee of future results.

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