Notes from the Trading Desk—Europe

The Digest

After a subdued start to last week (given a US bank holiday on 18 January), we saw mixed performance for global markets as US and Asian equities grinded higher, whilst European equities stalled. In the United States, there was much fanfare around the new administration, although little new to move the market. In Europe, the European Central Bank (ECB) meeting likewise did little to move the needle, but equities did fade on Friday on deteriorating sentiment regarding COVID-19 dynamics. On the week, we saw the STOXX Europe 600 Index +0.2%, S&P 500 Index +1.9%, MSCI Asia Pacific Index +2.1% and the MSCI World Index +1.5%.¹

COVID-19 Dynamics Remain in Focus

COVID-19 and the economic impact of prolonged lockdowns continues to be a driver for Europe’s markets. Whilst there are signs the hard-hit United Kingdom is turning a corner in terms of declining new cases, other European countries (such as Spain) are seeing increasing numbers and there seems little scope to ease lockdowns in the near term. Indeed, new restrictions have been implemented across the region in recent weeks amid the threat of new variants.

In that context, EU macro data continues to come in weaker than expected. The flash EU Purchasing Managers’ Index (PMI) hit a two-month low at 47.5 versus 49.1 prior. In the UK private sector, output hit an eight-month low of 40.6 versus 50.4 prior, both of which point to a double-dip recession in the United Kingdom and in Europe. In that context, the European Central Bank (ECB) kept policy unchanged last week, as expected.

Inevitably, the rollout of vaccines will be a key driver for markets, and any issues or delays will likely be a headwind for equities. For example, on Friday we saw a headline that AstraZeneca vaccine supplies to Europe faced some delay, and European equities declined that day. The vaccination program rollout and effectiveness of vaccines will be a key market dynamic for 2021.

Elsewhere, the picture in the United States shows some signs of improving, with the lowest number of new cases in eight weeks and emerging infections declining across all regions of the country, according to COVID-19 Tracking Project data. The new case level of 143,000 is the lowest figure since 01 December. In Asia, there have been some outbreaks, with Hong Kong locking down a district in Kowloon. Residents of an area of Shanghai have been banned from leaving the city, and Malaysia is extending lockdowns in most states.

As we enter fourth-quarter corporate earnings season, we will get more clarity on how the COVID-19 crisis has impacted the real economy.

Risk Correction Imminent? 

After the recent gains for equity markets in the fourth quarter and with a new US administration, the question of what’s next for markets is a focus now. The move higher on hope of US fiscal stimulus will likely become more of a ‘show-me’ mode as the proposed package makes its way through Congress.

There were some well-publicised comments from high-profile investors last week, with Baupost Group founder, Seth Klarman, warning that investors were disregarding market risks, similar to frogs being slowly brought to the boil. In addition, GMO founder Jeremy Grantham said the recent rally was an ‘epic bubble’.

However, many market observers remain positive on economic outlook, particularly in the United States. The impact of retail investing is important to keep in mind, if the US government does send US$1,400 cheques to millions of individuals.

Looking ahead, the risks related to the vaccine rollout and prolonged economic lockdowns are worth keeping in mind, and perhaps looking further out, the risk of taper tantrum as central banks look to eventually wean economies off the quantitative-easing sugar rush.

The Week in Review

Europe

European equity markets traded mixed for a second week running, struggling for any clear direction last week. The STOXX Europe 600 Index closed the week up slightly. It was a slow start to the week with US markets closed on 18 January for Martin Luther King Jr. Day, and volumes were much lower than average. COVID-19 lockdowns continue to be a key market overhang for now, with very little to suggest that restrictions will be eased in Europe any time soon.

US President Joe Biden’s inauguration came and went, but he signed a record 17 executive orders on his first day in office, which received some sector focus. European politics returned to the forefront somewhat as the Christian Democratic Union leadership vote in Germany passed without any drama. Meanwhile, Italian Prime Minister Giuseppe Conte won a couple of votes of confidence to continue governing without a majority.

The latest ECB policy announcements were largely as expected. Over the next couple of weeks, focus will shift to fundamentals as we head into a new corporate earnings season in Europe.

In terms of index moves last week, Germany’s DAX outperformed, up 0.6%, given strength in autos. At the other end, Spain’s IBEX underperformed, down 2.4%, given weakness in some of the heavyweight constituents, primarily in the travel and leisure and banks space.

Momentum stocks outperformed in Europe last week, whilst value stocks lagged. In terms of sectors, autos outperformed given stronger Chinese data earlier in the week, up 3.9%. Technology stocks were also better off, up 3.4% and buoyed by strength in the United States. Travel and leisure stocks lagged, down 2.8%, with COVID-19 lockdowns extended and travel corridors removed. Insurers also underperformed, down given the political uncertainty in Italy and with UK insurers already under pressure following last Friday’s decision by the Supreme Court in favour of the 370,000 businesses impacted by the pandemic.

Italian Politics

Italian Prime Minister Guiseppe Conte is under pressure to fill in the hole left by the exit of Renzi’s Italy Alive party over the government’s handling of the COVID-19 pandemic and could face new elections if he is unable to pull together a workable parliamentary majority. Conte narrowly won a confidence vote in the Senate on Tuesday, falling short of an absolute majority. He now faces another key vote in the upper house next week and has immediately got to work on trying to win over senators who did not vote for him on Tuesday (according to Italian media).

The chance of an election being called in the short term is still seen as low but remains a potential risk to sentiment given the uncertainty it would bring. Without a majority in the upper house, Conte will likely struggle to pass meaningful legislation, including annual budgets.

The spread between Italian and German 10-year bond yields widened on Friday as concerns mounted. Italian equities are underperforming as we kick off the new trading week. It’s worth noting that at the ECB meeting, President Christine Lagarde was asked about Italian government bonds and said that she doesn’t see any euro-area yield that poses a risk. This suggests the central bank is comfortable with the widening seen so far and appears unlikely to resist additional widening should we see further political upset in Italy. However, this is clearly unhelpful for the banks and insurers.

ECB: No Surprises and a Pragmatic ‘Wait and See’ Tone

As expected, no changes to any of the ECB’s policy settings in its latest meeting. If anything, Lagarde may have surprised a touch with her almost optimistic tone, notwithstanding the renewed wave of lockdowns. The ECB is sticking with previous baseline economic projections for 2021 as a whole, pointing to a number of positive factors which are countering the effect of the virus; i.e., vaccine rollout, avoidance of a hard Brexit, agreement of Next Generation fiscal stimulus (although this needs to be ratified by Parliaments), manufacturing resilience and finally, the removal of US political uncertainty.

Economic forecasts will be reviewed for the March ECB meeting, when there could be a bit more visibility on the progression of the pandemic. When pressed on policy options, the focus was on the Pandemic Emergency Purchase Program (PEPP). Lagarde was keen to stress that although purchases will continue until at least the end of March 2022, the programme could be recalibrated (increased) if needed. But, if a recovery comes through strongly, the full ‘envelope’ need not be used. The only time she sounded more cautious was when asked about the exchange rate. Here she said that the ECB is monitoring the exchange rate very carefully, that all instruments can be adjusted and that nothing is off the table. By the end of the meeting, the euro was unchanged and German bunds up by just 1 basis point.²

United States

US equities traded broadly higher in a holiday-shortened week, with equity markets closed on Monday for Martin Luther King Jr. Day. It was a momentous day on Wednesday as Joe Biden was sworn in as 46^th president. The NASDAQ outperformed on the week, up 4.4%, given the rotation into tech and growth stocks. The S&P 500 Index closed up 1.9%, whilst the Dow Jones Industrial Average lagged, up 0.6%. Fiscal stimulus, ultra-accommodative monetary policy and above-consensus earnings drove the market higher. In terms of sector moves, similar to Europe, tech was up (4.4%) on the week, but it was communications services which outperformed, up 6% on the week, given the strength in Facebook and Google. In terms of laggards, energy and financials were both down.

Earnings season is underway in the United States, with 122 companies in the S&P 500 reporting this week.

Once Biden was sworn in, he got to work immediately, signing several executive orders, including orders on immigration, the environment and coronavirus. Market sentiment remained optimistic, although there was nothing particularly market-moving. The new president will be laying out new vaccination plans as well as more executive actions to combat the virus in the days ahead, whilst also starting to negotiate the US$1.9 trillion stimulus bill that the administration released last week. Elsewhere, Amazon, a notable ‘winner’ from lockdown, has offered to help the Biden administration with vaccine distribution.

Relations with China remain a key focus for the Biden presidency. Janet Yellen, Biden’s pick to run the US Treasury, spoke of China’s ‘abusive’ practices, adding that the United States would be willing to ‘use the full array of tools’ and that there would be a comprehensive review of former President Trump’s ‘Phase-One’ trade deal. Biden’s defense secretary nominee, Lloyd Austin, added that China represented the US government’s ‘most significant challenge’.

Last week, Yellen also testified to Congress on a series of tax increases for corporations and high-net-worth Americans. Expectations were that tax increases would not come in until after the pandemic subsides, so markets were caught off-guard a little on Friday last week. She also defended the plans against criticism from Republicans who believe raising the corporate tax rate from 21% to 28% would make the US less competitive.

Asia and Pacific (APAC)

Equity markets were broadly higher last week, with the MSCI Asia Pacific Index closing the week up 2.2%. Positive Chinese fourth-quarter gross domestic product (GDP) data on Monday helped to support markets early in the week.

The Bank of Japan left rates unchanged as expected, but made marginal changes to GDP forecasts. Hong Kong’s Hang Seng Index outperformed on the week, up 3.1%, whilst Japan’s Nikkei lagged a bit, up just 0.4% as the number of seriously ill COVID-19 patients reached record levels in Japan. In terms of sectors, it was a similar story to the United States and Europe, with tech up 3.2% and communication services up 4.2%. But, it was consumer discretionary stocks which really led the way in Asia, up 5.5%. Financials were the only sector to finish in the red, down 1.4% on the week.

On Monday, it was reported that Chinese fourth-quarter 2020 GDP expanded at pre-pandemic levels amid strength in industrial production and exports. Meanwhile, retail sales and fixed-asset investment underwhelmed. China was expected to record the strongest GDP in a decade in 2021; however, activity is expected to slow given the recent increase in COVID-19 cases in China. Lockdown was extended in three cities in the Hebei province as authorities try to limit the spread ahead of the Lunar New Year holiday. It was also reported that Chinese authorities are discouraging movement around the country ahead of the celebrations, which are naturally expected to be a little more muted this year. Meanwhile, as mentioned, US-China trade relations continue to be fraught for reasons aplenty.

It was quiet in terms of data elsewhere. Nonetheless, Australian consumer sentiment showed a small drop in confidence this month. Japanese exports rose for the first time in two years, but imports remained weak.

Week Ahead

Eurozone fourth-quarter GDP figures will be worth watching for further clarity on the extent of the economic damage as lockdown restrictions tightened. Outside of Europe, the US Federal Open Market Committee (FOMC) statement on Wednesday will be closely watched. Commentary from the virtual Davos forum could give us some interesting snippets.

Monday 25 January

• Germany IFO Business Climate.
• The World Economic Forum’s ‘The Davos Agenda 2021’. Speakers include: Chinese President Xi Jinping, French President Macron and German Chancellor Angela Merkel.
• EU foreign affairs ministers are set to discuss current issues affecting the bloc.
• Key speakers: ECB’s Lane and Panetta.

Tuesday 26 January

• UK Claimant Count & ILO Unemployment Rate; Spain PPI; US state employment; Japan Retail Sales.
• The IMF releases its latest World Economic Outlook.
• Key speakers: ECB’s Centeno.

Wednesday 27 January  

• Germany Consumer Confidence; France Consumer Confidence, total jobseekers; US FOMC statement.
• Key speakers: ECB’s Lane.

Thursday 28 January   

• Spain unemployment rate; Italy Manufacturing and Consumer Confidence; Eurozone Consumer Confidence; Germany CPI; US GDP and Jobless Claims; Japan Jobless Rate and Industrial Production.
• Key speakers: ECB’s Schnabel.

Friday 29 January   

• France GDP, Consumer Spending PPI; Germany GDP, Unemployment Change; Spain GDP, CPI, CA Balance; Italy PPI.

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