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Notes from the Trading Desk – Franklin Templeton

Franklin Templeton’s Notes from the Trading Desk offers a weekly overview of what our professional traders and analysts are watching in the markets. The European desk is manned by eight professionals based in Edinburgh, Scotland, with an average of 15 years of experience whose job it is to monitor the markets around the world. Their views are theirs alone and are not intended to be construed as investment advice.

The Digest

Last week saw global equities recover ground, albeit on lower summer trading volumes, as US bond yields tightened through the week ahead of this week’s Federal Reserve (Fed) meeting. In terms of talking points, the European Central Bank (ECB) was in focus, as it raised interest rates by 50 basis points (bps), larger than the 25 bps hike many had expected. Italian politics also caught attention as Prime Minister Mario Draghi resigned. On the week, the MSCI World Index rose 3.2%, The STOXX Europe 600 Index rose 2.9%, the S&P 500 Index rose 2.5%, and the MSCI Asia Pacific was up 3.5%.

ECB: 50 bps rise more than expected, with a new anti-fragmentation tool announced

Ahead of the ECB announcement, market watchers were wondering whether the first rate hike in 11 years would be 25 or 50 bps, and, with a few dynamics at play, it was anyone’s guess. In the end, the hawks of the ECB prevailed with their demand for a 50 bps hike, taking the deposit rate to zero. The doves got a new line of defence against an excessive widening of yield spreads within the eurozone.

We have seen the recent past that “the left hand hasn’t been talking to the right hand,” as the guidance supplied on both rates and the anti-fragmentation tool ahead of recent meetings by ECB President Christine Lagarde hasn’t played out. As a result of this “disconnect”, the ECB now seems to have ditched much of its guidance by simply saying that the frontloaded start would allow it “to make a transition to a meeting-by-meeting approach to interest-rate decisions” on the way towards normalising its policy stance.

The ECB also announced a new anti-fragmentation tool—the “Transmission Protection Instrument” (TPI)—which “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area”. Importantly, activation of the TPI would be at the sole discretion of the ECB’s Governing Council and could not be vetoed by any European Union (EU) state. Lagarde commented “The ECB is capable of going big {on this}.”

The ECB will use four indicative criteria to judge whether a country under duress could be eligible for TPI purchases:

  • compliance with the EU fiscal framework;
  • absence of severe macroeconomic imbalances;
  • sustainable fiscal trajectory; and
  • sound and sustainable macroeconomic policies.

Whether the new TPI will prove effective in taming concerns over peripheral bond yields is hard to assess at this juncture, as not all features of the instrument are totally clear, and the level of stress that would lead to an activation of the instrument is unknown (and could be a source of disagreement among ECB members). Moreover, the homegrown political crisis in Italy adds another layer of complexity.

German Bunds tightened sharply at the end of last week, with the 10-year bund yield falling 32 bps to 1.02%. The Italian 10-year bond yield was unchanged last week, but political upheaval is muddling the picture.

Italian politics: usual chaos, but timing poor

Despite his positive comments on Wednesday saying that his coalition could be rebuilt, Italy’s Prime Minster Mario Draghi resigned on Thursday morning after losing the support of three coalition partners (Lega, 5 Star and Forza Italia).

The Italian constitution requires that elections take place within 70 days of the dissolution of parliament, and President Sergio Mattarella confirmed on Thursday that early elections will be held on 25 September with a new government to be convened 13 October. Mario Draghi will serve as a caretaker—urging that projects in progress need to continue. Italy’s EU COVID-19 recovery plan milestones need to be reached to secure planned instalments.

Democratic Party leader Enrico Letta stated that his party would continue with Draghi’s programme if it won the elections—but at least according to the polls—this looks unlikely, with a centre-right coalition of Brothers of Italy, Lega and Forza Italia commanding around 45% of the voting intentions. Therefore, it would require a broad coalition of PD, M5S and a host of smaller parties to counter the vote share as it stands now. Italy could therefore end up with its most right-wing government in recent years.

Aside from the imminent concerns around further delays to the reform agenda, worries around a tougher stance towards the EU could complicate the situation, and the bond market could test the new ECB TPI.

This is obviously not ideal for a country that needs to push forward with reforms.

Italy’s FTSE MIB lagged the broader STOXX Europe Index last week, although managed to close up 1.3%.

The Russian gas supply story: (reduced) flows resume, but Putin still holding Europe to ransom

The big focus last week was on whether Russian gas flow would resume to Germany via the Nord Stream 1 pipeline. On Thursday it was confirmed (as the market expected) that gas flows have resumed, albeit at the reduced 40% capacity level that we had before the maintenance shutdown started.

Ahead of Thursday’s announcement, policymakers were preparing for the worst, with the EU unveiling a plan on Wednesday to try to curb gas consumption by 15%. This proposal has put strain on EU harmony, with several countries (led by Spain) pushing back. The Spanish government said such a proposal is “not efficient, fair or equitable.”  This demonstrates the challenges that will lie ahead this winter.

So, the restart is obviously positive news short term, but we know that this story will continue to act as a significant overhang for European risk as Putin’s weaponisation of energy creates a high probability of further gas disruption into winter.

The week in review

Europe

European equity markets proved resilient last week despite a larger-than-expected ECB rate hike (as discussed), weak macro data and regional political uncertainty (Italy and United Kingdom). Sentiment was helped somewhat by Russia resuming gas flow via Nord Stream 1 following a maintenance shutdown and some reassuring US corporate earnings. Technology stocks made a strong advance last week, although the sector is still one of the worst performing year-to-date. Defensive names were poor performers last week, particularly telecommunications.

Positioning also seems to have helped drive market performance last week with shorts being covered. On the flip side, names that outperformed this year lagged last week, including defense names. There is some debate as to whether headwinds are really priced in, or whether this recent move higher is merely a positioning-driven bear squeeze.

In terms of macro data, weaker-than-expected European Purchasing Managers Index (PMI) data came out on Friday, increasing recessionary concerns. The Composite PMI reading fell from 52 to a 17-month low of 49.4 in JulyRegion-wise, Germany saw the biggest decline (48.0), while France saw modest growth (50.6). Forward-looking indicators were not encouraging, with new orders falling to 46.9. That said, the survey did imply some easing of price pressures.

Meanwhile, the UK Consumer Price Index (CPI) report showed that inflation rose to 9.4% from 9.1% year on year, the highest since 1982. Rising prices for motor fuels and food were notable. In our view, the report increases the risk of a 50 bps rate hike in August from the central bank, but some tentative signs of stabilisation in the labour market, as well as a slowdown in growth, could mean the Bank of England sticks with a 25 bps hike in August.

Regarding recessionary fears, last week’s European BoA Survey showed 86% of respondents expect a recession in Europe within the next 12 months and 49% of survey respondents expect further declines in European equities over the coming year (up from 34% in June).

Looking at credit markets, sentiment has improved in July, with the ITRAXX XOVER comfortably off recent highs and testing its 50-day moving average.

United States

US equity markets steadied up as US bond tightened ahead of the Fed meeting this coming Wednesday and some chatter of peak inflation circulated. With that, all US indices recovered to their 50-day moving averages, and the S&P 500 Index closed up 2.5% last week. The Fed’s blackout period ahead of the 27 July meeting helped, as we haven’t heard any further hawkish rhetoric from Fed speakers.

Looking at sector performance, it was a bit of a mixed bag as second quarter (Q2) earnings skewed the picture somewhat: Consumer discretionary outperformed, +6.8%, followed by materials and industrials. On the downside, communication services lagged.

There were some negative macro data points which added momentum for the view that we will see a “Fed pivot” to a less hawkish stance later in the year. The Philadelphia Fed Business Current Outlook came in at -12.3, which was lower than expected. Within the survey, a measure for business conditions six months from now slumped this month to the lowest level since 1979. In this context, market expectations for year-end rates dropped to 3.36% versus 3.51% at the end of last week.

A couple of other signs of investor sentiment improved: Bitcoin recovered further ground, and the CNN Fear & Greed Index remains above “Extreme Fear” reading. That said, the BoA Global Fund Manager Survey showed a record high of respondents taking lower risk than normal. In addition, cash levels are at the highest level since 2001, suggesting there is a meaningful amount of cash still on the sidelines.

Asia

Asian markets saw a bullish week, with Japan’s equity market the standout last week (up 4.2%), and the wider MSCI Asia Pacific up 3.58%.

The peak inflation narrative lifted risk appetite across the region as the US dollar skidded to a two-week low. This followed the pickup in concerns about dollar strength fueling inflation elsewhere, as other currencies fall to multi-decade lows. Declines in commodity prices, more aggressive central bank tightening, weaker growth outlook and tighter financial conditions also helped to put downward pressure on inflation expectations.

Japan’s market was closed on Monday for Marine Day, but the main driver for last week’s positive performance was the Bank of Japan’s (BoJ’s) continuation of its loose monetary policy and low inflation target, in contrast to most other central banks. At its July monetary policy meeting, the BoJ left its short-term policy interest rate unchanged at -0.1%, while maintaining its long-term yield target and asset purchase programme, with a view to achieving its inflation target of 2%. The yen strengthened slightly versus the US dollar.

Worth noting, Japan’s daily COVID-19 cases rose to record highs, including in the capital Tokyo. While the government is watching the impact on the medical system with maximum caution, it has ruled out the possibility of imposing movement restrictions.

In China, it was a “week of two halves”, where we saw a strong start to the week, only for it to fade Thursday and Friday. Despite this, the market managed to close higher last week overall.

At the start of the week, the market took hope from supportive comments by People’s Bank of China (PBOC) Governor Yi, who vowed stronger implementation of monetary policy in response to downward economic pressures. We also saw Chinese authorities stepping up real estate market intervention, reportedly looking at allowing homeowners to temporarily halt mortgage repayments while urging banks to boost lending to developers so they can complete unfinished housing projects.

The PBOC maintained interest rates as expected, keeping the one-year loan prime rate (LPR) unchanged at 3.70% and the five-year rate at 4.45%.

China’s COVID-19 trajectory remains on an upslope after the country recorded its highest daily  infections since late May last Saturday. The mainland saw a dip in new infections on Sunday, and Shanghai also recorded a drop after local officials described situation there as “relatively severe”. However, multiple regions are still battling outbreaks and have imposed various restrictions, with Macau extending its lockdown by a week.

In corporate news, China fined Didi Global more than $1.2 billion, wrapping up a year-long probe into the ride-hailing giant that’s come to symbolize Beijing’s bruising campaign to rein in its powerful internet industry. Regulators also fined both the company’s chairman and president. The long-awaited penalties for Didi—remove some of the uncertainty that at one point wiped 80% off its market value.

The week ahead

Looking at the week ahead, the Fed meeting on Wednesday will be front and centre, with consensus for a 75 bps hike. Q2 earnings will continue to be a driver too, with 51% of the S&P 500 Index  by weight and 45% of the STOXX Europe 600 reporting. Elsewhere, we have several global gross domestic product (GDP) releases this week.

Monday 25 July

  • Germany IFO Survey

Tuesday 26 July

  • BRC Shop Price Index
  • US new home sales

Wednesday 27 July                   

  • EU: M3 Money Supply
  • France Consumer Confidence
  • Germany GfK Consumer Confidence & Retail Sales
  • Italy Consumer Confidence Index, Manufacturing Confidence, Economic Sentiment & Hourly Wages
  • US Fed monetary policy meeting

Thursday 28 July

  • UK Nationwide House Price Survey, Lloyds Business Barometer
  • Germany HICP Inflation
  • EU: Economic/Industrial/ Services/ Consumer Confidence
  • France Producer Price Index, Total Jobseekers
  • Italy Industrial Sales
  • US Initial Jobless Claims

Friday 29 July

  • France 2Q GDP & HICP Inflation
  • Spain 2Q GDP & HICP Inflation
  • Germany 2Q GDP
  • Italy 2Q GDP & HICP Inflation
  • Euro-area 2Q GDP & Flash CPI Inflation
  • UK Net Consumer Credit, Consumer Credit, Net Lending Secured on Dwellings, Mortgage Approvals, Money Supply M4
  • EMU: CPI, CPI Core/Estimate, GDP SA
  • US University of Michigan sentiment survey


Franklin Templeton Key risks & Disclaimers:

What Are the Risks?

All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.  Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

Past performance is not an indicator or guarantee of future performance. There is no assurance that any estimate, forecast or projection will be realised.

This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of 25 July 2022, 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. Nothing in this document may be relied upon as investment advice or an investment recommendation. The companies named herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. Data from third-party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FT affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction.

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