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.
Last week saw a tough end to August as global equity markets traded lower on concerns around hawkish central bank action and fears of a China slowdown. The focus on central banks followed Federal Reserve (Fed) Chair Jerome Powell’s comments at Jackson Hole the prior week, but there was also increasing focus on the European Central Bank (ECB) meeting this week. In addition, European energy concerns remain in the limelight. Gas prices saw some respite last week, but the mood on this issue soured over the weekend after Gazprom suspended gas supply on Nord Stream 1 “indefinitely” due to “a technical fault”.
Last week, the MSCI World Index closed down 3.3%, the STOXX Europe 600 Index was down 2.4%, the S&P 500 Index was down 3.3% and the MSCI Asia Pacific Index declined 3.9%.
European energy woes
Last week sentiment had improved around the European energy situation as Germany highlighted it was ahead of schedule in filling gas reserves and the European Union (EU) talked about “concrete” measures to tackle soaring energy prices. With that, the European gas price fell back from recent highs, trading down 37% last week.
The mood changed over the weekend, as Gazprom suspended gas supply on Nord Stream 1 “indefinitely” due to a “technical fault”. It has been suggested that this is really a retaliation to the G7 plans to try and impose a price cap on Russian oil exports. Recall, the pipeline was closed on 31 August for a three-day maintenance shutdown. Although running at just 20% of capacity prior to the shutdown, it still accounted for a meaningful amount of Russia’s gas exports to Europe.
As it stands, EU gas reserves are in good shape, as falling domestic demand (due to high prices) and increased US liquified natural gas (LNG) has allowed Germany to fill its reserves to 85%, well ahead of schedule. Whilst this gives Europe a good cushion, the German energy regulator noted last week that a 95% full reserve (its November target) would only cover around 2-1/2 months of winter demand.
We have seen several European countries react over the weekend. On Sunday, the German government announced a new package worth at least €65 billion to help households and companies cope with the energy crisis. Together with the earlier measures of €30 billion, this takes Germany’s fiscal response to the surge in energy and food prices to €95 billion, equivalent to around 2.5% of its 2022 gross domestic product (GDP). Sweden and Finland have announced additional loans and liquidity facilities to utilities and energy companies at risk of default.
EU Council President Charles Michel said the interruption of the service was “sadly no surprise…Use of gas as a weapon will not change the resolve of the EU. We will accelerate our path towards energy independence. Our duty is to protect our citizens and support the freedom of Ukraine”. EU energy ministers meet this Friday (9 September) to discuss further action.
Unsurprisingly, European gas prices have jumped sharply this morning (5 September). In terms of sector performance, cyclicals have been hit the hardest, with the autos and chemicals stocks declining, while oil and gas stocks have risen. The euro has fallen through parity versus the US dollar once again, having fallen to 98.78—its lowest level since 2002. European credit spreads have widened recently too, although still not at year-to-date highs.
Looking ahead, the actions from European governments in the coming days and weeks will be crucial to easing investor nerves. The 9 September EU meeting looks to be an important focus the week. Furthermore, actions to improve alternative energy supplies will improve sentiment, with press reports that Germany will keep two nuclear power plants running rather than shutting them down by year-end a good example.
ECB–will hawks get their way with 75 basis point (bps) hike?
The EBC has its policy meeting this week on Thursday. Until about two weeks ago, the consensus was for a 50 bps interest-rate hike, but in the face of worsening inflation projections, together with some major hints from some of the ECB’s Governing Council members—Isabel Schnabel and Olli Rehn (at the Jackson Hole Conference) in particular—the consensus has now shifted towards a larger 75 bps hike.
A few vocal ECB hawks in the past week talked up more aggressive rate hikes, with Bundesbank President Joachim Nagel calling for a “strong rise in interest rates in September”, adding that “further interest rate steps are to be expected” afterwards. Also on Wednesday, his Austrian colleague, Robert Holzmann, said that there’s “no reason to show any kind of leniency”. Note, the Eurozone August Consumer Price Index (CPI) came in at 9.1% last week, higher than anticipated.
Faced with inflation that is expected to accelerate from a 40-year record of 9.1% year-over-year in August to at least 10% in coming months, the ECB wants to make sure that elevated inflation expectations do not get entrenched.
If we do see a larger rate hike on Thursday, the reaction of European sovereign bond markets will be important to monitor, given many yields are already at elevated levels. Focus would then turn to ECB’s new “Transmission Protection Instrument” to shield Italy and the rest of the southern European periphery from disruptive market moves.
It is important to note there are some ECB members calling for a more measured approach. ECB Chief Economist Philip Lane has advocated for “a multi-step calibrated series” of interest rate hikes rather than a smaller number of larger increases.
In this context, money markets have priced in 125 bps of tightening by October, which implies a half-point hike and a three-quarter point increase over the ECB’s next two policy decisions. European bond markets have seen some huge moves. For example, the German 10-year bund yield rose by more than 70 bps to 1.5%, its biggest monthly gain since 1990, and the two-year bund yield ended August with its biggest monthly gain since 1981.
The Week in Review
US equities closed broadly lower last week, with a lot of the focus on the hawkish commentary from the Fed. It was a third weekly decline for US indices, with the S&P 500 Index closing down 3.3% and the Nasdaq underperforming, down 4.0%. The US dollar strengthened once again, firmly through parity versus the euro and testing 1985 highs versus the British pound. Macro data showed that the US economy is still strong, meaning the Fed is unlikely to change course on hiking rates. In terms of fund flows, US equity funds recorded their largest outflow in 10 weeks.
All sectors closed in the red last week. Defensives (utilities, health care) outperformed but were still lower. Fears over a real hit to growth led to large drops in materials and technology stocks, with real estate investment trusts likewise taking a hit.
The Fed’s pushback against a policy pivot seemed to set the tone last week. At the Jackson Hole, Wyoming, central bankers conference, Fed Chair Powell said “restoring price stability will likely require restrictive policy for some time”.
Last week, New York Fed Bank President John Williams reiterated that language, saying that the Fed will need to hold rates in restrictive territory for “some time”. He added that he expects rates to rise “somewhat above” 3.5% and remain at that level through 2023.
Richmond Bank President Thomas Barkin said that the Fed would “do what it takes” to return inflation to its 2% target. He also stated that “a recession is obviously a risk in the process” but advised “it doesn’t have to be calamitous (like 2008)”.
Meanwhile, Atlanta Fed Bank President Raphael Bostic was a little more conciliatory, stating “I don’t think we are done tightening. Inflation remains too high”. However, he did go on to say, if “incoming data… clearly show(s) that inflation has begun slowing (that) might give us a reason to dial back”.
The Fed raised rates by 75 bps at its last two meetings, and the latest commentary has raised expectations of a further 75 bps this month, to 1.5%.
The S&P 500 Index closed near 3900 last week, which has been a key inflection point for markets since May. This suggests we may see a reversal/bounce on the back of short-term oversold conditions. Yet, some market observers are calling for another break to the downside.
Data out of the United States was fairly mixed last week. The August Employment Report on Friday was roughly in line with expectations, with 315,000 nonfarm payrolls added. Unemployment ticked higher to 3.7%. Average hourly earnings came in a little lower than expected, at +5.2%.
The Institute for Supply Management Manufacturing release was market-friendly overall, coming in at 52.8 for August. New orders and employment were better, whilst prices paid came in lower than anticipated. However, the commentary highlighted a pull-forward in demand of people trying to take advantage of the supply chain improvements, suggesting this was the reason for the better-than-expected headline, rather than a real increase in demand.
European equity markets finished broadly lower last week following Powell’s hawkish comments. Investors are becoming increasingly more fearful about future growth, and recession probability forecasts continue to be reset higher. Focus shifts to earnings revisions, and the outlook for equities over the next 6-9 months remains bleak. This week we’ll be watching the outcome of the ECB meeting, with sentiment shifting towards a 75 bps rate hike following the higher-than-expected CPI.
Equity fund flows were poor last week. European equities recorded their 29th consecutive weekly outflow, whilst US equities recorded their biggest outflow in 10 weeks. August was the lowest month of the year for market volumes; however, the month-end rebalance spurred activity, and volumes were also higher on Thursday amidst the market selloff.
In terms of sectors, basic resources stocks were big underperformers on global growth fears, exacerbated by another COVID-19 breakout in China. Utilities stocks were also in focus, slumping given the energy crisis in Europe. Poor earnings also dragged tech stocks lower last week. In terms of outperformers, automotive stocks and banks outperformed last week, with both sectors higher.
The United Kingdom will be in focus today as Liz Truss has been announced as the new prime minister (as expected). Clearly, she comes into power at a particularly difficult time for the UK economy. UK assets reflect this, with gilt yields rising sharply and the British pound slumping not only versus the US dollar but also the euro in the last week. Markets hate uncertainty, so one could argue that we could see some respite for UK assets now that the United Kingdom has a new prime minister, and if we see a quick response to the energy crisis from policymakers.
Finally, September is, on average, the worst month of the year for the STOXX Europe 600 Index, but the market is looking oversold on some technical levels, so we can’t rule out bear squeezes from here.
Last week was poor for Asian equities, with the MSCI APAC Index down3.8% (falling to a two year low) and all major indices in the red.
The week didn’t start well after Powell’s hawkish remarks on 26 August, which increased the likelihood of a quicker and sharper hike of 75 bps, together with more bad news on the COVID front.
China’s equity market closed the week down 1.5%, a relative outperformer. However, the country continues to struggle to contain multiple COVID-19 outbreaks, with many cities (e.g., Chengdu) and regions imposing severe restrictions and some even lockdowns. The usual concerns over how this is impacting the economy continue. The People’s Bank of China did cut a couple of key interest rates in response.
Meanwhile, Purchasing Managers Index (PMI) data were weak; China’s August Official Manufacturing PMI came out slightly better than expected, whereas the Caixin Manufacturing PMI was weaker than expected. On a positive note, Chinese officials announced that the country is entering into an agreement with the United States that would allow the US regulator, the Securities and Exchange Commission, to review the accounts of US-listed Chinese companies, resolving a dispute that threatened to delist about 200 Chinese companies from US exchanges. The agreement marked a retreat by Beijing, which had refused to give US regulators access to citing “national security concerns”.
Las week was tough for Japanese equities, as inflation fears dominated, along with rate hikes and economic data continued to scare investors. The yen traded above 140 against the US dollar for the first time since 1998. Japan’s Finance Minister, Shunichi Suzuki, acknowledged the somewhat high recent currency market volatility and its potential negative impact on the economy and financial conditions. He said that the government was prepared to take appropriate action as needed to bring stability, working closely with monetary authorities in other nations. The yen weakness continues to hurt importers and this, together with surging energy prices, continues to hurt the economy.
On a positive note, Prime Minister Fumio Kishida announced further easing of COVID restrictions on visitors to Japan. He said (without giving a timeline) that the government will ease border controls even further, to make the entry of people as smooth as the other G7 developed nations.
The Week Ahead
It will be a quieter start to the week with Labour Day holiday in the United States. As discussed, the ECB will be a key focus on Thursday as it considers accelerating the pace of interest-rate hikes. The market is placing about a 70% probability on a 75-basis-point increase, which would be the ECB’s single biggest hike since its inception. Sticking with Europe the energy crisis will remain front and centre given the Nord Stream 1 shut down. Markets will also be watching German Industrial Production data, out on Wednesday.
In the United Kingdom, the Conservative Party has announced the country’s next prime minister–Liz Truss.
In Asia, focus will be on Chinese trade balance data out on Tuesday, and Aug CPI and Producer Price Index (PPI) data out on Friday. In Australia, the Reserve Bank of Australia meets on Tuesday; consensus is for a 50 bps rate hike.
Monday 5 September
- UK Prime Minister announced (Liz Truss).
- UK New Car Registrations (Aug), Official Reserves Changes (Aug)
- Euro Area Retail Sales (July)
Tuesday 6 September
- German Factory Orders (July)
- US ISM Services Index (August)
Wednesday 7 September
- Bank of England Governor Andrew Bailey is due to appear before the Treasury Committee, along with members of the Monetary Policy Committee. including Huw Pill, Catherine Mann and Silvana Tenreyro. The central bank is expected to hike interest rates by another 50 bps on 15 September.
- UK RICS House Price Balance (August)
- Euro Area Employment, GDP, Household Cons, Govt Expend; Germany: Industrial Production (July); Italy: Retail Sales (July)
- US MBA Mortgage Applications (September), Trade Balance (July)
Thursday 8 September
- European Central Bank Decision; France: Private Sector Payrolls, Total Payrolls, Trade/Current Account Balance (July)
- US Initial Jobless Claims (September), Continuing Claims (August), Consumer Credit (July)
Friday, 9 September
- France: Industrial/Manufacturing Production (July)
- US Wholesale Inventories/Trade Sales (July), Household Change in Net Worth
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