Notes From the Trading Desk – EuropeNov 19, 2018

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.

Notes from the trading desk Europe

Political considerations weighed on European equities last week. Concern around Brexit and the Italian government budget brought to an end two weeks of gains in European stock markets. US equities were also lower as stocks in the technology sphere struggled. There was a mixed performance from stocks in Asia Pacific (APAC). Japanese equities underperformed as risk-off sentiment helped the yen strengthen. Meanwhile, stocks in China outperformed despite mixed macroeconomic data from the country.

The Digest

Brexit Again Dominates Headlines

american flag wood background

Last week was a busy one in Brexit developments. Late on Tuesday, UK and European Union (EU) negotiators announced they had agreed a draft text for a Withdrawal Treaty governing the United Kingdom’s departure from the EU.

The pound initially spiked in response to the news, but the currency quickly faded as it became clear that the agreement was merely a pre-condition for the final political agreement on Brexit.

Overnight on Wednesday of last week, UK Prime Minister Theresa May seemed to have cleared the first hurdle of securing the backing of her Cabinet for the deal. However, on Thursday morning Brexit Secretary Dominic Raab and Work and Pensions Secretary Esther McVey both resigned, saying they couldn’t support the agreement.

Further resignations of more junior ministers trickled in throughout the rest of the week.

Amidst the resignations and noise, the pound sold off dramatically against both the US dollar and the euro.

The FTSE 100 Index was a relative outperformer among European stock indices as negative sentiment towards the United Kingdom was balanced by strength among exporters as a result of the move in sterling.

Adding to the uncertainty and negative sentiment was the possibility of a leadership battle within the Conservative Party as some factions of the party looked to put forward a vote of no confidence in Theresa May.

As this week began, Theresa May’s precarious position seemed to have improved somewhat. By Monday morning her would-be ousters seemed to be short of the numbers required to trigger a challenge.

In addition, Germany’s Europe Minister Michael Roth warned May’s critics that the British negotiating position “won’t improve even with a new PM”. German Chancellor Angela Merkel has also made clear that she feels there is no question of negotiating any further on Brexit. So we think the EU is unlikely to provide further concessions.

What happens next?

This is unchartered territory and so there are a multitude of possible outcomes. We would note that the probability of a no-deal (or “Hard”) Brexit has not dramatically increased after last week’s developments. We felt there was always likely to be volatility at this point in the timeline. The real point, in our view, is that the route to a soft-Brexit is now more unclear.

Theresa May will be in Brussels midweek and a full version of the political declaration on the path to Brexit is expected to be ready for publication by Tuesday.

On Sunday (November 25) May and the leaders of other EU member states will meet at a special summit to sign off on the text and the 585-page withdrawal agreement. A large part of the objection to the deal is on the lack of clarity, and so a more detailed text has the potential to soothe some of these concerns.

The Difficulties of the Parliamentary Vote

Even if the draft Withdrawal Treaty does get the backing of the EU, Theresa May still faces the tricky task of passing it through the UK parliament.

With only a slim majority in the House of Commons and opposition to the deal both from elements in her own party and from the Democratic Unionist Party, she may have to rely on votes from the Labour and Scottish National Parties in order to gain the 320 votes needed. Spokespeople from both parties have already said their members intend to vote against the deal.

Should parliament vote against the deal, as is probable, we think it opens up a range of scenarios which are all likely to have a negative, risk-off impact on markets. These include a second referendum, a UK general election, a so-called “people’s vote” on the deal, and a no-deal Hard Brexit.

December 13 is a key date, which Brussels widely sees as the last point at which a deal may be done. As with all EU negotiations, deadlines are able to be extended, but the risk of a no-deal rises sharply if this date is missed. Therefore, we would expect plenty of noise and associated volatility in the pound in the coming days and weeks.

Another Volatile Week for Crude Oil

Oil prices had yet another volatile week, making new year-to-date lows late on Monday, November 12.

Oil field

The previous week, oil prices had moved into bear market territory following 10 consecutive days of moves lower. The volatility was tied to uncertainty around whether the Organization of the Petroleum Exporting Countries (OPEC) would cut supply in the face of rising US output and a slowdown in global demand.

Last week started brighter after reports suggesting OPEC members were preparing a production cut to be finalised at the December 6 meeting. Saudi representatives said they would be looking to scale back production by approximately 500,000 barrels per day in December, while Oman and Russia also released statements supporting a supply cut.

However, the price gains were undone late on Monday (November 12) after US President Trump urged OPEC not to cut supply. Trump tweeted: “Hopefully, Saudi Arabia and OPEC will not be cutting oil production. Oil prices should be much lower based on supply!”

In response, the price of West Texas Intermediate (WTI) crude crashed to a new year-to-date low. Prices stabilised through the rest of the week after comments from United Arab Emirates’ (UAE) Energy Minister Suhail Al Mazrouei, suggesting that OPEC+ (OPEC members plus 10 other oil producing nations) would likely reach a conclusion on balancing the market and keeping prices and inventory levels stable.

Last Week

Europe

European equities traded lower last week as the headwinds of Brexit uncertainty and Italy’s budget wrangles with the EU both weighed on sentiment.

From a sector perspective, unsurprisingly defensive names outperformed, in particular telecommunications stocks. Stocks in the financial sector were the laggards.

The spat between Italy and the European Commission over Italy’s budget proposals rumbles on. Last week saw Italy submit revised budget plans to the EU. The new plans included some amendments, but they stuck to the Italian government’s 2.4% budget deficit target and 1.5% growth forecast for next year. In response to this, European Commission spokesman Valdis Dombrovskis said the Italian government was openly challenging budget rules agreed by all eurozone countries. He said the policy was counterproductive as it pushed bond yields higher.

The Commission is due to rule on the Italian budget on Wednesday, so we can expect this to be a talking point mid-week.

Last week, the  League party Spokesman Claudio Borghi claimed  his party could angle for Italy to leave the eurozone should it get a majority in the next election.  As we have discussed before, The League’s support has grown in opinion polls, and harsh action from the European authorities could further boost populist support.

In a speech on Friday, European Central Bank (ECB) President Mario Draghi acknowledged the eurozone economic slowdown raised questions about the strength of Europe’s growth outlook. Still, Draghi expects European growth to continue in the coming years. He said the ECB needs to monitor trade risks carefully over the coming months, adding that the bank would assess any loss of momentum in the eurozone in December.  The ECB is due to complete its asset purchasing programme in December.

In terms of macro data, it was notable the German economy shrank for the first time since early 2015 after its auto industry took a hit.

Look Out For... (November 12-19):

Monday, November 19

  • Japan October Trade Balance Link
  • Eurogroup Meeting Link
  • US October Housing Starts Link
  • Reserve Bank of Australia Meeting Minutes Link

Tuesday, November 20

  • German October Producer Price Index Link

Wednesday, November 21

  • US October Core Durable Goods Orders Link

Thursday, November 22

  • US Thanksgiving Holiday
  • Japan October Consumer Price Index Link
  • European Central Bank Publishes October Monetary Policy Meeting Minutes Link

Friday, November 23

  • German Third-Quarter Gross Domestic Product Link
  • Canada October CPI Link

Monday, November 26

  • New Zealand October Trade Balance Link

Americas

Last week saw some profit taking in US equities. It was a quieter week in terms of newsflow.

With US midterm elections behind us, attention this week will likely shift to the planned talks between US President Donald Trump and Chinese President Xi Jinping at the G20 Summit in December. White House Economic Adviser Larry Kudlow confirmed a report that indicated China trade talks have resumed in earnest ahead of the G20 meeting.

With the pause for breath from markets, defensive sectors outperformed last week. Consumer staples and telecommunications stocks were higher while retailers and technology sectors ended the week down.

US Federal Reserve (Fed) speakers last week seemed a little more dovish than recently.

On Friday, Fed Vice Chair Richard Clarida said that there was “some evidence of global slowing,” adding that the Fed should pay attention to the slowing global economic outlook. Earlier in the week Fed Chair Jerome Powell by and large stuck to his hawkish stance. However, he did not repeat the comments he made in October that US interest rates were “far from neutral”.

Asia

Asian markets were mixed last week, closing a touch lower overall. Japan struggled as risk-off sentiment allowed the yen to strengthen. China outperformed despite mixed data.

Much of the focus in the APAC region remains on US/China trade tensions.

There were some developments over this last weekend at an APEC (Asia-Pacific Economic Cooperation) summit where China’s President Xi and US Vice President Mike Pence traded verbal blows.

Xi said US protectionist policies were “doomed to fail” while Pence accused China of “taking advantage of the United States for many, many years”. He added those days were over.

Pence also attacked China’s approach to technology, intellectual property rights, and China’s “Belt and Road” initiative. Interestingly, it is the first time in the APEC forum’s 29-year history that there has not been a post-meeting joint communique. That seems to us to confirm that there are still some real differences between the United States and China on how to resolve current tensions.

The next big meeting between the two nations will be at the G20 summit in Buenos Aires, which starts on November 30th.

Chinese data was mixed last week with industrial production and fixed asset investment slightly ahead of estimates. Retail sales growth slowed and auto sales fell for the sixth straight month. China’s new lending came in behind estimates, with the main driver being corporate loans.

Also, the Peoples Bank of China (PBOC) released its quarterly monetary policy implementation report. The report indicated the bank intends to maintain prudence around monetary policy. It highlighted a number of specific potential measures such as issuing special-purpose bonds for private companies, widening the range of eligible collateral and reducing the reserve requirement ratio.

In Japan, the economy contracted, down 1.2% on the quarter. Natural disasters were blamed for the downturn in economic activity.

Elsewhere, newly released data revealed the Bank of Japan’s (BOJ) assets are now larger that the country’s economy following the central bank’s continued asset purchasing programme.

Week Ahead

Politics

  • Talks continue between the United Kingdom and the EU after the release of the draft withdrawal deal last week. There will be a Brexit summit on Sunday where EU leaders could confirm their acceptance of the proposed deal.
  • On Wednesday, the European Commission releases its opinion on member states’ draft budgets. This is very much in focus given continued tension between the EU and Italy around the Italian budget.

Economic Data

  • In Europe: French unemployment and German purchaser price index (PPI) data is due on Tuesday; eurozone consumer confidence and UK inflation on Thursday; German third-quarter gross domestic product (GDP) and eurozone composite purchasing manager index (PMI) on Friday.
  • In the United States: housing starts and building permits data is scheduled for Tuesday; mortgage applications and goods orders for Wednesday; and manufacturing and services PMIs on Friday.
  • In the Asia and Pacific region, Japan inflation is set for Thursday.

Monetary Policy

  • Bank of England GI don’t overnor Mark Carney speaks on the UK’s Inflation Report on Tuesday.

Holidays

  • US markets are closed on Thursday and a half-day on Friday for Thanksgiving.

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This article reflects the analysis and opinions of Franklin Templeton’s European Trading Desk as of November 19, 2018, and may vary from the analysis and opinions of other investment teams, platforms, portfolio managers or strategies at Franklin Templeton Investments. 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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