Notes From the Trading Desk – EuropeOct 1, 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.

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Last week offered a lacklustre end to the third quarter of 2018. Global trade tensions remained high on the agenda and there were concerns about the new Italian government’s larger-than-expected spending plans. Equity markets in Europe and the United States drifted lower. On the other hand, the picture was a little more balanced in Asia, where Japanese and Chinese equities saw some small gains.

The Digest

Italian Government Pushes The Envelope On Fiscal Spending

Italy

Italian assets sold off sharply on Friday after the government unveiled its budget spending plans.

Italian banks led the country’s stock market lower, but Italian bonds were also hit.

Italian government’s deficit target of 2.4% of gross domestic product (GDP) spooked investors on Friday. The figure was significantly higher than the 1.6%-1.9% that Italian finance minister, Giovanni Tria, had suggested earlier.


The proposed 2.4% figure represents not just the target for 2019, but also for 2020 and 2021. The Italian government hopes the additional spending will help it push ahead with plans for a universal income worth around €10 billion and a lower retirement age. The government also confirmed that it intends to scrap a planned increase in value-added tax.

This news is likely to test Italy’s relationship with the European Union (EU). A deficit over 3% of GDP is a red flag for the EU, but Italy’s debt already stands at 130% of GDP—the highest in the EU after Greece—so EU nerves over increased spending are likely to be heightened. EU Economic Commissioner Pierre Moscovici described the budget as “out of line with our rules.”

Regulations set out under the bloc’s Stability and Growth Pact (SGP), say that EU countries should have nominal budget deficits below 3% of economic output and public debt below 60%. However, countries have breached these limits in the past and EU hasn’t always done much.

For example, France only brought its public deficit below the European Union’s 3% limit for the first time in a decade last year and it hadn’t been sanctioned previously.

Italy would also likely argue its budget deficit targets should still allow its debt-to-GDP ratio to decline slightly over the next three years.

Net/net, we expect Italy to face greater scrutiny from EU, but we think it will probably get away with this budget.

Looking forward, Finance Minister Tria will meet his European Counterparts next week and will present documents setting out the 2019 budget on October 15. We can expect other Italian politicians to come out making soothing comments for the benefit of the markets, too.

Brexit Noise Rumbles On

The political party conference season continues this week in the United Kingdom. The focus of the season so far has been on the Brexit policies of the main UK parties, rather than the actual negotiations between the UK and EU.

In its announcement, the central bank added that it would end foreign-exchange purchases in the open market by the end of the year.

At last week’s Labour Party conference, much of the focus was on the possibility of the party endorsing a second Brexit referendum.

Brexit morton

In the end, Labour members voted through a motion which left all options on the table. While some senior figures were reluctant to commit specifically to a second vote, Shadow Brexit Secretary Keir Starmer, said: “Nobody is ruling out Remain as an option.”

We took this as the clearest indication yet that Labour could back a second vote. The other clear message from the Labour conference was that Labour MPs would not back any deal Theresa May puts to Parliament (if she can agree one with the EU). That makes her task of obtaining parliamentary approval for any deal she gets more challenging.

The Conservative Party conference takes place this week and we have already seen a number of high-profile figures criticise their party leader.

Over the weekend, former Foreign Secretary Boris Johnson described Theresa May’s Brexit plans as “deranged” and former Brexit Secretary David Davis blamed May personally for the UK’s weak hand in EU negotiations. Theresa May’s speech on Wednesday will be an important event to watch this week.

Last Week

Europe

UK and French stock markets were the outperformers on the week, while Germany’s market declined as autos lagged and Chancellor Angela Merkel continues to face political discontent. The negative news out of Italy also dragged the euro lower.

The top-performing sectors were media and oil & gas. Autos were the laggards and banks fell following the news from Italy.

In central bank news, ECB President Mario Draghi made some hawkish comments on Monday, stating eurozone inflation was “relatively vigorous”. His sentiment was undermined somewhat later in the week when the underlying consumer price index (CPI) data was lighter than expected.

EU macro data was a little softer overall with Italian, French and Spanish CPI all missing estimates and Spain’s second quarter GDP was revised lower.

There was some further respite for emerging markets, as the Turkish lira did see some relief. One of Turkey’s major banks refinanced some debt, easing concerns about a debt crisis, and there was some merger-and-acquisition interest in one of the country’s major telecoms businesses.

Americas

US markets drifted lower last week against a backdrop of ongoing trade tension and US Federal Reserve (Fed) tightening. On US-China trade, the tone was negative after China turned down the offer of fresh mid-level trade talks.

The Federal Open Market Committee (FOMC) meeting was largely in line with expectations. Committee members raised rates by 25 basis points (bps) to a range of 2% -2.25%.

In the subsequent commentary, Fed officials also dropped a reference to “accommodative” policy. A further rate hike in December remains very much on track, with the market seeing a 77% probability. Some had thought that the rhetoric might have had a more hawkish tone, so we did see some flattening of the yield curve and some downward pressure on financial stocks.

Asia

Japan was the standout performer in Asia last week, as the Nikkei Index hit its highest level since 1991. Continued weakness in the yen acted as a catalyst for Japanese stocks’ move higher.

In addition, the minutes from the Bank of Japan’s monetary policy meeting were supportive as they highlighted most members found it appropriate to continue easing persistently.

The narrative from trade talks with the United States was also helpful, as US President Donald Trump suggested negotiations had reached “a satisfactory conclusion”.

Performance in the Greater Chinese markets diverged. The Shanghai market closed up last week, while its Hong Kong counterpart closed the week in the red.

News that the MSCI is looking to increase in the weighting of Chinese A-shares in its Emerging Markets index next year helped spur gains in Chinese stocks. Meanwhile ,the Hong Kong Monetary Authority announced its first interest-rate increase in over a decade, lifting the base rate 25 bps.

Week Ahead

We have had a positive start to this week thanks to the news of a trade agreement between the United States and Canada. More details are likely to emerge during the week. The new deal will replace the North American Free Trade Agreement (NAFTA) and will be called the US-Mexico-Canada Agreement, or USMCA.

In Europe, politics will be centre stage as Theresa May gives her keynote speech to the Conservative Party conference, while in Europe all eyes will be on Italy.

Asia is likely to be quiet with China’s markets closed all week for Golden Week.

Economics

  • Global purchasing managers index (PMI) data for September is scheduled for release across the week.
  • It’s a big week for US macro data, including manufacturing figures and jobs data.
  • In Asia Chinese PMIs were released on Sunday which disappointed. On Monday, we expect Bank of Japan’s third quarter business confidence survey.

Monetary Policy

  • The Reserve Bank of Australia has an interest-rate decision scheduled for Tuesday this week.
  • US Fed’s Chairman Jerome Powell is due to speak publically twice this week.

Politics

  • UK: Theresa May will speak at the Conservative Party Conference on Wednesday.
  • European Union trade ministers are due to meet in Innsbruck, Austria on Thursday.
  • Donald Trump is expected to issue a formal statement in the “next few days” authorising United States Trade Representative Robert Lighthizer to commence the process of considering the next round of Chinese tariffs on $267 billion worth of imports.
  • Elsewhere, Sunday is the deadline in the US for President Donald Trump to sign spending bills passed by Congress to avoid a government shutdown.

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