Notes From the Trading Desk – EuropeSep 17, 2018

Key Points

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.


European equities ended last week mostly higher. Some positive headlines on trade and Brexit and optimism on Italy’s upcoming budget lent some support. We also saw some respite for emerging-market equities and currencies during the week, with Russia and Turkey leading the way. US and Asian equity markets also enjoyed a positive week.

The Digest

Small Respite for EM as Trade War Concerns Continue to Bubble Away

A number of catalysts last week offered some relief from the gloomy tone that has beset emerging markets for some time.

Turkish Central Bank Signals its Independence

Firstly, Turkey’s central bank pushed through a higher-than-expected interest-rate hike.

Turkish President Recep Tayyip Erdoğan has made little secret of his desire to see a cut in interest rates in his country. However, last week the Turkish central bank increased the one week repo rate to 24%. Expectations had been for an increase to 21%.

In our view, this was an important move, because the independence of the central bank is crucial to restoring the confidence of external investors. Both the Turkish lira and Turkey’s stock market closed the week in positive territory.


Unexpected Rate Hike from Russia

Later in the week, the Russian authorities surprised the market with an unexpected rate hike after a larger-than-expected inflation increase spurred the central bank to act.

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

This move is the first rate hike since the Russian currency crisis of December 2014. In the aftermath, Russian equities rose and the ruble strengthened against the dollar.

Softer US Macro Data Offers Boost to EMs

Also positive for emerging-market sentiment were softer US inflation data as producer price index (PPI), consumer price index (CPI) and import/export prices for August all fell short of expectations.

Alongside this, there were some positive signs midweek that the United States and China could hold additional trade talks.

The United States reached out to Beijing, potentially in an effort to push back the new US$200 billion worth of tariffs. Interestingly, this move came after China had asked the World Trade Organisation (WTO) for authorisation to impose sanctions on the United States.

A number of observers have suggested US President Donald Trump could be looking to reach a deal quickly to give him a win ahead of the US midterm elections in November.

We would urge caution, especially given the volatile nature of the situation and the lack of progress seen in prior rounds of negotiations.

Over the weekend, President Trump insisted he would be pressing on with the next round of sanctions against China and media reports suggested Chinese authorities would be likely to decline the US offer of additional talks, not wishing to negotiate with a proverbial gun to their head.

It’s interesting to note too that while the US economy seems largely to be holding up (despite some lacklustre data last week), data from China suggests that things are slowing more severely there.

At the same time, the United States seems to have given itself an extra buffer, with Trump “running the economy hot” early in his presidency amid policies such as tax breaks.

Looking ahead, a weaker US dollar would provide a further tailwind for emerging markets. We think the next big catalyst for the dollar could be the US Federal Reserve (Fed) meeting on September 26. A rate hike is widely expected, but any change to the policy description or any further clarity on the Fed balance sheet has the potential to impact the dollar.

After that, we see the next likely catalyst as the US midterms in November.


Brexit: Lots of Noise but Little Progress

The Brexit negotiations between the United Kingdom and the European Union (EU) are at a crucial stage, although signs of any concrete progress are tantalisingly hard to find.

On Monday last week, there was some positivity from the EU’s lead negotiator Michel Barnier, who said that a Brexit deal was “realistic” in six to eight weeks. That optimism helped the pound close the day up 0.8% versus the US dollar and gain 1.2% on the week.

However, it’s worth bearing in mind that Barnier has still said that he is strongly opposed to the UK government’s favoured Chequers proposal.

Equally, reports on Tuesday suggested the Brussels team was concerned that the United Kingdom was over-reacting to its more upbeat statements.

Away from the official Brexit negotiations Theresa May continues to feel the pressure with reports that a number of Eurosceptics in her own party discussed the options for ousting her.

Meanwhile last week, shadow Foreign Secretary Emily Thornberry made clear that the opposition Labour party would vote against the government’s Chequers’ deal. This opposition means that it would require as few as 10 conservative MPs to vote against the plan in order to defeat the government.

May made it clear over the weekend she has no intention of wavering, telling the BBC in an interview she was irritated at the talk of a leadership contest and ready for a fight.

The Conservative Party conference, which begins on September 30, now looks to be pivotal for May’s future.

On Thursday European leaders will meet in Salzburg to discuss Brexit. Ahead of this, there are reports that the EU may discuss whether to instruct Barnier to be more flexible with the talks with the UK, but other than this, the summit is unlikely to provide any big breakthrough. Still, it will be important to watch headlines for any change in tone or language.

Last Week

Europe

European equity markets bounced back last week thanks to improved sentiment around the upcoming Italian budget and optimism about the potential for a Brexit deal.

Sector-wise, European energy names that led markets higher thanks to higher crude oil prices.

In addition, European autos outperformed as talks between the United States and EU on auto tariffs appeared to progress well. Utilities were the laggards, as so-called defensive stocks fell out of favour.

The European Central Bank (ECB) and Bank of England (BOE) both held monetary policy meetings last week. Both kept rates and policy on hold, which was very much in line with expectations and market reaction was muted.

The ECB confirmed it would continue with its plan to reduce asset purchases to €15 billion in October, before ending them in December.

In addition, the ECB governing council reiterated that it doesn’t see interest rates changing “at least through the summer” of 2019.

Separately, the BOE also kept rates on hold. Ahead of a crucial period in the Brexit negotiations, most observers—including us—had felt it was extremely unlikely it would have rocked the boat with a change.

Sweden: In Politics, the Swedish election ended in a hung parliament, with no group achieving the 175 seats needed for a majority.

Negotiations over a coalition government are expected to be lengthy. The far-right, anti-EU Swedish Democrats did increase their share of the vote but to a lesser extent than some expected. Given their anti-EU message, the fact they failed to make even larger gains was reassuring for markets.

Italy: Elsewhere, the focus on the Italian budget discussions remains a central concern for investors. The outcome should offer a hint as to how far the new government could push spending in implementing its expensive flagship policies.

Press reports over the weekend suggest Finance Minister Giovanni Tria aims to keep the 2019 deficit to 1.6% (vs. the prior government’s target of 0.8%). We think that would be encouraging for the market given some suggestions it could be much higher.

New fiscal targets are expected to be set on September 27 and presented to parliament. A draft budgetary plan will follow, which must be submitted to the European Commission by October 15.

Americas

US equities were stronger last week as anticipated headlines around new tariffs didn’t materialise until late on Friday.

Macroeconomic data was on the weaker side last week. CPI data came in behind expectations, while August PPI was also soft.

In central bank policy, the Fed’s Beige Book report showed the economy had expanded with stronger consumer spending and manufacturing and business optimism.

As a result, expectations that the Fed could raise interest rates again in December rose. This sentiment was compounded on Friday when Chicago Federal Reserve Bank President Charles Evans said borrowing costs may turn “mildly restrictive” and that by next year, current monetary policy may “hold back the economy just a little bit.”

This is a change in tone for someone who has previously been considered relatively dovish on interest rate rises.

Asia

The MSCI Asia Pacific Index ended the week higher on Friday despite dipping to more-than-one-year lows on Thursday1 amid fears over increased trade tariffs from the United States.

The rebound at the end of the week came after headlines that the United States had attempted to re-engage in trade talks. Chinese equities lost ground on the week: the impact of the ongoing trade rhetoric and evidence of a slowing Chinese economy were hard to ignore.

In Japan, Prime Minister Shinzo Abe said that “Abenomics”—his ultra-loose monetary policy—does have a shelf-life.

Abe seemed to attempt to downplay the importance of the Bank of Japan’s inflation target of 2%. Although the target has long been quoted as the main indicator that Japan is ready to exit its radical stimulus programme, Abe insisted it was just one factor that the central bank would use to determine whether the country is ready for change to monetary policy.

Macro data in Japan was largely positive last week. Japanese equities finished the week up after robust gross domestic product (GDP) data countered head winds from trade-war worries.

In China, trade balance data showed that both imports and exports fell in August. The overall trade surplus fell slightly to US$27.91bn in August. Shipments to the EU and Japan slowed. Interestingly, the trade surplus with the United States expanded to US$31.0bn, up from US$28.1bn.

This will not have gone unnoticed by the Trump administration. It has been reported that August would be the first full month impacted by US tariffs on US$50bn of Chinese goods. Elsewhere, consumer inflation rose 2.3% on the year while retail sales exceeded expectations, up 9% on the year to August.

Week Ahead

The discussion around US trade tariffs will no doubt continue to drive sentiment. From a European perspective, the Brexit talks will be squarely in focus given the EU leader summit in Salzburg. We will be keeping one eye on Italian budget talks as well.

Politics

EU in focus: On Tuesday, the EU’s Chief Brexit Negotiator Michel Barnier is due to brief EU European affairs ministers in Brussels ahead of Thursday’s leader summit.

In the United Kingdom, the Labour party conference starts on September 23. All eyes will be on its Brexit policy.

In Asia, North Korea’s Kim Jong Un and South Korean President Moon Jae-in will meet in Pyongyang on September 18-20.

Monetary Policy

The main event this week will be the Bank of Japan policy decision on Tuesday. The market expects rates to stay on hold.

We also have a Brazilian interest-rate decision on Wednesday and the Swiss National Bank rate decision on Thursday.

Given South Africa recently entered a recession, the South African Reserve Bank meeting will be a focus. Market expectations are for the benchmark rate to remain unchanged at 6.5%.

ECB President Mario Draghi is due to give a keynote lecture at “Making Europe’s Economic Union Work” conference in Berlin on Wednesday.

The Fed is in black-out ahead of its rate decision on September 26.

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1. The MSCI Asia Pacific Index captures large- and mid-cap representation across five developed-markets countries and nine emerging markets. Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future performance.