by Franklin Templeton Investments blog, Franklin Templeton Investments
Global equities were stronger last week as dovish central bank rhetoric raised market hopes for interest-rate cuts both in the United States and the eurozone. US-Mexico trade tensions did weigh on investor sentiment at the start of the week; however, developments since then seem to have alleviated that pressure for now. The euro strengthened by the end of the week, while sterling ended four straight weeks of losses. Dollar weakness aided both currencies. Italian bond yields rose as the European Commission recommended disciplinary action against Italy over public debt.
All We Need is Doves
US Federal Reserve
With the recent dovish skew to global central bank sentiment of late, the US Federal Reserve (US Fed) release on Wednesday (June 5) as well as commentary around it was a clear focal point for investors last week.
Mixed economic data releases, as well as continuing global trade tensions, provided the backdrop for the Beige Book release on Wednesday night.
Central bank interest rate cuts have provided a theme globally of late, and on Tuesday of last week the Reserve Bank of Australia (RBA) joined its counterparts in New Zealand and the Philippines in cutting rates. The Reserve Bank of India also cut rates last week. Therefore, the key point of interest was the possibility the US Fed could follow suit. Previously hawkish sentiment from the US central bank has turned increasingly dovish of late, so the market has been focusing on the potential for any upcoming rate cuts.
Dovish comments last week from Federal Open Market Committee (FOMC) members James Bullard and Charles Evans, as well as Fed Chair Jerome Powell, added to the rate-cut speculation. Low inflation has been a cause for concern recently, and some market observers were anticipating the Fed may look to introduce a more accommodative fiscal policy, with issues around global trade remaining a key overhang.
The Fed’s latest Beige Book report noted: “Economic activity expanded at a modest pace overall from April through mid-May, a slight improvement over the previous period. Almost all Districts reported some growth, and a few saw moderate gains in activity. Manufacturing reports were generally positive, but some Districts noted signs of slowing activity and a more uncertain outlook among contacts. Residential construction and real estate both showed overall growth, but both sectors saw wide variation in sentiment across Districts. Reports on consumer spending were generally positive but tempered. Tourism activity was stronger, especially in the Southeast, but vehicle sales were lower, according to reporting Districts. Loan demand was mixed but indicated growth. Agricultural conditions remained weak overall, but a few Districts reported some improvements. The outlook for the coming months was solidly positive but modest, with little variation among reporting Districts.”
The market reacted favourably overall to both Fed commentary and the Beige Book, and the probability of rate cuts in July and September both rose rather significantly, to the extent that they now look fully priced in (based on CME Group Fed Funds Futures).
A more accommodative fiscal policy from the Fed is clearly expected, and we think this is unlikely to change until the United States achieves sustainable inflation of 2% and while the health of the US economy remains uncertain given ongoing trade tensions.
Interestingly, a lacklustre monthly US employment report on Friday (the weakest print since February) was seen to have supported global equities as it further raised expectations for a rate cut.
European Central Bank
On Thursday, the European Central Bank (ECB) gave its interest-rate decision and monetary policy commentary. Expectations pre-announcement were for a dovish tone and no changes to interest rate or forward guidance. Outside of that, the key focus was on the terms of the next round of Targeted Long-Term Refinancing Operations (TLTROs) due to be launched in September.
The details around these loans, as sources of cheap liquidity for banks, have been a subject of debate in the last few months. Ultimately, the release was rather underwhelming. Interestingly, one of the key takeaways was around forward guidance.
The market had been expecting interest rates to remain unchanged until at least the end of FY2019 with the possibility of cuts thereafter. So, guidance that rates will remain unchanged until the end of the first half of FY2020 was perceived to be particularly hawkish.
ECB President Mario Draghi explained the reason for the extension, stating the current data is “not bad” and noted that there has not been “any substantial worsening in the outlook”. More generally, Draghi cited “better than expected data for the first quarter” but did concede that “global headwinds continue to weigh on the euro area outlook”.
On TLTROs, the terms were not as favourable as anticipated. Draghi stated the interest rate in each operation would be: “10 basis points above the average rate applied in the eurosystem’s main refinancing operations over the life of the respective TLTRO. For banks whose eligible net lending exceeds a benchmark, the rate … can be as low as the average interest rate on the deposit facility prevailing over the life of the operation plus 10 basis points”.
This means rates can be as low as -0.3%, which is right in the middle of the pre-announcement estimated range (-0.4% to -0.2%). Markets were disappointed with the relatively hawkish announcement and the TLTRO terms. With that, European equities sold off while the euro rallied.
US-Mexico Deal Struck
At the start of last week, European equities were playing catch-up on after the US market selloff late on Friday the previous week.
Further trade concerns drove risk-off sentiment after US President Donald Trump tweeted that the United States would impose a 5% tariff on all goods coming from Mexico from June 10 onwards. He said the tariffs would increase until the United States was satisfied Mexico was doing everything it could to stop illegal immigration. US Senate Republicans then threatened to block such tariffs.
A deal was finally reached on Friday, June 7. Trump stated in a tweet that Mexico would take “strong measures” in tackling illegal immigration into the United States.
There was little in the way of development in the US/China trade spat, with focus now turning to the G20 meeting at the end of June. However, there were headlines in China itself over retaliatory measures the Chinese government could take over tariffs. These headlines weighed on Chinese equities last week.
Tory Leadership Race
In the United Kingdom, the Conservative Party leadership race remained front and centre of investors’ minds as Theresa May’s official tenure ended on Friday; she remains in interim charge of the country until a new leader is elected.
Last week, the process of whittling down the list of candidates continued. Eleven candidates remain in the running; however, only six of those have the required eight confirmed backers needed so far.
Tory members of parliament (MPs) will go through a series of votes over the coming weeks, until they are left with two candidates. At that point, all Conservative Party members vote on the next leader who will also become prime minister.
Given the Conservative Party membership is overwhelmingly pro-Brexit, we expect an ardent Brexiteer to take the helm. The process should be complete by the week of July 22.
Most European indices closed last week higher. Greece’s equity market was the underperformer in the region, but it had outperformed dramatically the previous week after Prime Minister Alexis Tsipras moved towards a snap election.
European bond yields continued to move lower, with the German 10-year bund yield reaching record lows. This helped to boost defensive names: utilities in particular outperformed.
As the lower yield trend continued, gains in banking stocks were muted. Meanwhile, real estate stocks were generally in the red, thanks to stock-specific losses in Germany related to a proposed five-year rent freeze in Berlin, along with broker downgrades.
Macro data looked better last week, with better purchasing manager index (PMI) data and euro-area gross domestic product (GDP) outweighing a softer consumer price index (CPI) print.
Italy’s fiscal situation remains a concern after the European Commission recommended legal action. Italy broke the EU’s debt rules last year and is likely to do the same again, with officials expecting debt to rise to 134% of GDP this year and 135% in 2020. According to EU rules, governments should limit debt levels to 60% of GDP.
Deputy Italian Prime Minister Luigi Di Maio was defiant, blaming the previous government for the debt levels. He also pointed out that other countries which had breached EU rules had not faced disciplinary action. With this backdrop, the spread between Italian and Spanish yields has widened further as Italian debt appears to look less attractive to investors. We can expect to be watching this saga play out for some time.
US equities also enjoyed a rally last week, with all major indices higher. As such, all sectors closed the week higher, with materials the standout. Technology and consumer staples also outperformed. Gains in the financial sector were more muted amid the lower yield environment. The US 10-year Treasury yield hit a 20-month low on Friday after May nonfarm payrolls saw the weakest print since February.
The outperformance of so-called momentum names versus value stocks continues to be a theme, with the spread between valuations of these two factors making new highs. In addition, defensive names remain over-owned versus cyclicals, which are under-owned alongside value.
Investors are focusing on positioning, with concerns over politics (including trade wars) helping drive the rotation. It will be interesting to see how this dynamic plays out in the coming weeks and months.
It proved to be a mixed week for Asian equity markets last week as China’s response to US tariffs dominated headlines there.
Chinese equity markets are testing recent support levels, so we think it will be important to keep an eye on these levels in coming sessions.
Aside from trade headlines, there was some notable macro data, with May manufacturing PMIs out across the region. South Korea was the notable equity market underperformer, as exporters continue to struggle.
Australia’s equities ended the week higher after the RBA cut its cash rate to 1.25%. In justifying the decision, RBA Governor Philip Lowe stated: “[The] decision to lower the cash rate will help make further inroads into the spare capacity in the economy… It will assist with faster progress in reducing unemployment and achieve more assured progress towards the inflation target.” He added it would not be “unreasonable” to expect another rate cut.
It’s been a quieter start to this week in Europe with a number of bank holidays for Whit Monday (Austria, Denmark, Germany, Norway, and Switzerland).
- In the United Kingdom, the Conservative Party leadership race will be front and centre. Thursday sees the voting process kick-off. Boris Johnson remains the favourite.
- As has been the case for some time, headline risk around trade tensions will remain a driver for market sentiment. The G20 meeting is coming up on June 20, so expect attention to build up ahead of it.
- Tuesday: US purchaser price index (PPI) data
- Wednesday: US CPI; China CPI
- Thursday: Euro area: (Apr) industrial production
- Friday: China (May) industrial production, retail sales; US May retail sales, industrial production.
- Wednesday: ECB President Mario Draghi Speaks in Frankfurt
- Thursday: Swiss Central Bank (SNB) meeting
- Friday: Bank of England (BOE) Governor Mark Carney speaks in London.
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