Notes From The Trading Desk – Europe

Franklin Templeton’s Notes from the Trading Desk offer 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.

The Digest

Last week was more constructive for European markets (with a gain of 6% for the STOXX Europe 600), as European equities tracked gains in the United States and Asia.¹ Whilst the US bailout package was the catalyst for the strength, it did feel like a short squeeze/pain trade drove the move higher earlier in the week. In addition, the systematic selling that we saw prior has abated.

As the week progressed, markets did feel a little more orderly and volumes were lower. Greenshoots in China also helped sentiment, as trackers of aggregate economic and virus-exposed consumer activity in China continued to improve. There is also evidence that lockdowns are working, with various news outlets reporting a reduction in the day-on-day increase in COVID-19 cases in Europe—notably Italy.

Overall, however, the picture remains fairly bleak with regards to COVID-19 newsflow and it’s unlikely normality will return in Europe for some time. Even if lockdowns are lifted in coming months, it is hard to see consumer behaviour quickly returning to previous habits, unless there are sudden advancements in testing for antibodies or vaccinations. However, any meaningful positive news on improving rates of infection/deaths would support investor sentiment.

Market Developments We’re Watching

Systematic selling: A question we have considered  in recent weeks is how much selling pressure remains.

Quarter-end rebalancing: Europe is trading lower as at 30 March on low volume with no new positive catalysts, but with just one more trading day left in the quarter, much has been made this week of the potential for pension-fund demand for equities into quarter-end. Given the dramatic declines in equity markets, many balanced pension portfolios are left skewed to bonds, so they will likely need to add to equities if they want to remain balanced per their mandates. Some observers suggest there will be a US$255 billion rebalance, US$190 billion of which could go into equities.

Sign of hope in Italy and the steepening Spanish curve: Whilst there had been reports from Italian regions that they had seen the number of cases slowing, on Friday there were news reports that the previous 24 hours had been the deadliest yet (with 969 deaths), which hit sentiment. Over the weekend, new cases did decline for two days running, but we must continue to monitor the situation.

Last week, we saw attention turn to Spain, where there has been a dramatic steepening of the death toll curve. It was only a couple of weeks ago that Prime Minister Pedro Sanchez was encouraging the Spanish people to join together in a mass demonstration for International Women’s Day, a calling which saw as many as 120,000 take to the streets of Madrid. Spanish deaths now approach 6,500, making it the second most-affected country by fatalities globally. On 27 March, Health Minister Salvador Illa said Spain had “not reached the peak yet” and on 29 March, we saw Spain’s deadliest day so far.

Health care systems in both Italy and Spain are being stretched to near breaking point, with an alarming number of medical workers infected. Both Italy and Spain are struggling for ways to tackle the crisis, with Europe split along economic fault lines.

Central Bank and European Union (EU) Summit: A Call for Fiscal Solidarity

• We expect headlines surrounding central bank measures to slow down as it does seem that they are really doing (almost) all they can currently, with the focus now on a joint fiscal stance from Europe. This was the focus of Thursday’s EU summit.
   
• From an individual perspective, EU (and UK) governments have largely responded with impressive “whatever it takes” measures to contain the economic fallout at the national level.
   
• The issue is that Spain and Italy in particular need centralised help, which has led to a lot of discussion about the issuance of Eurobonds (or “coronabonds” as some have been calling them) this week. The Emergency Stability Mechanism (ESM) was voted through in Germany today and will help the more troubled member states fiscally, but there is a need for a joint centralised pledge to ensure factions within Spain and Italy can’t say they were being choked out by Northern Europe during this crisis. At last week’s EU summit, Italy also apparently blocked a reference to potential support through the ESM for hard-hit member countries. Italy reportedly objects to the (light) conditionality and the stigma of a potential ESM credit line. EU Finance Ministers will meet this week to discuss the potential use of ESM.
   
• No strong signal of the desired solidarity came out of last week’s summit, with any decision delayed by two weeks and no agreement to issue Eurobonds. It was the “Hansa” group of fiscally conservative northern countries who rejected jointly issued bonds. It was the same story during the credit crunch. German Chancellor Angela Merkel made it clear that Germany prefers the ESM option, whilst Dutch Prime Minister Mark Rutte said his country would not agree to coronabond issuance under any circumstances.
   
• Because the European Central Bank (ECB) has already done almost all it can, the lack of centralised action should not cause serious near-term economic damage. However, there is potential for further economic risk down the line and, importantly, severe political risk as the failure for all member states to agree to Eurobond issuance could critically weaken support for European integration. This environment is one in which the extreme right parties could be set to thrive. At this point in time, a show of solidarity—or lack thereof—could have lasting impact on the perception of what Europe stands for. Any headlines on this clash will be key this week.

Balance-sheet scrutiny: Whilst single-stock news had been getting lost within the bigger picture, focus on balance sheet is a big theme. Friday saw an  example of the stress balance sheets are under as Volkswagen said production halt on both sides of the Atlantic currently costs EUR€2 billion a week. It is notable that we have already seen a number of UK companies coming to the market to shore up their balance sheets and raise capital. We are seeing some tangible indications of the pain smaller companies in particular are feeling already, and likely a sign of things to come.

In this context, dividends are being slashed across the board. In addition, the EU Banks Sector Index was down 6.5% on Friday after the Financial Times reported that European Banking Federation backs suspension of dividends and buybacks for banks in fiscal year 2020.² We’ve also heard anecdotal evidence that some investment managers are themselves encouraging companies to cut dividends, with those holders not focused on income strategies preferring that companies preserve capital to have a better chance of survival.

No doubt, dividend payments as well as buybacks will become politicized going forward as companies benefit from bailouts, etc.

Summary of where we are in the United Kingdom: On 27 March, we heard the latest update from the UK Chancellor on capital that would be made available for self-employed UK workers. Also, whilst the United States recently reported new jobless claims, we also note there are reports of some 500,000 claimants for social benefits in the United Kingdom in the last 10 days, a remarkable increase.

UK Prime Minister Boris Johnson has confirmed he has tested positive for the coronavirus and is suffering from mild symptoms. UK Health Secretary Matt Hancock has also tested positive and Chief Medical Officer Chris Witty is showing symptoms. So,  the main figureheads of the UK’s effort to combat the virus are now infected. It  seems inevitable other members of the government will test positive in the coming weeks. This will be a test of the government’s efforts to navigate the coming weeks as the situation escalates in the United Kingdom.

Over the weekend, the government’s leading epidemiology advisor warned that Britain must remain in full lockdown until June if it is to avoid the worst effects of the coronavirus.

Keep an eye on crude oil: One more thing to be aware of: oil prices may come under renewed pressure this week as the OPEC+³ agreement to restrict oil production and support prices comes to an end and members are allowed to produce as much oil as they want. The end of the agreement comes as relations between Saudi Arabia and Russia fracture despite the United States’ attempts to mediate, given its significant shale industry and the exposure of the US banking system to oil.