Markets wait for outcome of Saudi talks on Ukraine

Stocks in Europe have followed Asia and are lower on Tuesday as  the market rally appears to be on pause, due to some key event risks this week. The US and Russia have begun talks in Saudi Arabia about the war in Ukraine and later this week the German election will take place. The next few days could be critical for Europe’s future, so a pause in the uptrend that has seen European stocks rise more than 12% YTD is to be expected.

Reports at the weekend that Europe will need to beef up its defense spending and pledge to defend Ukraine from future Russian aggression sent some European defense names to a record high at the start of the week. It’s worth noting that since the onset of war in Ukraine, the biggest European defense manufacturers have outperformed the biggest US defense manufacturers. However, markets may have jumped the gun with defense stocks rallying even though a negotiated end to the war between Russia and Ukraine is still not a reality.  

Gold and Oil higher, in case Saudi talks come to nothing

There are no guarantees that a deal will be reached to end the war during these talks in Saudi Arabia. Although Donald Trump has been keen to end the war since first taking office, these early talks do not include Ukraine, and some in Europe think that Trump’s efforts will embolden Putin and could prolong the war. Trump seems to have given Russia territorial rewards before a peace deal has been reached, and he has dismissed the idea of Ukraine joining NATO. We are still in the very early stages of any potential negotiations, updates from today’s meetings will be worth watching closely. Gold is higher today and is above $2910 per ounce, after rising $15 on Tuesday, the oil price is also higher after falling sharply last week. The increase in the gold price and the price of oil are signs of anxiety in financial markets that a deal may not be reached, and the war could continue.

Some defense names are rallying once more on Tuesday, and Rolls Royce has reached a fresh record high. However, there could be some sideways movement for defense stocks in the near term, as we wait for the outcome of the Saudi Arabia talks.

Europe’s disagreements, leaves the US in charge

There is another factor to consider when trading defense names this week, Europe does not seem to be in unison when it comes to responding to the latest stage in the Ukraine war. The meeting between European leaders in France on Monday failed to deliver a concrete plan for Europe’s response to the situation in Ukraine.  .For example, France had proposed sending a unified European defense force to a potential ceasefire line in Ukraine, to protect the country from future Russian aggression. However, the meeting ended with no agreement from European leaders. Also, the prospect of common Euro area borrowing to allow Eurozone members to boost defense spending has been put on the back burner for now, and no plans to boost defense budgets have been confirmed.

Geopolitics dominates for financial markets

All of this matters for financial markets. Government spending is a major part of Europe’s economy, and if spending is going to pivot to defense in the future, then Europe’s biggest defense firms including Airbus, Rolls Royce, BAE Systems, Thale and Safran could see their future revenues soar. There is still a very good chance that defense budgets will rise in Europe in the coming years, however, for the European defense trade to take another leg higher, we may need to see significant progress in today’s talks between Russia and the US. Since Europe is not involved in these talks, it will be the price taker in this situation. If a deal is agreed, then Europe will be forced to spring into action and boost defense spending immediately. Thus, we are in a waiting game for now, but the ramifications could be huge for European stocks and for European bond markets.

UK labour market: resilient for now

Elsewhere, European bond yields are stable after popping higher at the start of the week. UK bonds are under performing European bond markets on Tuesday after stronger than expected wage data. Wage growth rose to 6% YoY in the three months to December. Next month’s wage data will be the first reading with the full effect of last October’s budget, which could be more useful to determine the future direction of wage growth. Payroll employees also jumped last month, there was a 21k increase in payrolled employees at the start of the month, after an upwardly revised 14k decline in employees in December. This suggests that the UK labour market is more resilient than first thought, although the accuracy of the data makes it difficult to make an assessment of the UK labour market right now.

The FX view

The dollar is one of the top performers in the G10 FX space on Tuesday, as a risk off tone impacts markets. However, we continue to think that the weaker dollar is intact for now, and that the pound and the euro can extend recent gains and rally further vs. the USD. In the past week, the pound is the top performer vs. the USD, and is higher by nearly 2%. GBP/USD is above $1.26, and the next key resistance level to watch is $1.2666, the 100-day sma.