<strong>By:</strong> <strong>Franklin Templeton fund managers</strong>

Equity markets continued their recovery from December lows last week, thanks to growing hopes of a US/China trade deal, further dovish commentary from the US Federal Reserve, and a positive start to US corporate earnings season. As expected, Brexit dominated the headlines in much of Europe, as the impasse in the UK parliament remains. However, by and large, European equity markets took this in stride.

<h3><strong>Optimism Grows On US/China Trade Talks</strong></h3>

Equity markets continued to recover ground last week, thanks to optimism that the United States and China were making meaningful progress towards a trade deal.

Mid-week, there were reports that US Treasury Secretary Steve Mnuchin had discussed lowering US tariffs on Chinese imports. This was later denied by the Treasury, but the market clearly felt there was some substance to the story, given the strong weekly performance for US indices.

In addition to that story, separate reports suggested China had offered to increase US imports by a combined value of over US$1 trillion in order to reduce its trade surplus to zero by 2024.

Again, nothing has been confirmed by any official source, but the story helped build a narrative that investors want to hear. There are still major sticking points in the US/China disagreement that cannot be overlooked, notably on the issue of intellectual property, but for now the market seems happy to look for the positives.

Looking ahead, eyes will be Chinese Vice Premier Liu He’s visit to Washington on January 30. He is scheduled to meet leading officials in the Trump administration.

This week a number of macro data points from China have confirmed the rate of growth is slowing. Quarterly gross domestic product (GDP) growth was 6.4% compared with 6.5% in the prior quarter. This was in line with expectations, but it means 2018 has seen the slowest rate of annual growth since 1990.

As we highlighted last week, China is trying to implement stimulus to address this issue, but we believe the weakening data will add extra impetus to the trade negotiations.

<h3><strong>Brexit Impasse Remains</strong></h3>

Last week was another tumultuous one for British politics. The House of Commons rejected Prime Minister Theresa May’s proposed Brexit deal, but May overcame a vote of no confidence in her government. At the end of the week, it felt as if we were no closer to solving the Brexit conundrum.

May’s Deal Rejected: As expected, Theresa May lost the House of Commons vote on her withdrawal agreement, but by a greater margin than many forecast.

Sterling actually rallied after the vote (after an initial knee-jerk dip) possibly because investors felt the outcome might lead to a softer Brexit deal. Should a softer Brexit materialise, we could see further gains in domestic shares, too.

May’s Government Survives No-Confidence Vote: Following the rejection of May’s deal, the opposition Labour Party tabled a vote of no confidence in the government. However, on January 16, the vote was defeated as Conservative and Democratic Unionist Party (DUP) members of parliament (MPs) both voted to support the government.

Cross Party Talks Fail To Yield Progress: The remainder of the week saw May hold talks with a number of opposition parties to explore any common ground on a way forward. The main opposition Labour Party chose not to participate unless the government ruled out the threat of a “no-deal” Brexit, something May said was an “impossible condition”.

Overall, this process appears to have been fairly fruitless, with many of those involved suggesting the government’s representatives were essentially going through the motions of trying to build cross-party consensus.

Backstop The Focus: It now appears May has gone back to pursuing concessions on the Irish backstop in order to gain support from the rebel Conservatives and the DUP, rather than trying to woo Labour support. We expect this to be the focus for the coming week, with May likely to go back to Europe to try to seek some concessions on this subject.

May was due to set out her “Plan B” withdrawal proposal on Monday afternoon (January 21). A vote on the proposal is scheduled for January 29.

It will be important to watch out for any amendments that try to give parliament greater say. If successful, it could see parliamentary backbenchers wield greater power on future decisions. Notably, there are groups of MPs that are keen to delay Article 50 and also ensure a no-deal outcome is not an option.

EU Reaction: The reaction from the European Union (EU) has been mixed. It’s worth noting that while the market reaction suggests less expectation of a harder Brexit, European Commission president Jean-Claude Juncker said the rejection of May’s deal had increased the risk of a disorderly UK withdrawal.

Others also took a harder line, including European Council President Donald Tusk, who said the Brexit deal could not be re-negotiated and called on UK to clarify its position. French PM Emmanuel Macron took a similar stance, saying that the EU had gone “as far as it could” on the deal.

German officials seem to be more open. Angela Merkel said she would work until the “last day” to ensure an orderly Brexit. She added that responsibility for finding a deal did not just lie with the UK.

Market Thoughts: Overall, market reaction was pretty benign last week, as the feeling is a no deal is less likely given the consensus in Parliament seems to be for a softer Brexit rather than no deal.