Brexit Is No Match for the Pandemic’s Grip Over European Markets

European investors started the past week preparing for a Brexit showdown. They ended up getting blindsided by a fresh wave of virus restrictions, in a reminder of the pandemic’s power to thrash markets.

The announcements of Paris curfews and London curbs on activity on Thursday was what ultimately drove the Stoxx 600 to its first weekly loss in three and sent the euro to its lowest level so far this month. Meanwhile, the fallout from U.K. Prime Minister Boris Johnson’s self-imposed Oct. 15 deadline for a trade agreement with the European Union was blunted as both sides left room for further talks.

“The second wave in Europe is getting bigger and bigger,” Joost van Leenders, senior investment strategist at Kempen Capital Management, said by phone. “Last week, we cut European stocks in favor of emerging markets because of concerns about the second wave of Covid-19.”

A resurgence in infection rates across Europe and U.K. tops Brexit on the list of worries for investors, according to Bank of America Merrill Lynch’s client survey this month. The pandemic shock on consumption and investment remains the main driver of risk in the euro zone, while for now, Brexit is looking more like a local affair.

Getting Nervous

Just look at the trading action among Europe’s equity investors. On Thursday, eight days of gains were wiped out in one session that saw heavy selling volumes on Euro Stoxx 50 futures. Traders also look to be bracing for wilder swings, with the Euro Stoxx 50’s volatility gauge testing an uptrend and one-month implied volatility climbing above the three-month tenor.

“Curfew and restriction measures won’t be enough to stop the virus numbers from rising,” said John Roe, head of multi-asset funds at Legal & General Investment Management. “So the base-case should be more measures.”

The portfolio manager is waiting longer before buying the dip. “Velocity of moves matters for us particularly with virus risks,” Roe added.

Changing Fortunes

In sovereign bond markets, the revival of virus concerns was most evident in Europe’s riskiest corner — Italian debt.

The week opened with Italian 10-year yields extending their decline to a record low, and the country sold debt on Tuesday without a fixed interest payment for the first time. But by Thursday, benchmark yields had risen as much as nine basis points, their largest intraday gain since August.

Local Risk

It’s not that Brexit risk has completely disappeared from European investors’ horizon. After all, investors could be staring down the same no-deal cliff edge in just a few weeks. But Brexit seems to have become a purely British problem.

The FTSE 100 Index has strongly underperformed the Euro Stoxx 50 this year, and sterling’s concurrent weakness against the euro has failed to provide the same support for U.K.-listed multinational companies as it had in the past.

Sentiment Sours

In currency markets, the trepidation was broad. The risk-sensitive Norwegian krone plummeted more than 1% on Thursday and led Group-of-10 declines for the week. Only the haven yen appreciated against the dollar, with the euro also retreating. Sentiment on the shared currency, based on short-term options, was buoyant at the start of the week. It soured considerably on Thursday, as demand for euro puts pushed one-week risk reversals near parity.

European indexes closed higher on Friday, and both the euro and pound recovered from the week’s lows. Yet the concern remains that the raging pandemic might force central banks to experiment further with more yield targeting and fresh quantitative easing.

“Any central bank with room to ease monetary policy is likely to do so, especially in places where Covid infection rates are high and new restrictions on movement are taking place,” said Kit Juckes, chief foreign-exchange strategist at Societe Generale.

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