With the French election in the rearview mirror, Europe's anti-establishment wave seemingly receding, and Merkel's crushing victory (and stunning defeat for the SPD) in this weekend's North Rhine-Westphalia election in Germany, some strategists have gone so far as to say there is virtually no political risk left in Europe (and certainly looking at a chart of Eurostoxx50 Vol or European credit spreads, this appears to be the case). To be sure, stocks have been ahead of the curve, with European YTD returns trouncing those in the US, and some pundits saying there is much more upside to come. Not all, of course, as we showed earlier when we reported that equity strategists are cooling on the prospects for further gains in European stocks just as investors poured a record amount of money into the region’s equity funds.
Picking up the bearish baton, JPMorgan has gone one further, and in an overnight note from equity strategist Mislav Matejka, the bank says that the European upside thesis has now "played out" and recommends to not only tactically cut exposure to European stocks but to "even lay on outright shorts."
Here is the summary thesis from JPMorgan:
As per our May chartbook, we argued that the market will keep grinding higher in the very short term, given bears’ ongoing capitulation and the return of inflows into Eurozone. We think this support is now close to being spent. We advise to tactically cut directional exposure to stocks and even lay on outright shorts, in addition to having recently reduced portfolio beta.
But what about the relentless inflows into European equities - recall last week there was a record inflow into European stocks - which still have a ways to go before catching up with historical levels? Here is JPM's response:
Looking at the largest 25 ETFs for Eurozone, since the worst point of outflows at the turn of the year, when the region lost 15% of AUM, as much as 64% has come back. We believe that a chunk of the long Eurozone trade hasn’t been done in the cash equity space, but in options, so the above inflows are probably understating the extent of current exposure to Eurozone. Also, flows are not a lead indicator, as they have typically tended to lag equity performance.
Furthermore, there are few if any euro shorts left:
Speculative Euro positions have fully erased all their past shorts. Measures of Eurozone volatility are back at lows, credit spreads, too, and Eurozone P/E relative to World is now outright expensive, suggesting that repositioning has been significant. Anecdotally, we find it interesting that pundits who were arguing to sell earlier in the year have now turned into cheerleaders, but accept that if SPX breaks through 2400 this could drive some remaining capitulation.
The market internals are also no longer euphoric:
Market internals are already turning more cautious, despite overall equity indices holding up as we had hoped. Cyclicals are rolling over sharply vs Defensives,. This is not a good sign for the overall market and could lead to a broader correction.
JPM also notes some recent divergence among Cyclicals. Commodities, which are the only Cyclical to have done poorly ytd, are starting to stabilize, but other Cyclicals, which have performed exceptionally well, are now weakening. Looking at the pattern of last year, Commodities were first up, followed by other Cyclicals and Banks. This year, Commodities were first down, and now appear to be followed by other Cyclicals.
Finally, JPM muses about the role of the USD during any potential upcoming risk-off event:
USD behavior will be an important factor in driving relative sector and regional trends. Typically, USD rallies during risk-off market phases, as investors unwind carry trades and the US is seen as a relative safe haven. This, in turn, puts pressure on EM, where central banks must tighten policy to protect their FX, thus hurting growth. Stronger USD is also a problem for commodities.
What could be different this time around is that due to the potential further narrowing in the extreme rate differential between the US and RoW, the USD could continue rolling over. That is why we are not closing our EM OW, and the commodity legs of our proposed trades get a boost.
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Below are some additional key snippets from the JPM report:
We argued in our May Chartbook that easing political stress in Eurozone should lead to further near-term upside for equities, as bears capitulate and inflows come back to the region. We believe that most of this has now played out. Following our downgrade of Cyclicals last week, we advise to use the recent market resilience as an opportunity to reduce directional risk into summer, as well.
Eurozone is not a consensus UW anymore – reversal of last year’s outflows is advanced…
Anecdotally, we find it interesting that many pundits who earlier in the year were advising caution, have now turned into bulls, calling for new highs to be reached. Their main argument appears to be that investors are still UW the region and that the return of inflows could drive significant upside.
We note that this process is already well advanced. Eurozone has seen 15 consecutive weeks of inflows. Just last week saw $2.7bn coming back into the region, the biggest weekly figure since March ’15.
As a result, Eurozone has caught up with Japan in terms of ytd cumulative inflows. Both are well above the other regions. At the worst point last year, Eurozone outflows amounted to nearly 14% of AUM. Since then, one third has come back, based on EPFR data.
Of these, we note that domestic-based investors, who account for nearly 50% of AUM, have already reversed 96% of last year’s outflows. International investors are still lagging. The US, which accounts for 16% of AUM, has only unwound 17% of last year’s outflows from Eurozone equities.
Looking at the country breakdown, in Eurozone it is Spain that has seen the biggest reversal of last year’s outflows, at 45%, followed by Germany (33%) and France (32%). Only 19% of last year outflows have come back into Italy.
ETF flows, which are more timely than EPFR data, show that 64% of last year outflows have already come back into Eurozone equities.
…there could be some more to go, but our key point is that flows have tended to lag market performance, not lead it
Of course, there could be more to go in terms of inflows. However, the key question in our view is whether this will drive further significant upside for the market.
The above chart shows that equity flows and market performance have tended to be at best coincident. In a sense, one could say not only that inflows are needed for Eurozone equities to sustain their recent strong run, but also that the market needs to continue rallying for investors to keep buying.
In relative terms, the relationship between the Eurozone / US equity performance and the regional flows shows that market performance leads the flows by seven weeks, on average. Put another way, equities might be peaking now, even though the region could well continue to receive inflows for another two months.
As good as it gets? Euro shorts have been covered, credit spreads are record tight, Vol is record low…
Short positions on the Euro have now been closed for the first time in three years, as investors are apparently becoming more comfortable with respect to the region’s political backdrop.
Consistent with this, equity volatility has fallen sharply. V2X now stands at 14, the bottom of its historical range.
Eurozone credit spreads have moved to the lows of the historical range, too.
…and Eurozone valuations have moved to the expensive side of fair value.
Clearly, if inflows into Eurozone equities were to pick up materially over the medium term, this could drive a significant relative re-rating of the region.
However, we note that Eurozone is no longer trading at a discount to historical relative to MSCI World. Its P/E relative is above the long-term median, near the highs of two years ago. Even adjusted for sectoral composition, Eurozone P/E has moved to the expensive side of fair value.
Market internals are turning defensive
While the overall market level has held up well recently, as we anticipated, sector leadership is starting to turn more cautious. Cyclicals, which led the market higher last month, are rolling over again vs Defensives. We downgraded Cyclicals last week and continue to see little relative upside for the group over the next few months.