There are two pillars that have supported the recent cross-asset class rally: 'improving' macro news and a reduction in concerns about European and financial risks. While this pattern is not new, as the interplay between the two has been a key focus for some time, Goldman manages to differentiate the impact of both and quantifies which assets have more sensitivity to each pillar. Unsurprisingly, European assets have been driven more by Euro area risks than non-European assets, equities (even in Europe) have been driven more by growth views, and credit spreads (including in the US) have been more responsive to Euro area risks. A number of other assets are much more closely to the market's view of growth than to the Euro are risk perceptions and global FX ranges from highly cyclical to highly Euro-sensitive while many of the major EM currencies are stuck in the middle. Overall they find that the market has more confidence in global growth (with markets pricing little more than +1.75% US growth for instance so not over-confident) but that Euro-area risk has been discounted excessively given the nature of the ECB's actions relative to the underlying problems (as we discussed this morning [8]). Goldman provides a good starting point for consideration of which risks (and how much is priced in) across global asset classes.
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Goldman Sachs:- Two Main Factors: Growth and Euro Area Risk
For our own forecasts and market views, the dominant focus over the past year or two has been the interplay between Euro area sovereign and financial risks on the one hand, and global growth outcomes on the other. We have written extensively about both the sovereign crisis itself and the extent of its transmission to the rest of the global economy. We have also attempted periodically to separate our trading views so that they focus on one or the other risk.
Of course, the two kinds of risk cannot be separated completely, either conceptually or in the way markets have behaved. Financial risks increase the perception of growth risks and European banking stresses tend to heighten concerns that the problems in the Euro area periphery may transmit into economic restraint elsewhere. But we have argued that these two issues are genuinely distinct and that while some assets will respond directly to Euro area risks, others will respond (and on occasions have done so) only to the extent that those risks affect global growth outcomes.
Although we often talk about the twin risks of growth and Euro area financial worries, and benchmark them in various ways, it is helpful to think of a more formal way of separating them and demonstrating how other assets respond to each force. We have therefore constructed proxies for the two asset market drivers: (global) growth and European sovereign/financial risk. We do this by extracting the common elements of groups of assets that our earlier work suggests are closely related, in theory and practice, to each driver.
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Major Equity Indices Driven by Growth; Credit and Vol More Evenly Leveraged to Europe and Growth
The results—both when they are intuitive and when they are not—are very informative about which assets are most responsive to each of these two drivers.
At a big picture level (Chart 2 above), equities have been driven by both factors (they explain over 70% of the major European and US index movements) but are generally keying significantly more off growth views than off Euro area risk views. This holds true even within the major European bourses. European assets, including FX, bond yield spreads and especially financial credit and equity have unsurprisingly been highly responsive to perceptions of the twists and turns in the European crisis.
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Corporate credit spreads, equity volatility and EM equities are more of a halfway house, in that they are driven relatively more by Euro area risk than is true for equity indices. But even here, outside Europe, growth risk is at least as important a driver as views on the European crisis.
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The Cleanest Growth and European Risk ‘Plays’
Identifying the primary risk factors—growth or risk, or both—for each asset is an important first step. But in order to determine which assets constitute the purest growth ‘plays’ and European risk ‘plays’, it is also important to know—within the group of growth leveraged and Europe-leveraged assets—which assets are best explained by our simple two-factor model (in Rsquared terms), and where other asset-specific idiosyncratic considerations are more pertinent.
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More Confidence in Growth than in European Risk
These results reinforce the conclusion that some assets trade Euro area risk views directly and some trade it only to the extent that it affects growth more broadly. So for many assets, it is the transmission of European financial stresses that is the critical judgment to make, and here it has been important to remain open-minded in evaluating the data over the past few months.
To trade cyclical assets without too much European exposure, our results here suggest it is better to focus on equities than on credit, and on cyclical and commodity-related areas more than others. To trade European risk views, EUR and CEE-3 currencies and European credit and banking assets are the most obvious candidates. And to trade an easing (or increase) in risk in both, several EM currencies and broad credit indices have significant exposure to both factors. The hardest view to express is to take an active view to be long cyclical risk and short European risk. In general, that is likely to require a combination of assets. Some FX crosses may provide a version of that exposure, although it may still be easier to trade each ‘leg’ of the view separately.
Within that context, our views point to two key questions for the coming months. The first is whether US and global growth momentum holds up at current levels. Markets are not pricing much more than around 1.75% growth on a forward basis (based on our Wavefront US Growth basket) so they are not yet overextended in their views here.
The second, and arguably more important, question is the degree to which European sovereign risks resurface. As Huw Pill and team have described, while the ECB’s actions have materially reduced near-term funding stresses for banks, the challenge of funding peripheral sovereigns has not been completely resolved. The outlines of the political process (and any implicit or explicit ‘bargain’) to resolve those issues are becoming clearer. But the political challenges of the Greek PSI and disbursement, a heavy month of Italian issuance, an EFSF/ESM process whose main support functions have still not been described and forthcoming French elections all provide obstacles to clear.