On Sunday evening we brought you the latest from Goldman’s chief equity strategist David Kostin who explained that sharp swings in crude prices have created pronounced (and in fact historic) momentum swings, catching those who had piled into “popular investment themes” to be caught flat-footed. Here’s what Kostin said:
The correlation between major macro trends has caught many popular investment themes in the momentum spin cycle. In 2015 and the first weeks of this year, lower oil prices were accompanied by lower Treasury yields and downward revisions to US growth expectations, boosting the performance of popular growth stocks and defensive equities while weighing on banks. At the same time, the US dollar, which carries a strong negative correlation with oil, strengthened by nearly 15% and presented another headwind to the US economy. The combination of growth concerns and low oil prices widened credit spreads to recessionary levels and benefitted the performance of stocks with strong balance sheets. All of these trends have reversed sharply in recent weeks.
But as we wrote, Kostin is far from bullish. Instead, he says the market may be underestimating (or else just plain ignoring) the “largest current macro risk”: a hawkish Fed and consequently, a stronger USD. The result, another sharp reversal as stocks with strong balance sheets are once again in vogue versus momo plays, energy, and anything with nosebleed leverage.
Well now Deutsche Bank is falling in line, suggesting that European equity investors are missing the very same risks (i.e. a hawkish Fed, resultant strong USD, and weaker commodities).
“Our European credit strategists estimate that the ECB could buy €5bn - €10bn a month in IG corporate bonds starting at the end of Q2, out of an eligible universe of €400bn - €500bn,” the bank’s European equity strategists write, in note out Monday. “If ECB easing in combination with stronger oil prices pushes up Euro-area inflation expectations, while increased asset purchases reduce peripheral bond spreads, GDP-weighted Euro-area real bond yields have further downside, which should boost European P/Es.”
But, you should be cautious. Why? Because “we are just one hawkish Fed statement away,” from a series of events that will end in investors returning to their “clearly depressed” positioning in February. To wit:
However, we maintain our cautious stance on equities, given that: (a) we think we are just one hawkish Fed statement away from a potentially sharp re-pricing of Fed tightening expectations, which would push up real bond yields (as happened after the start of the ECB’s QE program in Mar 2015) as well as the dollar; (b) the surge in Chinese credit growth in January, a key driver of the recent commodity rally, looks unsustainable (and, in fact, credit figures show lending slowed sharply in February). Any drop in commodity prices would risk putting renewed upside pressure on credit spreads (despite ECB buying); (c) investor positioning is now at neutral levels, while it was clearly depressed in mid-February.
Here is that progression in chart form:
And here's the collapse in TSF growth which suggests January was a blip, along with DB's positioning proxy which certainly suggests that something has to give:
In other words, it's the ECB versus the Fed for the hearts and minds of investors as the policy divergence tug-of-war just got more intense with Draghi's move into corporate credit. As we wrote on Sunday, "the European central bank is backstopping bond issuers, it will almost certainly lead to even more outperformance by weak balance sheet companies as yet another central bank intervention unleashes another divergence between fundamentals and central planning." Unless Yellen accidentally tanks the whole effort.
As for Deutsche's bull case, you'll note that quite a lot has to go right for European equities to realize their supposed 10%-13% upside. In fact, it would appear that nearly everything would have to go right. We'll leave you with the bull case description and let readers judge how likely it is to unfold:
What is the bull case? Anticipation of the ECB corporate bond buying program (CSPP) leads credit spreads to tighten across markets, while real bond yields drop in response to ECB easing and a dovish Fed in March. European macro data stabilizes and commodity prices rise further, as Chinese growth surprises on the upside in H1, in line with our Chinese economists’ projection. Under this scenario, European equities have around 10% upside: if the ECB’s CSPP and stronger commodity prices push US HY credit spreads back to 2015 trough levels (down another 230bps), this points to 13% upside for European equities. Similarly, a drop in Euro-area real bond yields to the Dec trough of minus 55bps (down another 20bps) would mean 6% upside to European P/Es (15.5x, versus 14.6x now). For investors wanting to position for this scenario, banks, autos and insurance benefit the most from a combination of lower credit spreads, lower real bond yields and improved macro momentum.