Thursday, May 18th, 2017

Peak Euphoria

It is not often that we write about the active weight of our recommended Eurozone portfolios, but – believe it not – something quite interesting has just happened, following the French elections. Active weight measures the extent to which the aggregate underweight and overweight positions differ from their benchmark weights. We consider two portfolios, Eurozone government bonds and Eurozone equities, both allocated on the basis of countries. The active weight of the bond portfolio has reached a two-year high in the same week as the active weight of the equity portfolio has hit a two-year low. Investors are happy to take big country bets in the Eurozone bond market, but do not want to replicate these bets (or any other bets) in the equity market. What’s going on?

The first half of the question is easy to explain. Now that the risk of Mme Le Pen as President has been completely removed, the chances of a euro-crisis are held to be much lower, and investors are free to avoid ultra-low yields in the core and buy the periphery, apart from Italy. But why is this divergence not reflected in the equity market? If the active weight carries on falling at the same rate as it has for the last month, by early June it will be challenging some of the all-time lows, set in 2013, 2009 and 2002. These levels are always associated with the onset of – or a recovery from – financial or political crisis. And herein lies the clue. If the Eurozone is now “safe” for equity investors, the first thing they have to do is buy the benchmark. They can worry about sector and country tilts later. It doesn’t matter whether they are domestic investors getting out of bonds or international investors diversifying away from the US, beta is more important than alpha. They need to increase their weighting before the end of the quarter./p>

History is full of examples of these periods of indiscriminate buying. Although neither President would be flattered by the comparison, the most recent parallel for the Macron trade is the Trump trade, from November 2016 onwards. In local currency terms the chart is almost identical, if we date it from the first round of the French elections. For international investors the effect has been compounded by currency movements with the euro and dollar both strengthening after the results were announced. Remember this is the whole of the Eurozone equity market, not just France./p>

So how long does this euphoria last? Nothing in this paragraph should be taken as an indication that Eurozone equities cannot make further progress in the short term. However, they already account for 37% of our model portfolio and this is unlikely to get much higher. Since the start of QE, there have only three previous occasions where its exposure to any equity region has been greater than 30%: EM in July-August 2009, Japan January-May 2013, Eurozone November-December 2013. In this respect the Macron trade is already more powerful than the Trump trade, which peaked at 29% of our portfolio in February 2017. Even if there is no challenge from another equity region, a correction in global equities could well require us to increase our weighting in fixed income. Our exposure to the Eurozone hit 30% at the end of March. In terms of time spent above this level, it is already the second-longest run behind Japan in 2013. This, together with our evidence of indiscriminate buying, makes us think that we are already at peak-euphoria./p>

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