Friday, July 24th, 2020

Signs of Life in the Eurozone

The new story in global markets is the rehabilitation of the Eurozone. For the last 12 months – and arguably for the last four years – it has been outshone by the US almost all the time, and when US investors did look elsewhere, it was either to Japan or Emerging Markets, rarely Europe and almost never specifically at the Eurozone. This may be changing.

Exhibit 1 comprises the standard charts we include in every asset allocation report. The one on the left shows the recommended weight of the Eurozone relative to its global equity benchmark and the one on the right shows the lead indicator, which is our estimate of how the left-hand chart will move over the next four weeks. Both charts have suddenly gone vertical, with the improvement dating from the last week in June, when the left-hand chart broke up through its moving average. The lead indicator shows that the bullish signal gets progressively stronger as we shorten the time period under consideration – in other words the pace of change is accelerating.

When we make calls like this, we are often asked whether they are justified by the underlying data. In this instance, we could reply by mentioning the new EU budget deal, the creation of a new risk-free asset for the Eurozone, Europe’s better recovery from Covid when compared with the US and the valuation gap with the US. But that’s not really the point. The point is that sentiment towards the Eurozone has improved significantly and our numbers suggest that this is likely to continue. Positive sentiment is a good thing, in and of itself, and should not be wilfully ignored.

It also helps if the macro and micro stories are aligned. When the Eurozone rally first started, we noted that there was not much evidence of a shift away from defensive sectors towards cyclical sectors like Industrials or Materials, or deep value sectors like Financials. This is beginning to change. We have just upgraded Materials to overweight, having had it as an underweight or neutral for the last two years. We could not get excited about it in June, because its lead indicator was not attractive, but this is now improving. We upgraded Industrials to neutral two weeks ago and it now has a set of charts, compared to the rest of the Eurozone, which look very like the Eurozone compared to the rest of the world.

But the key sector for the rehabilitation theme is Financials, which has always been the Achilles heel of previous rallies. We still have it as an underweight, but the lead indicator is now as good as that of Industrials and of the Eurozone itself. At the current rate of progress, the left-hand chart will break up through its moving average in early August, at about the same level as it did in October 2019. That rally ended with the onset of Covid in Europe, so there is a sense in which this rally is just the resumption of a pre-existing trend.

Clearly the world has changed since then, but if the Eurozone/EU really has embraced fiscal activism and abandoned austerity, the outlook for Eurozone banks may be better than the loan loss projections imply. We would argue that they are already included in the price as a result of the massive underperformance between March and May. A Eurozone rally without the participation of Financials will be anaemic at best. But if the region and the sector rally together, the result could be quite powerful.

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