Challenging economic background vs booming markets
Recent changes in our proprietary indicator point to gradually increasing deflationary pressure in the major markets, especially China. Accommodative monetary policies in developed markets will likely continue until a capex-fuelled credit cycle takes over from ultra-low interest rates and central bank liquidity. This should happen in the US first.
Accommodative policy is now also needed in Asia. We prefer markets benefiting from the most positive liquidity trends and currency weakness ie, Europe and Asia. Deflationary pressure shows no sign of abating in the major economies: our proprietary indicator indicates a slight deterioration in all major regions except in the eurozone. This appears to justify the recent decline in interest rates in most markets, dovish central bank comments on soft economic data and status quo in quantitative easing programmes. While Europe continues to be the most depressed area in our model, China has experienced the most rapid deterioration and pressure for more monetary easing or economic stimulus is mounting fast.
This will likely accelerate if job market conditions start to worsen. Easing policies will soon reach North Asian countries at a time when the US and the UK will start to tighten policies, while European and Japanese central banks continue to buy bonds, pushing asset prices higher and investors into more risky products. The recovery since the global financial crisis has been slower and more painful than previous recovery episodes. The level of government deficit and central bank injections has been unprecedented, but now appears to represent a universal model: central banks have replaced government in engineering the economy until conditions are met for the private sector to take over.
This will be more difficult outside the US, as European and EM corporates still need to get rid of the large surplus in production capacity that is weighing on profitability. European corporates are also very cautious on leverage, while the EM corporate leveraging trend is slowing. The key to the global recovery is a capex cycle in the US which triggers a credit cycle allowing the Federal Reserve (Fed) to normalise interest rates. In the meantime we prefer markets benefiting from the most positive liquidity trends and currency weakness ie, Europe and Asia.
Chart 1: Deflationary pressure still strong Chart 2: Europe is the new Japan (followed by Asia) -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 BNPP Japanization Index EURxUK China UK US Japan -12 -10 -8 -6 -4 -2 0 2 4 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 US Output Gap (IMF) Forecasts (IMF) EM exAsia Asia UK US Stagflation Recession Recovery Inflation QE sweet spot Europe Japan Source: IMF, BNP Paribas Source: IMF, BNP Paribas This publication is classified as non-objective research 16 April 2015 Equity Strategy Plus 5 www.GlobalMarkets.bnpparibas.com European rally to continue European assets are heading towards a bubble, with bonds already disconnected from fundamentals, while the valuation of equities, starting with exporters, is rising in the expectation of higher margins and EPS growth. We think the rally in European stocks is set to continue, despite the impressive performance in 2015 so far. European QE continues to put pressure on risk premia. We expect pressure on valuations to intensify as liquidity passes “through into other fixed-income assets, as well as to equities and the exchange rate” (ECB president Mario Draghi). Eurozone exporters BNP economists recently raised their eurozone growth forecast to 1.8% for 2015 and 2% for 2016, driven mostly by improvements expected in Germany and Spain (Table 1). The EUR nominal effective exchange rate has depreciated by 13% in the last year, and BNP FX strategists expect the EUR to fall further; boosting eurozone exports by 7-8%. A 10% depreciation in the EUR NEER would boost exports by 5pp. Table 1: BNPP GDP Forecasts (% y/y) Region 2014 2015 2016 Eurozone 0.9 1.8 2 Germany 1.6 2.5 2.4 France 0.4 1.2 1.8 Italy -0.4 0.7 1.3 Spain 1.4 3 2.8 Source: BNP Paribas The German economy is by far the biggest beneficiary of this trend, as we have already highlighted. Germany benefits from a high share of exports in its GDP, a higher proportion of exports to non-eurozone countries, a relative competitive advantage and a strong external net investment position. Second to Germany, Spain has the highest proportion of exports as a % of GDP and benefits significantly from a weaker euro. German and Spanish exports account for 46% and 32% of GDP respectively, versus 28% and 29% in France and Italy respectively (Chart 5). Chart 5: Eurozone export shares Chart 6: Average (DAX, IBEX) – Average (CAC, FTSEMIB) 135 140 145 150 155 160 165 11 12 13 14 15 (0.5*DAX + 0.5*IBEX) – (0.5*CAC + 0.5*FTSEMIB) Source: Bloomberg, BNP Paribas Source: Bloomberg, BNP Paribas This publication is classified as non-objective research 16 April 2015 Equity Strategy Plus 6 www.GlobalMarkets.bnpparibas.com Investors agreeing with our view might consider buying a 0.5x DAX Dec15 105% Call and a 0.5x IBEX Dec15 105% Call by selling a 0.5x CAC Dec15 105% Call and a 0.5x FTSEMIB Dec15 105% Call for 1.2% premium indicatively. The risk in this strategy is theoretically unlimited. Europe rally to continue Since we last pushed the idea of European stock outperformance over US stocks in February, European equities have risen by more than 10%. As a result, the call spread on the SX5E is fully in the money, while the SPX is still below the lower strike. Despite this outperformance, we think the trend is not over and positioning for this outperformance of Europe over US with a call spread versus a call spread at 0 premium is still very attractive. Chart 7: Europe’s solid outperformance since February 2015 0.95 0.97 0.99 1.01 1.03 1.05 1.07 1.09 1.11 1.13 SX5E SPX Source: Bloomberg LLP, BNP Paribas European Central Bank President Mario Draghi was extremely clear in his March 2015 speeches that he is not overly concerned by potential asset bubbles in Europe as by-products of European QE, saying: “…the reduction in government bond yields caused by the ECB’s interventions will set in motion a chain of propagation channels. These include the impact on prices of a large variety of assets and loan contracts in the economy, as well as the reallocation of portfolios into a multitude of other assets not directly included in the purchase programme.” (10 March, 2015) “The reductions in sovereign yields seem to have passed through into other fixedincome assets, as well as to equities and the exchange rate… Such spillover effects are associated with portfolio rebalancing, which is one of the channels through which the asset purchase programme reaches the real economy: our purchases reduce returns on safer assets. This encourages investors to shift to riskier, higher yielding assets. Pension funds, banks and other market participants that we buy securities from are likely to substitute these for other longterm assets, thereby eventually pushing up prices more broadly.” (11 March, 2015) We think European stocks will continue to benefit from the large European QE, further weakening of the EUR (at parity with the US dollar in December 2015) and the ECB’s desire to reflate the European economy at almost any price. The appreciation of the US dollar and the start of the normalisation process of US interest rates should also support the relative performance of European equities in 2015. This publication is classified as non-objective research 16 April 2015 Equity Strategy Plus 7 www.GlobalMarkets.bnpparibas.com Chart 8: Sep-2015 expected performance of SX5E and SPX Euro Stoxx 50 S&P500 SX5E SPX Real GDP Growth 1.8% 3.0% Rate of inflation 0.0% 0.0% Nominal GDP 1.8% 3.0% Revenue Beta to GDP 1.5 1.3 Revenue Growth 2.7% 3.9% Margin Expansion 6.0% -1.0% Net Buyback Accretion 0.0% 1.5% EPS Growth 8.7% 4.4% Multiple Expansion (Lower Bound) -1.0% -2.0% Multiple Expansion (Upper Bound) 6.0% 5.5% Lower Annualised Performance 7.7% 2.4% Upper Annualised Performance 14.7% 9.9% Investment Horizon 0.45 0.45 Lower Point-to-Point Performance 3.4% 1.1% Upper Point-to-Point Performance 6.4% 4.3% Average 4.9% 2.7% Current Index Level 3830 2100 Dividends to Maturity 80 16 Lower Target 3880 2107 Upper Target 3994 2175 Economy Income Statement Market Source: Bloomberg, BNP Paribas Investors who share this view could buy 3750/4050 Sep-15 SX5E Call Spreads and Sell 2100/2250 Sep-15 SPX Call Spreads for approximately 0 cost. The risk of selling the call spread is limited to the strike difference. Hedge Europe, monetise higher volatility Following the announcement of ECB QE, the Euro Stoxx 50 Index rose in January and February, while short-term implied volatility dropped to 16.5 (see Chart 1). March has seen further good equity performance, with the Euro Stoxx 50 posting a +2.73% increase, but short-term implied volatility also rose 3 vols, from 16.5 to 19.5, during the same period. Instead of selling a straddle to benefit from this higher level of volatility, investors may want to consider the following structure, which potentially widens the range of positive P&L : Maturity : 19-Jun-15 Sell Daily Lookback Call + Sell Daily Lookback Put Indicative bid : 11.75% (at time of writing) Ref. ATMF Vanilla Straddle price : 6.50% This strategy will return a positive P&L if the Euro Stoxx 50 stays within a range of 440 points (11.75% x 3,750) between 10 April (pricing date) and June maturity, ie just over two months. In particular, the break-evens for ‘one-way market’ scenarios are: This publication is classified as non-objective research 16 April 2015 Equity Strategy Plus 8 www.GlobalMarkets.bnpparibas.com One-way down market: 3,310 points One-way up market: 4,190 points The risk of selling a put is limited to the strike; the
