3 june 2020


Welcome to CLEARCUT, a monthly discussion on macro and allocation


  • Two key upside risks have started materialising, leading to a more balanced macro outlook.
  • A Hamiltonian moment is playing out in Europe with important steps towards fiscal federalism. That could lead to a broad re-rating in euro assets.
  • The cyclical rotation has started. Investors are still applying distancing as winning trades look far from crowded.
  • SPARK has upgraded equities to neutral and maintains the overweight in credit vs. sovereign debt. In commodities, we rotate from oil to copper.



Elusive bear_ As of early May, most investors were considering the rebound in global markets as a ‘bear market rally’, according to Bank of America’s Fund Manager Survey. Well, the month of May brought yet more gains, making a return to March lows less likely. Compared to our own expectations, the past weeks have brought better macro news, leading us to adjust allocations on the way.

Light at the end of the tunnel_ Regarding the pandemic, the number of cases is evolving broadly as expected. Encouragingly, the number of infections does not seem to have picked up following the easing of lockdown measures in Europe and the US. The epicentre of the epidemic is unfortunately moving yet again, this time to Latin America, and to a lesser extent, India (Exhibit 1). The situation in those countries needs careful monitoring given the pool of population and weaker health infrastructure.

V for Vaccine_ The true positive piece of news came from the biotech company Moderna. The firm announced a promising Phase 1 trial for a vaccine candidate, the mRNA-1273. Despite a very low sample size, the molecule seems to generate positive responses, enough to be fast-tracked by the FDA. Phase 2 and Phase 3 trials are expected to be completed over summer. The company is also benefiting from government funding to support its research. Even though many are dampening expectations about the availability of a vaccine before 12 to 18 months, the news, if confirmed, is a game-changer in our view. Financial markets are likely to adjust well ahead of the vaccine being available at your local pharmacy. Markets are a discounting machine that constantly projects into the future. If the probability that a vaccine becomes available sometime in 2021 rises from, say, 30% to 60%, the markets react right away as it alters the distribution of outcomes related to longer-term earning prospects.

Enough is enough_ Meanwhile, the cyclical backdrop is moving broadly as expected. Most regions have now moved to gradual deconfinement and the data is confirming that the low point in activity was most likely April. European and US surveys, such as the PMIs and regional Fed indices, point to moderate improvements in the manufacturing and services sector. The Citi surprise indices are also starting to level off (Exhibit 2), implying that expectations have fallen sufficiently to reflect the sudden stop that the global economy is facing in Q2.


Exhibit 1: Pandemic moving to emerging markets

  Source : Financial Times – 31 May 2020


15% off on everything_ The fact that the outlook is no longer deteriorating does not mean it is great. To be clear, GDP is likely to be falling 15% in Q2, by far the largest drop on record in peace time. As we have argued at length, a decline of such magnitude is likely to leave scars over the medium term. The data coming from China continues to confirm that the recovery in services is slow, gradual, and uneven.


Exhibit 2: Economic surprises are turning


Source : Citi, SILEX – May 2020


Europe is upping its game_ Another game-changer in May is the coming fiscal response in Europe. While we had been critical, even worried, about the lack of fiscal reaction in the eurozone compared to the US, one must admit that the Franco-German proposal is going further and faster than we had expected. A 15-year old taboo is being broken as Europe is moving towards debt mutualisation. Moreover, a truly federal fiscal mechanism is being built that aims to support most affected areas and sectors, irrespective of the country they belong to. Clearly, this could be the most significant achievement of A. Merkel’s legacy. The European Commission endorsed the idea through its own ‘Next Generation’ proposal. The pressure is now building on the opponents to this initiative, the ‘frugal four’ led by Austria. Negotiations will be fierce until July when the multi-annual EU budget needs to be agreed upon. As usual, the devil may be in the details. But we doubt that smaller Member States can block such a historic decision.

The geopolitical scar_ These two major positive developments are partially offset by the rapid escalation of tensions around Hong Kong. The new security law adopted by China is de facto putting an end to Honk Kong’s political autonomy. From a markets’ perspective, what matters in this issue is the level of international spill-over. As long as Hong Kong is kept a ‘domestic matter’ in China, systemic implications are limited. As we speak however, several foreign countries have already started getting involved. In the context of a US election campaign where the economy is no longer helping him, President Trump is tightening his rhetoric against China. With the recent Phase I deal on agricultural goods and the Huawei controversy on the backburner, tit-for-tat could re-escalate quickly. Taiwan and the UK have offered residence to Hong Kong citizens. The EU has adopted unusually strong language to condemn the Chinese decision. The direction of this conflict is highly uncertain, but the time horizon looks key. In the near term, it looks unlikely that any government will take the risk to add downside risk to the economy, especially the US until November. Longer term, the decoupling between China and the West looks increasingly likely and may not be contained to technology.




Pain trade, episode 2_ The price action in markets continued to surprise most. While the economy was collapsing, financial assets staged an impressive come-back that, if anything, amplified in May. As a result, observers and forecasters are in the process of post-rationalising and marking-to-market, pushed by the well-known Fear Of Missing Out (FOMO).


Exhibit 3: Light equity positioning in allocation funds


Source : Reuters, SILEX - May 2020


Still distancing_ The good news is that our indicators of sentiment and positioning remain well below normal. Most of the recent winning trades are far from crowded and enjoy ample room to develop further. This is the case in allocation surveys, where equity exposure is at the low end of the historical range (Exhibit 3). This is also the case across most flow and price indicators we track. Similarly, derivative markets suggest that investors have only started to re-deploy long positions after a long period of short covering. The conclusion from our point of view is that sentiment is still a key support for markets in the near term.



Exhibit 4: Towards a compression of the euro risk premium

Source : Bloomberg, SILEX – May 2020


Hamiltonian moment_ A key change however from the first stages of the rebound in April is that the European Hamiltonian moment of joint debt is leading to a potential re-rating of all euro-denominated assets. This is important for investors more comfortable to have valuation on their side. The rally led by Tech and the US was clearly driven by momentum and a structural lack of economic growth, as discussed last month. But European assets are undeniably cheap. Fixed income and the currency have embedded a structural risk premium since the 2011 sovereign crisis that has never fully gone away (Exhibit 4). If the current proposal comes to fruition, risks to fiscal sustainability for weak sovereigns should be reduced, limiting credit risks in the sovereign space, the ultimate risk of a euro break-up and a doom-loop for the financial sector.

European credit_ Last month, we showed that the risk premium is not straight-forward in equities. As a result, we reiterate our conviction that a European conviction is best expressed in the fixed income space, where the premium is both easily observable and more likely to be directly impacted by the catalyst at work. We anticipate a strong performance from financial debt. The sector is not only benefiting from the structural change, but also supported by regulators in the current environment and could harvest the benefit of a multi-year restructuration.

Rotation time_ A second key development in the recent price action is the rotation towards cyclical assets. As markets focus on the end of confinement in most Western countries, the most beaten-down segments are starting to show signs of life. This is benefiting markets where the sector mix is tilted towards Value and Cyclicals: Europe is again on the list. But there are other ways to express this view, not least with small caps. The relative performance of the Russell 2000 compared to the S&P 500 for example has been remarkable since mid-May. The move has been quick and sizable but remains far from overplayed. As an illustration, the short interest on US financials remains close to historic highs (Exhibit 5).


Exhibit 5: Significant short interest on US financials

 Source : Refinitiv, SILEX – May 2020


Go East_ For investors who have large European exposure in fixed income and wish to benefit from the cyclical rotation in a different way, our best conviction is Japan. This market currently screens very cheap despite the recent rebound, and even compared to its own history of cheapness. Investor positioning is very light, to say the least, and the sector mix is favourable, with a large weight in cyclical sectors. Finally, unlike emerging markets, Japan does not rely on foreign capital to fund budget deficits.

SPARK it up_ With implied volatility and correlations having now come down their recent peaks, our quantamental process allows to take a bit more risk within a given volatility budget. As the machine points to significant expected returns in global equities, we have cut our underweight and returned to a neutral stance. Within the asset class, our convictions are reflected with overweight positions in Japan, EMEA and, to a lesser extent, Europe.



Exhibit 6: SPARK expected returns and Sharpe ratios

 Source : SILEX. Investisseurs en base euro – June 2020


Credit_ Still, the best Sharpe ratio remains in credit, leading our process to maintain the overweight there (Exhibit 6). European credit has started to outperform in late May, and we see room for more. We have also added back to emerging debt which is starting to benefit from the broad depreciation of the US dollar. EM FX looks cheap on many metrics and a better risk environment is likely to fuel a return to the search for yield.

Oil on the boil_ Finally, we had allocated small positions to oil last month given the volatility, but these have paid off handsomely. With less upside from here, we trim positions and rotate to copper, where the recovery has been milder. A more meaningful recovery in China, and infrastructure investment more generally, should support industrial metals, whose correlation to reflation themes is high.