Is Europe Well Positioned To Sustain Its Equity Leadership Position?

Global equities broke out last week, ending the two month consolidation phase. A strong earnings season, upbeat guidance and reduced geopolitical uncertainty have spearheaded the breakout and financial conditions have eased substantially falling to multi-year lows.

Last September we postulated that the global Equity Risk Premium (ERP) would continue to narrow on the back of easy global monetary policy and a recovering global economy. While the Fed has hiked interest rates twice since then, global monetary conditions remain loose and we doubt they are about to abruptly tighten. Leading indicators signal that the global economy is also on track to continue expanding at a healthy clip, sustaining a goldilocks equity market scenario.

Historically, the ERP and global growth have been inversely correlated. The current message is to expect a further narrowing of the global ERP. Importantly, the ERP has consistently moved higher, rising about 300bps per decade on average for the past 20 years. Were the ERP to break 4% (and still remain ~200bps above last decade’s mean) from 4.84% currently, all other things equal, then the MSCI All-Country World Index (ACWI) would rise by 15%.

Nevertheless, regional equity market returns will not be uniform. Drilling beneath the surface of recent G3 performance is instructive. As a reminder last September we highlighted that “the laggards (Eurozone and Japan) will have to do the heavy lifting in order to propel the MSCI ACWI into uncharted territory”.

Indeed the Eurozone and Japan have been leading the charge especially since the Trump election. While the U.S. has hit a small speed bump recently, the Eurozone and Japan are firing on all cylinders according to sharply divergent Economic Surprise Indexes (see Chart). The implication is that Europe and Japan are well positioned to sustain their equity leadership position in the coming months.

True, the bond market has not yet confirmed the equity market’s euphoria, but leading indicators…

For additional details, please see the May 5th Report titled “Buy The Breakout”, available at

Does It Still Pay To Play Defense?

There are tentative signs that the profit advantage may be starting to slowly shift away from defensives and toward cyclicals.

First, the gap between hard and soft data remains unusually wide. The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance.

Second, commodity prices and the U.S. dollar – especially versus emerging market (EM) currencies – are still signaling that the cyclical/defensive ratio has more downside.

Bottom Line: within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer.

For additional details, please see the U.S. Equity Strategy Report titled “Pricing Power Comeback” available at


Is The Bond Market Sniffing Out Equity Market Trouble?

A short-term testing phase is underway in the global equity market, and a number of factors argue that it needs more time to play out. Five major concerns could weigh on stocks from a tactical perspective.

First, policy divergences between the Fed and the ECB are unlikely to widen further, as the ECB signaled at its March meeting that the Eurozone is past peak monetary policy easing with the latest 4-year TLTRO II bank take up coming in at €233bn fixed at 0%. Historically, the relative sovereign spread has been a reliable equity market topping out signal. The chart shows that the U.S./Eurozone 10-year sovereign bond spread has been an excellent leading indicator of the broad equity market, and the current message is to expect at least a tactical pullback. In fact, every time the spread has hit 100 basis points, relative bond market mean reversion has subsequently occurred, leading also to a broad equity market wobble.

We doubt that monetary policies can diverge significantly for much longer without any negative global ramifications. Given that the inflation expectation gap between the U.S. and the Eurozone has remained intact since last summer, real interest rate differentials are the driving factor of the recent steep divergence. Historically, this pushes capital flows onto U.S. shores to the point where the dollar typically overshoots thus draining global liquidity and eventually a tipping point occurs.

The weak link this time could be emerging markets, as a sustained and unchecked dollar bull market (underpinned by policy divergence) risks uncovering the hard currency debt excesses in the region. This is a risk we are closely monitoring.

Second, our global equity market EPS model has…

For additional details, please see the April 7th Report titled “Quarterly Review And Outlook”, available at


Is The S&P500 Suffering From Short-term Fatigue?

Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (see chart). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves.

Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, see chart). Crude oil price
corrections have accurately timed equity retreats (see chart), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run.

Contrary to popular perception…

For additional details, please see the U.S. Equity Strategy latest report titled: ”Reading The Market’s Messages”, available at

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Are Eurozone Banks A Buy?

Buying Europe at the expense of America has been a widow maker trade since the depths of the Great Recession, but factors finally appear to be falling into place for a preference shift away from the U.S. and toward the Eurozone.

Given the relative regional outlook, buying euro area banks/financials at the expense of U.S. banks/financials should be a winning pair trade.

Nevertheless, we would rather err on the side of caution and boost euro area financials to overweight in global equity portfolios.

The euro area is lifting out of the economic doldrums. The ECB’s easy money policies have finally coaxed the economy close to a self-sustaining recovery. The latest manufacturing PMI data were very strong, signaling that real GDP growth should accelerate. In addition to easy monetary policy, fiscal policy has also contributed to GDP growth. Keep in mind that in calendar 2016, the euro area’s real GDP grew faster than the U.S. A healthy economic backdrop typically spurs loan demand, which is positive for bank profitability (see chart).

Moreover, inflation is at the ECB’s target. Headline CPI has accelerated…

For additional details, please see the February 24th Report titled “Nearing Stall Speed”, available at