Equities - Is European optimism far-fetched?

"Optimism is the opium of the people." -  Milan Kundera

While we recently touched on the disconnect between Credit and Equities and the different messages between the USA and Europe, and concluded that, in Europe, the correlation between Credit versus Equities seems to have moved back towards negative territory since last Friday with renewed nervousness in the European equities markets, we agree with a recent note from BNP Paribas's recent note entitled "Four "angry birds", One stone" namely that European optimism is far-fetched if one looks at the EU earnings divergence from GDP growth:

BNP Paribas'rationale being:

"-Fade to Fundamentals? Europe still needs to substantially deleverage and is in the midst of a recession. Investor focus should fade back to these still concerning fundamentals. Positive economic surprises are unlikely to catch up with market expectations for growth.  

-European Misses More Likely: Despite substantial foreign revenues, it is rare for an equity market to manifest double-digit EPS growth while the underlying domestic economy is in recession. This current contradiction is almost always resolved in favour of the economists.  

-Euro losing the Currency War. The trade weighted Euro has risen by 12% since last July. In addition, the Euro rallied by 32% against the JPY over the past 6 months driven by part by “Abenomics” politics in Japan and the 200bn LTRO repayment contracting the ECB balance sheet driving up European rates. Europe is therefore becoming less competitive relative to other regions.  

-Not Cheap. On sector adjusted valuations or free cash flow yields, Europe looks expensive. The US however appears cheaper than implied by headline P/E given “Equity Easing” through share buyback and distortive effects of cash on balance sheet (cash P/E>100x)." - source BNP Paribas

On top of that, and as reported by Bloomberg in their Chart of the Day displaying BNP Paribas Love-Panic sentiment indicator for Europe, a positive reading as displayed in BNP's chart can be a contrarian sell indicator - source Bloomberg:

"Investors are too optimistic about European equities, according to a BNP Paribas SA index that has reached its highest level since September 2011. 

The CHART OF THE DAY shows BNP Paribas’s Love-Panic sentiment indicator for Europe climbed to 22.21 yesterday from minus 8.46 last week. The Paris-based bank says that a positive reading can be a contrarian sell indicator. The Euro Stoxx 50 Index rose 4.3 percent from the beginning of this year through Jan. 29, reaching its highest level in 18 months. “Investors’ sentiment is getting increasingly bullish,” Ankit Gheedia, a strategist at BNP Paribas in London, said in an interview yesterday. “Sentiment is getting as bullish as it was in the first half of 2011. Investors should consider buying cheap protection.” 

Euro-area stocks rose for eight straight months through January, their longest winning streak since 1998, even as economists forecast that the region’s gross domestic product would contract by 0.1 percent in 2013. The combined economy of the 17-nation bloc shrank 0.4 percent in 2012, according to the median estimate in a Bloomberg survey. 

The VStoxx Index, which measures the cost of protecting against declines on the Euro Stoxx 50, surged 26 percent to 20.15 yesterday. The gauge fell to its lowest level since February 2007 last week. The VStoxx remains 15 percent below its average over the last year, data compiled by Bloomberg show. BNP Paribas’s Love-Panic indicator for the U.S. climbed to 23.53 yesterday, its highest level since April 2011. The Standard & Poor’s 500 Index advanced 6.1 percent from the end of 2012 through Feb. 1, when the equity benchmark reached its highest level since December 2007." - source Bloomberg

Maybe it is time to hedge after all? We wonder...

"I don't think in terms of optimism and pessimism when writing a story. I am telling a story." 

- Doris Lessing

Stay tuned!

The Change in the Volatility Regime - a follow up

"If you change the way you look at things, the things you look at change." - Wayne Dyer, American psychologist   

While yesterday we touched on implications relating to regime changes in the volatility space, the phenomenon witnessed in the US is similar in Europe where European equity volatility trading has been trading marginally below the VIX as displayed in the below graph from Cheuvreux's recent Cross Asset Research paper from the 7th of January - The Tactical Message:

"The VStoxx index of implied volatility has followed the American example by falling to a cycle-low. The increase in America's political-fiscal risk premium since September has allowed indices of European equity volatility to trade marginally below the VIX." - source Cheuvreux Cross Asset Research, 7th of January 2013.

Cheuvreux makes the argument that the decline in financial volatility is a general phenomenon, with the lead coming from debt markets. They argue that there is more to it than financial repression:

- source Cheuvreux/Bloomberg

MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.

CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.

Back in March 2012 our good cross-asset friend indicated in relation to the relationship between Treasuries vs Equities and Forex volatility at the time:

"If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast..."

At the time, of the bond market correction of March 2012, there was a similar disconnect, as indicated by Cheuvreux's graph between the CVIX and MOVE index, were Treasuries volatilities were up quite strongly and risky assets volatilities (equities and Forex volatilities remained at the low end of their recent range.

We can see a similar pattern in early 2013.

"Always remember that the future comes one day at a time." - Dean Acheson, American statesman

Stay tuned!