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Equity Focus - June 2024

Did reduced tails break the VIX?


Rotation incoming


Key Points

Feelings vs reality – it feels different, but the median Nasdaq 100 stock is up only +4% this year and the equal-weighted index gained only +4,5% YTD. This tells a more mediocre picture of Tech’s performance when compared to other assets like Copper +21%, Gold +14%, SX5E +12%, Nikkei +16% or Hang Seng +11%.

The (less) magnificent 7 - Q1 was the 5th quarter in a row where, if Mag-7 contribution is taken out, the remaining 493 S&P500 constituents showed outright negative yoy% EPS growth. The group however cracked apart performance-wise as only 2 names managed to beat the market on a 3-month horizon.

Beware the discount rate – while a strong US economy should benefit stocks, not all are created equal. Valuations may become an increasing concern for those hoping that the discount rate in their dividend discount model might soon recede. Rate cut expectations continue to get pushed further out. We stick to our expectation of a first – and sole - 2024 cut in September.

Wind of change - Over the past quarters, US earnings strongly beat the Eurozone. This is changing, with Q1 US earnings spread vs Europe beginning to narrow. Looking at median Q1 EPS growth rates, Europe improves from -7% to 0% yoy. The shift is consistent with relative bottoming in Euro Area PMI momentum vs the US and strengthens our relative preference of European vs US equities. 

Main recommendations

Stay long Europe: The sentiment around Europe remains poor which is reflected by a recent “The Economist” cover. Historically though, such extreme headlines have had a track-record of proving a contrarian indicator (something even they have discussed in the past, highlighting a 68% contrarian hit rate on a 1Y view). Looking at the facts, the economy is recovering, and valuations remain attractive. Reiterate overweight

Taking profits on Basic Resources: Hopes for a stronger demand rebound, M&A activities and ongoing strength in copper pushed prices higher. While we still like the long-term story, a 20% run in 3 months looks should limit the potential to outperform in the near term -> downgrade to neutral

Potholes ahead- we downgrade EU Automobiles to underweight due to increasing margin pressures from Chinese BEVs and falling used car prices. The sector is also vulnerable to a deterioration in global trade, especially from tariffs.

The key risks are that the US Federal Reserve or the ECB could be forced to further push out rate cuts or even shift back to a hawkish rhetoric should inflation surprisingly pick up again.


Is the VIX broken?

We have a war in Europe and the Middle East with Israel involved, a high-profile Iranian leader recently dies in a helicopter crash, China continues to flex its muscles towards Taiwan, a convicted felon is most likely to run for the most powerful office in the world and leading the polls… can say a lot about today's world but not that it´s a boring one.

Despite plenty of reasons to keep investors on their toes, the VIX (equities) and the MOVE (rates) index, which measure the future expected volatility, are trading at depressed levels. Apparently, the future path of the US economy and – consequently – the response function of the US central bank seems to be the only thing really concerning markets.

In this sense, a mix of a steady Fed, softer US growth, and modestly better US inflation outcomes seems to be providing exactly the sort of Kool Aid that markets are looking for. Weaker US growth has reopened a path towards rate cuts, while alongside better non-US growth, it has limited the scope for “divergence” that seemed to be opening up in April. The Fed was clear in regard to growing fears of a “hawkish pivot”, saying on one hand that it retains faith in the disinflation path with a high threshold for hiking. On the other hand, it still feels able to cut rates if the economy or the labor market weakens. Both reassurances reduce key tail risks for the equity market and, by lowering the chances of hikes and deep and early cuts, for the rate distribution too. 

Such outlook for reduced tails attracts a lot of interest from volatility sellers who – overly simplified – bet on the market to stay rather range bound with muted moves only. Those Volatility sell programs currently provide record oversupply to banks derivatives trading desks. With risks being perceived so low, there are only a few buyers out there looking to hedge. This is creating a dealer long gamma dynamic. Goldman Sachs estimates that index dealers are currently long $8.1B worth of gamma per every 1% move in spot. This means, that index desks will sell $8.1B worth of equities if the market gains one percent and will buy the same amount if it falls. This feature will help to mute a larger potential drawdown and is subduing volatility at the same time, nudging model-based strategies to re-lever further.

While its hard to predict when those dynamics turn, they always do and often in a violent manner, its safe to say that investors can benefit from it by buying volatility via structured products which include the purchase of optionality, be it for upside participation or downside protection.