BY PAOLO MARONGIU
May was a month of two halves for European equities, in the first half of the month we witnessed a follow through rally which took the MSCI Europe Index (MXEU) to the 134 level (up +2.48%), which acted as strong resistance in the short term as the market posted five daily highs near this strategic level. The second half of the month was corrective at first followed by a sideways movement. Overall in May the MSCI Europe Index gained +0.79%, closing at 131.62.
The first half of April was good for European equities in relative terms, if we normalize both the European and the American markets in Euro terms; then a reversion to mean occurred and the American market regained relative strength, posting new historical highs, while the European markets ended the month trading sideways.
The French elections were the main catalyst, a huge part of the political risk premium was removed as the markets realized that the gap between Macron and Le Pen was getting wider. The political issue in Europe is still in focus, due to the rumors of early elections in Italy, this may lead to a revival of the political risk premium attached to the peripheral markets.
The markets are waiting for the Central Banks to meet in the United States and Europe in the first half of June, the focus is both on their actions (no action is expected from the ECB, while a rate hike in America is very likely) and their language, in particular for details on the exit strategy from the unconventional monetary policies which have characterized recent years. The Investment Adviser thinks the ECB will remain on hold, while the FED could send a hawkish message about their exit strategy.
In May the risk premium attached to the European equity market was smaller than the one we observed in the first part of the year, the volatility attached to the Eurostoxx 50 equity market is still quiet but unstable, the V2X Index dropped from 17.5 to 13.5 after the second round of the French elections, then rose back to 17.5 and eventually dropped again to the 13.5 – 14.5 area. The sudden spike in the middle of the month was due to the pickup in the political risk premium in Italy.
The typical seasonality of the US in a post–election year is favorable for the quarter, but in general June is a negative month for equity markets. All in all, there is no clear indication from seasonality, so the Investment Adviser therefore prefers to adopt a cautious stance. Market sentiment is balanced, there are no signs of excessive complacency among the global investment community, yet neither is there any sign of excessive pessimism. “Smart money” is still adopting a positive approach and this could be supportive for equity markets, preventing huge corrections and limiting the downside risk to 3 to 5% downswings.
In May the Strategic Beta Flex Fund’s performance traced the pattern of April, the first half of the month followed an upward trend, a correction took place mid-month, and finally a strong upward move in the last part of the month. The Fund held a mid – low net long equity exposure. After the equity rally which followed the French elections the Investment Adviser has focused even more than usual on controlling volatility and drawdowns, trying to achieve stable returns in any given scenario.
The Investment Adviser may adopt a very cautious stance if political risk emerges, the main focus in June will be on the UK and Italy, while the other driver may be the monetary policy adopted by the Federal Reserve and the ECB.
The risk premium attached to global equities is no longer as favorable as it was in May, after the rally we now have a situation in which the short term risk / reward ratio is finely balanced and is not particularly attractive.
As mentioned in the last commentary, there is still relative value to be caught in the latter part of the year, as the macroeconomic context is still favorable, but in the short term the Investment Adviser prefers to adopt a cautious approach.
In June we await important indications from the yield curve in the United States, the flattening process has continued since December whilst the reflation trade (also known as the "Trump trade") seems to be forgotten.
The views and statements contained herein are those of Sofia SGR in their capacity as Investment Adviser to the Fund as of 19/06/2017 and are based on internal research and modelling.