The Banks and the Pain Trade of 2014

  • This is a dangerous period for European equity, financials especially, because there is no catalyst for out-performance. However, we presume that money stays invested in equity. Market pullbacks for major benchmarks should remain limited.
  • It seems to us that the disinflation shock in the developed economies is fading, led by America. It remains our interpretation that yields of longdated Treasuries have established a floor. However, the adjustment of bond markets may be a slow process.
  • The bid for secure growth and equity quality has strengthened. Nonetheless, the valuation return-to-trend of Europe’s large cap, lower quality, non-financial value stocks continues. This is the pain trade of 2014.
  • We conclude that the defensive bias in our recommended portfolio should be more explicit. We are downgrading Insurance and Banks to neutral until the adjustment in bond markets becomes apparent. We are also downgrading the Media sector whilst increasing exposure to the Personal & Household and Energy sectors.

Recommended sector and market asset allocation

The period following the announcement of the ECB’s anti-deflation programme was always going to be dangerous for European equity, for financials especially, because there is no catalyst for out-performance at this time. On the contrary, a degree of international under-performance would seem to be almost inevitable. This said, our presumption is that money stays invested in equity markets at this time. Market pullbacks should remain within the 5% limit for major benchmarks. The deflation debate is focused upon the price regime, in the EZ above all. In this respect it does seem to us that the disinflation shock in the developed economies is fading, led by America. It remains our interpretation that yields of longdated Treasuries have established a floor through May-June. Consequently, equivalent yields of German government debt should stay above their lowest points of 2012-2013.

Money has been shifting into Europe’s large cap defensives for several months. The recent behaviour of Europe’s banks is troubling. The perception of the burden of restriction and incrimination of the region’s heavyweight international commercial-investment banks has increased. The bid for secure growth and equity quality has strengthened. Nonetheless, the valuation return-to-trend of Europe’s large cap, non-financial value stocks have continued despite their low growth, lower quality characteristics. This is the pain trade of 2014 because active funds remain under-invested in these stocks. It reflects a fundamental shift in the investment environment.

We conclude that the defensive bias in our recommended portfolio should be more explicit. We cannot expect a stronger performance of European equity until the reference bond markets provide more positive signals. Patience may be required. The pain trade should extend. Accordingly, we are downgrading Insurance and Banks to neutral until the adjustment in bond markets becomes apparent. We are also downgrading the Media sector to under-weight in recognition of the loss of growth momentum in the sector. We are increasing exposure to the Personal & Household sector and to the Energy sector. As a consequence of the changes we are increasing our exposure to Nordic markets slightly, through Norway and Denmark at the expense of Sweden.

Weightings and asset allocation for the MSCI Europe Universe



20/06/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 9.9 1.1 OW 11
Automobiles & Components 3.0 1.6 OW 4
Consumer Durables & Apparel 2.7 1.2 OW 3
Consumer Services 0.9 0.9 OW 2
Media 1.9 0.8 UW (N) 1
Retailing 1.3 0.9 UW 1
Consumer Staples 14.1 0.5 UW 13
Food & Staples Retailing 1.7 0.8 UW 1
Fod Beverage & Tobacco 10.7 0.5 N 11
Household & Personal Product 1.8 0.5 N (UW) 2
Energy 9.4 1.0 OW (N) 11
Financials 21.6 1.5 N (OW) 22
Banks 11.0 1.5 N (OW) 11
Diversified Financials 4.0 1.6 N (OW) 4
Insurance 5.6 1.4 N (OW) 6
Real Estate 1.0 1.1 OW 2
healthcare 12.7 0.5 N 13
Healthcare Equipment & Services 1.2 0.4 N 1
Pharmaceuticals & Biotechnology 11.5 0.5 N 12
Industrials 11.6 1.1 UW 9
Capital Goods 9.0 1.2 UW 7
Commercial Services & Suppy 1.4 0.8 UW 1
Transportation 1.2 1.0 OW 2
Information Technology 3.1 1.0 UW 2
Software & Services 1.4 0.9 UW 1
Technology & Hardware Equipment 0.9 1.2 UW 0
Semiconducors 0.9 1.0 UW 0
Materials 8.1 1.3 N 8
Telecommunication services 5.5 0.8 OW 6
Utilities 3.9 0.9 N 4
Exposure to risk
(beta value)
  1.01    
Lquidity ratio   3%    
* The exposure to risk is measured by the weighted average of 2-y betas.
We manage the liquidity ratio within a 0-10% rank.
Source: Kepler Cheuvreux