Euro-morality and Scottish mist

  • Deflationary anxiety has met its reflationary response from the ECB. The outstanding feature of this summer in financial markets is the transfer of volatility from equity to currency and debt. The euro zone now has both cheap capital and currency adjustment - but most investors remain sceptical.
  • Europe has discovered a new source of anxiety in Scotland’s referendum. The bigger story is the way in which the nature of investment risk in Europe this year has been misinterpreted. This is not EZ crisis redux. We do not think that the recovery of EZ equity is yet complete.
  • We explain the link between the transition to a stronger US$ and our downgrade of Europe’s Oil and Gas sector. We raise our exposure to US$-sensitive growth that is likely to benefit from a positive reassessment of the earnings outlook in Europe.

Recommended sector and market asset allocation

The reference to the period of June-August last year has proved to be appropriate. Most EZ equity markets are already back close to their highs of June. Deflationary anxiety has met its reflationary response. It can no longer be said that the ECB is complacent about the risk of economic stagnation and deflation in euroland. The outstanding feature of this summer in financial markets is the transfer of volatility from equity to currency and debt markets. There is not just a supplement of reflation in the euro zone. There is also unprecedented monetary divergence between America and the euro area. The euro zone now has both cheap capital and currency adjustment. It also has investor scepticism about the ECB’s strategy, notably in respect of the message to “buy the Banks, not the Bunds”. We explain why we think there is more upside for equity values over the next couple of months before this year is done.

Investors have just discovered a new source of anxiety: Scotland’s referendum. There is a bigger story here in the way in which the nature of investment risk in Europe has been misinterpreted. There is crisis in Europe in 2014 but it is no longer financial in nature. Investors did not realise the vulnerability of Germany revealed by the conflict in the Ukraine. Cease-fire or not in the Ukraine, the conflict with Russia is unresolved. Nor have investors realised the implications of political divisions within Britain. Financial assets in the EZ periphery, both debt and equity, continue to out-perform. In fact, the distinction between the EZ centre and periphery is becoming obsolete.

We are making an adjustment to our recommended portfolio that relates directly to our message that Jackson Hole 2014 marked the transition to a stronger US$. We are downgrading Europe’s Oil and Gas sector to UW. The reinforcement of the US$’s role as a store of value raises the uncertainty about future returns on investment in commodity projects with high sunk costs and long lead times. The counterpart is to raise our exposure to US$- sensitive growth, both domestic and global, that is likely to benefit from a positive reassessment of the earnings outlook for European companies. We are closing our under-weight position in the Media sector, and moving from N to OW in Tech Hardware and Semiconductors.

Weightings and asset allocation for the MSCI Europe Universe



08/09/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 9.9 1.1 N (UW) 10
Automobiles & Components 3.2 1.5 N 3
Consumer Durables & Apparel 2.4 1.1 UW 2
Consumer Services 0.9 0.9 OW 2
Media 2.0 0.9 N (UW) 2
Retailing 1.4 0.9 UW 1
Consumer Staples 13.3 0.7 N 13
Food & Staples Retailing 1.2 1.0 UW 1
Fod Beverage & Tobacco 10.4 0.7 N 10
Household & Personal Product 1.7 0.7 OW 2
Energy 9.4 0.9 UW (OW) 8
Financials 22.7 1.3 OW 25
Banks 12.6 1.3 N 13
Diversified Financials 3.1 1.4 N 3
Insurance 5.8 1.1 N 7
Real Estate 1.1 0.9 OW 2
healthcare 13.1 0.8 OW 15
Healthcare Equipment & Services 1.1 0.6 OW 2
Pharmaceuticals & Biotechnology 12.0 0.8 OW 13
Industrials 11.1 1.1 UW 9
Capital Goods 8.4 1.1 UW 6
Commercial Services & Suppy 1.2 0.8 UW 1
Transportation 1.5 1.0 OW 2
Information Technology 3.3 1.1 OW (UW) 4
Software & Services 1.5 0.9 UW 1
Technology & Hardware Equipment 1.0 1.3 OW (N) 2
Semiconducors 0.8 1.1 OW (N) 2
Materials 7.9 1.2 N 8
Telecommunication services 4.9 0.9 N 5
Utilities 4.4 0.9 N 4
Exposure to risk
(beta value)
  1.02    
Lquidity ratio   2%    
* 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