Trading Ideas June 2010: Staying the course


IDEA of the month:  Staying the course

In our portfolio we stick to our high equity weight of 50%. We continue to prefer equity exposure outside Europe (US 20%, Japan 20%). Within Europe we prefer German equities (Dax 20% long vs. Eurostoxx50 short 10%). Equities have   been volatile  …….

over the last 6 weeks with a 10% decline, a subsequent 8% recovery, another 10% decline and another 10% recovery (Stoxx600). The market was torn between fears about sovereign risks on the one hand and an ongoing economic recovery and positive news flow from the company level on the other hand. Over the last two weeks risky assets have moved into different directions: equities have recovered, while peripheral European credit spreads have risen. Greece was downgraded to non-investment-grade status by Moody’s and Spain came increasingly into the focus, while company earnings estimates have remained stable over the last month in all major regions of the world.
With our high equity weight we are more positive than our scorecards. The equities score has declined to +1 and flags now only a marginal preference to fixed income with a 0 score (see top table). The valuation and the momentum score for equities are still positive, but the macro score is negative for equities.
Currency diversification has come increasingly into the focus of European investors over the last months. We had increased our US-Dollar exposure in our last note by buying the Fed Funds Effective Rate Total Return Index. This move has worked well with the Euro declining further since our last note 6 weeks ago, but recovering more recently. In this note we sell the Fed Funds Effective Rate Total Return Index and put the money into the EONIA benchmark index. Our FX strategists expect a strengthening Euro forecast for the second half of 2010. Still, 40% of our currency exposure is outside the Euro with 20% in US-Dollar and 20% in Japanese Yen.

Our economists believe markets are underestimating both the fundamentals and the EU’s rescue initiatives. With regards to fundamentals, they believe the global recovery remains intact with industrial and export indicators in the euro area benefiting. The joint rescue initiatives of the European Union/IMF with a volume EUR750bn is a very significant commitment of resources relative to the likely liquidity requirements of the peripherals. The ECB’s liquidity and bond purchasing policies are important backstops, the peripherals are correcting their imbalances in which the markets have lost confidence, and the reforms of the Stability and Growth Pact are proceeding apace. The austerity measures throughout Europe could become a burden for European GDP growth in 2010 and going forward and an argument in favour of equities outside Europe. For Europe our economist continues to expect a slowdown of GDP growth in H2/2010 whereas in the US the slowdown is expected to be less pronounced. Admittedly, risks might shift back from Europe to the US with some weaker economic data observed in the US in the last weeks.
Market volatility could persist for the next month or two until southern European governments have demonstrated their ability to pass difficult fiscal and labour measures.
Spanish cajas have been recapitalised and the ECB’s commitment has, we believe, been convincingly tested by the markets. The modelling of our economists suggests that Spain – the markets’ current focus of concern – is in better shape than is commonly assumed and will defy the fears that its banking system is in danger of collapse (see Global  Macro Issues, The EMU crisis: this centre will hold, 18 June 2010).
We continue to prefer equity exposure outside Europe (US, Japan) and within Europe we prefer German equities. Our regional equity positioning continues to reflect a preference for the growth regions within developed markets. Our economists expect US GDP growth in 2010 of 3.5%, Japanese growth of 3.3%, German GDP growth of 2.0% and Eurozone GDP growth of only 0.9%. In 2010 Germany may have the strongest GDP growth in Western Europe for the first time in 30 years. Germany and German exports benefit from stronger growth outside Europe. Our regional equity position is also supported by the latest CROCI report. Our CROCI team finds better value among equities outside Europe than within Europe (see CROCI views, 16 June 2010, The Contrarian Nature of European Value).
Our US equity strategist is still positive on US equities. His baseline remains that the economic recovery will continue, driven by the large sales-production gap, which remains sizeable. Equities could well correct up as they have in past episodes when corrections did not disrupt the economic recovery. Our Japanese equity strategist has become a bit more cautious. He expects a near-term TOPIX peak at 1,000 points, representing upside of 11.8%.
Japan has strongly underperformed all other major equity regions in the recovery over the last 12 months. With regard to the Euro-Dollar rate, market participants had struggled to find any scenario where the euro could stabilize, but the  recent Euro recovery seems to reflect a pause in this way of thinking. Our FX strategists expect a strengthening Euro forecast for the second half of 2010 with a level of 1.25 for end Q3/2010, a level of 1.30 for end Q4/2010 and a level of 1.35 for end Q1/2011. But Fed policy changes and Eurozone sovereign risks could make a Euro recovery more difficult.

Scorecard Asset Classes
Equities continue to be the most attractive class on our asset class scorecard. The scorecard is neutral for fixed income and commodities and negative for foreign exchange.

Scorecard Equities
Our region scorecard favours EMEA, supported by attractive valuation and positive momentum. Asia ex-Japan and Lat-Am are the least attractive regions, while Japan and the US appear neutral. According to our scorecard for European sectors, Oil & Gas look the most attractive, while Industrial Goods & Services is the least favoured.

Scorecards Fixed Income Commodities and Forex
In the fixed income segment, our scorecard continues to support the longer-maturity bond classes with Iboxx Sov. Eurozone 10-15 being the most attractive, while Global Sovereign Euro hedged and Iboxx Sov. Eurozone 3-5 Yrs bonds look the least attractive. According to our commodity scorecard, Aluminium and Heating Oil are most attractive while the Precious Metals group comprising Gold and Silver and Platinum finds the least favour. Our forex scorecard favours the Euro, while the Japanese Yen looks least attractive.

ETF Flows
Total AUM of all the European ETFs amounts to Euro 172.3bn with 65.2% of the AUM focused on equities followed by 13.9% on debt and 14.3% on commodities. On an aggregated basis, European ETFs overall enjoyed inflows of Euro 4.0bn (2.3% of AUM) over the last month. Credit ETFs attracted inflows of 19.8% of their AUM while exchange-traded commodities added 6.3% to their AUM. Equities remained moderately attractive and added 1.6% to their AUM. Even on a three-month horizon, the ETCs remained most attractive by adding 10.4% to their total assets. At the regional level, ETFs focused on Germany registered strong inflows of 25.9% of their respective AUM.

Overview of our current positions
“Dax” index 20% weight vs. Eurostoxx50 short 10%
The Dax could continue to outperform the Eurostoxx50 over the next months because Germany and in particular the Dax companies are structurally stronger and benefit more than other European countries from the global recovery via strong export growth and are less affected by problems in peripheral Europe and austerity packages throughout Europe. Therefore we keep a Dax long position with 20% weight and the Eurostoxx50 short with 10% weight. In 2010 our economists expect Germany to be the country with the strongest GDP growth in Western Europe, for the first time in 30 years. The German GDP growth 2010E of 2.0% compares to Eurozone GDP growth of 0.9%. The stronger German  GDP growth is mainly driven by very strong 2010E export growth of 9.0%. The German Ifo index surprised in June on the upside and reflects an ongoing recovery. Also German car companies see a continuing recovery especially due to strong sales in emerging markets and China. Within Europe, Germany is the country that benefits most from strong momentum in other global regions and the global synchronous recovery also supported by the weak Euro. The announcement of the Chinese government to reform the RMB exchange rate regime could become a longer-term positive for German exports to China. In addition to the current momentum, Germany is clearly ahead of most Peripheral European countries with regard to longer-term structural measures including GDP per capita, industry share of GDP, unemployment rates, unit labour cost growth, openness to trade, trade surplus and competitiveness scores. From 1998 to 2008, real German unit labour costs increased by only 0.7%. Germany has been able to keep its share of production to GDP roughly stable at a level of 25% over the past 15 years, whereas the production share has continued to decline in the other major European countries. Main risks for buying the Dax index are negative news flow from the German economy, especially German exports and a general decline of equity markets.

“MSCI USA TRN” index 20% weight
The economic recovery is expected to be much more pronounced in the US with a GDP growth 2010E of 3.5% compared to the Eurozone with 0.9% according to our economists. The decline of the Euro has additionally supported the performance of this US-Dollar position. Admittedly, the recent economic data in the US has been mixed, giving way to more concerns about a possible double-dip. Jobless claims rose and the Philadelphia Fed survey fell, although leading indicators posted a decent gain. Industrial activity continues to post a solid recovery. Manufacturing production rose again in May (+0.9%) for the fifth consecutive month. In conjunction with the industrial production data, durable goods are a key input into estimating capital spending (capex), which has made a noticeable V-shaped recovery. Following a sharp 21.3% peak-to-trough decline in capex that spanned Q4 2007 to Q2 2009, as measured in the GDP accounts, capex has grown at a 10.8% annualized pace since then and our economists expect another double-digit gain this quarter, marking the third such increase in a row. One reason is that corporations have a record amount of free cash  flow on their balance sheets. There has been only one double dip in the US in the last 60 years and three double dips in the last 160 years. The baseline scenario of our US equity strategist remains that the economic recovery will continue, driven as it has been so far by the large sales-production gap, which remains sizable. On this baseline view and the implied path of corporate earnings, US equities look cheap and should correct up as they have in past episodes when corrections did not disrupt the economic recovery. Our strategist therefore maintains his year-end target of 1375 on the S&P 500. But the rally in equities re-connecting to the economic recovery will likely take time. Both history and a variety of fundamental catalysts suggest risk aversion will persist through July and this is our baseline view. Main risks for buying the MSCI USA index are negative news flow from the US economy and a general decline of equity markets.

“MSCI Japan” index 20% weight
We had bought the “MSCI Japan” index two months ago because our Japanese equity strategist believes in a strong (mainly export driven) rebound of the Japanese economy. Japanese GDP growth 2010 is expected to come in at 3.4%, nearly as strong as for the US. Japanese Exports are expected to grow by 24.1% in 2010. Core machinery orders (i.e., private-sector orders excluding shipbuilding and electricity orders) increased 4.0% mom in April, up a second straight month after March’s 5.4% mom gain. The Japanese economy  looks to enter a soft patch in 4Q 2010 and 1Q 2011 due to the fading impact of fiscal stimulus measures enacted by Japan and governments worldwide. After this brief correction, our Japanese economist expects a return to a modest expansion. Our Japanese equity strategist does not see much downside risk in the short term because of low consensus valuation. He expects a near-term TOPIX peak at 1,000 points. The long-term trend even suggests that TOPIX could be trading above 1,100 points in 2010 (see Japan Investment strategy: EPS forecast changes and long-term Topix outlook, 22 June 2010). He believes investors have a solid opportunity to purchase Japanese stocks from a long-term perspective if 2005 is treated as the normal level. The appreciation of the Yen vs. the Euro was supportive for this position over the last two months. Main risks for buying the MSCI Japan index are negative news flow from the Japanese economy, especially Japanese exports and a general decline of equity markets .

Emerging Markets Liquid Eurobond Euro Index” 10% weight
We had bought the “Emerging Markets Liquid Eurobond Euro Index” mainly because of the attractive coupon. We acknowledge that this is a high-risk investment. However, contrary to the development in peripheral Europe (Portugal, Ireland, Italy, Greece, Spain), EM sovereign CDS spreads have mostly returned to their pre-crisis levels, indicating that fiscal policy makers there have weathered the financial storm relatively well. The two major regional blocks in the “Emerging Markets Liquid Eurobond Euro Index” are Latin America and Emerging Europe. The countries (issuers’) weight is determined based on GDP, GDP per capita, outstanding Eurobond volume and liquidity. The countries with the highest weight in the index are Venezuela, Mexico, Turkey, Brazil, Philippines and Russia.

Trading portfolio
This month we sell the Fed Funds effective rate total return index with 10% weight and transfer the funds into the EONIA total return index. The portfolio targets absolute return and has the EONIA index as benchmark.

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Source: Trading Ideas ETF: Ideas and Flows – Deutsche Bank AG

rated “BB”. 13% of the basket is rated “B” and this is one issuer, Venezuela. So the country
with the biggest weight in the index is also the country with the lowest rating. While
Venezuela is clearly a high risk country with 13% weight in the index, the remaining countries
are clearly more solid (for more details on the “MSCI USA TRN” ETF see ETF: Ideas and
Flows, 25 November 2009).
“db x-trackers Currency valuation” ETF 20% weight
In currency markets the majority of the participants are “liquidity seekers”. “Profit seekers”
are a minority in currency markets and can generate returns on the expense of the “liquidity
seekers”. Profit-seekers can generate returns by buying “under-valued” currencies and
shorting “over-valued” currencies. A widely used measure to determine “under-valued” and
“over-valued” valuation for currencies is the concept of “Purchasing Power Parity” where
“fair” exchange rates are calculated by comparing the prices of a basket of goods in different
countries. The ETF “db x-trackers Currency valuation” buys each quarter the three currencies
with the “lowest” valuation out of the universe of the G10 currencies and sells the three
currencies with the “highest” valuation using the PPP concept. In addition, the correlation to
equities and bonds is very low and therefore the currency valuation index helps to diversify
our ETF portfolio. The index is currently long in the US Dollar, New Zealand Dollar, and the
British Pound whereas the index is short in the Swiss Franc, Swedish Krona and the
Norwegian Krona. Risks to the investment include that currencies movements become less
rational again. Especially increased uncertainty about the economic development could
trigger a flight back into expensive currencies like the Swiss Franc (for more details on the
“db x-trackers Currency valuation” ETF see ETF: Ideas and Flows,12 June 2009).
Trading portfolio
We have kept the portfolio unchanged this time. Earlier we bought the “Emerging Markets
Liquid Eurobond Euro Index” ETF with 10% weight and sold the “db x-trackers DJ Stoxx
Global Dividend 100 ETF”. The portfolio targets absolute return and has the EONIA index as