Trading Ideas May 2010: Reducing the equity weight

IDEA of the month:  Reducing the equity weight

Major sovereign risks as far as the eye can see have started to materialise in the Eurozone. This has triggered a strong decline in equities: the MSCI World declined by 8% over the last two weeks. Strong …….

Q1 reporting and strong economic data have not been supportive for equities anymore. The decline in equities has clearly hurt our index portfolio with a high equity weight of 75% and has partly taken away the outperformance generated YTD.

In order to lower the downside risk we reduce the equity share in the portfolio from 75% to 50%. We do this by selling the Stoxx600 Banks index which was the position with the highest beta/risk in our portfolio. Instead, we buy the Eurostoxx50 short with 10%. The long Dax position vs. Eurostoxx50 short reflects our preference for Germany over the Eurozone. Our economists expect Germany to be the country with the strongest GDP growth in Europe in 2010E for the first time in 30 years. Germany benefits more than other European countries from the global recovery via a strong export growth  from which the Dax companies benefit more than the Eurostoxx50 companies.

The Eurozone is in the focus of the sovereign risk worries and consequently the Euro has fallen to a 14-month low vs. the US-Dollar (but is still 7% above the 12-year average).
Currency diversification will come increasingly into the focus of investors. Our portfolio held already 40% in Non-Euro currencies (20% US-Dollar via MSCI USA, 20% in Japanese Yen via MSCI Japan) and this has been supportive during the Euro decline. We increase the currency weight outside the Euro to 50% by buying the Fed Funds Effective Rate index with 10% weight.
Our economists and equity strategists are clearly more positive for the US than forEurope. The US benefits from a much stronger economic recovery in 2010, a strongerQ1 reporting, a stronger momentum in earnings upgrades and is much less affected from the sovereign risks in the Eurozone. This is reflected in our portfolio with a 20% weight of the MSCI USA.


Idea of the month: Prefer Dax30 over Eurostoxx50
The equity performance over the past six months shows a clear gap between Core and Peripheral Europe. Since 1 Oct 2009, Core European countries have posted a performance of 6.7% (simple average), whereas Peripheral Countries have declined by 18.2%. Greece, Ireland, Austria, Spain and Italy have been the weakest performers since 1 Oct 2009, but have been the strongest performers in the six months beforehand . The sovereign risks in Europe and more diverse country performance make country strategies increasingly important for stock returns.
The Dax has posted a positive performance of 7.3% since 1 Oct compared to -3.0% for the Eurostoxx50. In our view, the Dax could continue to outperform the Eurostoxx50 over the next months because Germany is structurally stronger and benefits more than other European countries from the global recovery via a strong export growth. Therefore we keep our Dax long position with 20% weight and have bought the Eurostoxx50 short with 10% weight. We discuss the call in more detail on the following pages.




“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 3.8% compared to the Eurozone with 1.1% according to our economists. The stronger growth is also reflected by the stronger Q1 reporting season in the US compared to Europe. With more than half of the S&P 500 by market cap having reported, EPS is coming in a strong 20% above consensus for the firms that have reported. Our US strategist is positive for the US equity market. Because of the strong Q1 reporting he has raised his year-end target for the S&P 500 to 1375. US outperformed Europe recently because it was less affected from the sovereign risk discussion. The decline of the Euro has additionally supported the performance of this US-Dollar position. Also economic data continues to come in strong in the US. Non-farm productivity has increased to a year-on-year rate of change to 6.3%, the highest reading since Q1 1962. The April manufacturing ISM finally breached 60, rising to 60.4 from 59.6 previously. The April Chicago PMI continued a succession of strong readings from the various regional production surveys in April. The fiscal stimulus package has increased fiscal deficit in 2009F to 10.2% driving overall public debt levels to comparably high levels with debt hitting debt hitting 53 percent of GDP in FY2009 and poisoning it to rise to 70 percent of GDP by FY2012. . Main risks for buying the MSCI USA index are negative news flow from the US economy, including the commercial real estate market which remains mired in a deep recession with its output shrinking 14.0% in Q1.

“MSCI Japan” index 20% weight
We had bought the “MSCI Japan” index one month ago because we believe in a strong (mainly export driven) rebound of the Japanese economy and a moderately favourable valuation of the market. The appreciation of the Yen was also supportive for this position. Overall news flow has been positive for Japan. FY3/10 results began on a positive note. of the 321 TSE First Section companies, results were better-than-expected for 261 and worse for 59.The median of the BoJ policy board members’ forecasts for real GDP growth in FY10 was revised upward from January’s +1.3% to +1.8%. Real spending of all households jumped 5.9% MoM after seasonal adjustments in March (vs -1.6% in February), the first rise in three months. Japan had a seasonally adjusted trade surplus of ¥666.2bn in March, up 41.2% from the previous month’s ¥471.8bn. Nearly all product categories posted substantial export growth YoY in March in both volume and value terms.

However, industrial production edged up 0.3% in March, below the consensus expectation of a 0.8% increase in a negative surprise. At the same time, nationwide CPI was down 1.1%. Japan’s public debt represents 189.8% (2009F) of GDP, by far the highest debt rate in the industrialized world. Still, our economists do not expect any fiscal adjustments, as Japan is equipped with low interest rates and a current account surplus that enables the country to postpone a painful adjustment. The current account surplus seems unlikely to disappear, thanks to the large private saving surplus. The Upper House election in July could result in a “no winner” situation where neither the ruling parties nor the opposition LDP obtain a majority. This could relegate important policy decisions to the back burner .


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 clearly admit 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. Their CDs spreads have been largely unaffected from the worries in the Eurozone .


“Stoxx 600 Banks” index
We have sold the Stoxx600 Banks sector because risks have increased since our last note. The risks are reflected in a strong decline of the Stoxx600 Banks sector of 18% over the last 2 weeks despite good Q1 reporting by many investment banks. Overall market focus over the last weeks has been on sovereign risk in European peripheral countries (Portugal, Ireland, Greece, Spain) and European Banks exhibit a large exposure to these economies. One more negative for Banks are the plans for stricter regulations/ higher taxations.

Trading portfolio
This month we buy the “Euro Stoxx 50 Short Index” with 10% weight and “Fed Funds Effective Rate Total Return Index” with 10% weight. We sell “Stoxx 600 Banks TR Index” with 15% weight and partially sell the “Short IBOXX Euro Sovereign Eurozone TR Index” by 5%. 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

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