3 signs the EU agreement could be a big deal

It seems like investors are looking for the next trade. Could the dollar be the key?



The next trade

Investors have been hiding out in the tech and tech-enabled giants who have (to borrow a phrase from our Chairman and CEO) fortress balance sheets and clear paths to growth in a very uncertain time. In fact, the S&P 500 has not had this much concentration in the top five names (Apple, Microsoft, Alphabet, Amazon and Facebook) in over 40 years. Just from the end of May, those five stocks have added around $750 billion to their market capitalizations, which is comparable to the value of the entire S&P 500 energy sector. But there are some signs that investors are getting antsy as they look for the next trade. The NASDAQ 100 is down around -5% since trading near its all-time high on Tuesday. Microsoft is likewise down -5% even after reporting that its cloud computing business “only” grew at a 50% pace. But where is there to go? 

Do stock investors really want to venture back into the cyclical sectors of the market when the outlook is so uncertain? Bank stocks have been underperforming the market even more than they did during the Global Financial Crisis! They have built billions in loan loss reserves to protect against the coming rise in consumer and commercial real estate delinquencies and corporate bankruptcies. A lot of stress is still in the price, but is it enough to entice investors?

Meanwhile, gold is partying like it is 2011. Real yields (nominal Treasury yields minus inflation expectations) are plummeting, the dollar is declining against other major currencies, and money supply growth is shooting higher. Does this mean that 1970s style stagflation is coming? We don’t think so. Real yields are falling because inflation expectations are rising from very low levels, and nominal yields are being capped by the Federal Reserve’s bond buying program. Money supply growth is plugging the massive hole in financial markets and the economy that COVID-19 lockdowns caused. With no competition from bond yields, gold looks even more attractive.

That next trade? The dollar could be the key. If it continues to fall, it could signal that investors are finally starting to see opportunity outside of the United States. The European Union (EU) agreement could be a big deal, and the inability to contain COVID-19 and the uncertainty caused by the U.S. presidential election could make other regions look more attractive than they have been. The United States is still our preferred region, but regional diversification could prove valuable in the coming months.

3 signs the market is starting to think the EU made a breakthrough

Perhaps the most important driver of markets this week was the EU breakthrough reached on Tuesday.
The most important takeaways from the €750 billion recovery fund are:

  • It represents the first attempt at a fiscal redistribution mechanism within the Eurozone. The Eurozone has always been a monetary union, but it has never been able to enact fiscal policy to help all of its member states. This agreement changes that. The EU will be able to issue debt and use the proceeds to support weaker links. This mitigates the risk of a country having to leave the currency union, which has been a constant fear of global investors.
  • This increased Eurozone cohesion could result in inflows back to European risk assets. These flows should be supportive for the currency and markets.
  • This watershed deal isn’t an end-all-be-all solution, but it is a signal that compromise and burden sharing in the EU is possible. 

We see 3 key signs that the market thinks this could be a big deal.

1. Since Angela Merkel and Emmanuel Macron proposed the plan on May 18, the deal in combination with a broader rally in risk assets pushed EUR/USD higher to ~1.16, the highest levels in over a year. We continue to expect EUR/USD to rally.  

2. As of yesterday’s close, the Euro STOXX 50 had outperformed the S&P 500 by more than 6% since May 18. A USD-based investor can tack on another ~8%, given the euro’s move against the dollar in that same timeframe. That is roughly +14% outperformance.

3. The spread between Italian 10-year yields and German 10-year yields is declining back toward its post-financial crisis average. When trying to decipher what this means, a higher spread tends to indicate more stress in Europe, and a falling spread indicates less stress (and lower likelihood of a Grexit or Italexit or Spexit or Portugexit, etc.)

The recent agreement to install a fiscal transfer mechanism could signal to investors that a Eurozone breakup is highly unlikely, which should lead to lower risk premiums charged by investors for Eurozone assets—but it’ll probably be a one-off adjustment, rather than a period of persistent European asset outperformance. Indeed, Europe is still challenged by the fact that the European Central Bank is probably close to the limits of stimulus it can offer. Policy rates are already deeply negative, and bond yields are low. However, the fiscal agreement could augment the power of stimulus. In the United States, the federal government can spend money to support households and businesses while the Federal Reserve helps to finance the borrowing by buying Treasury bonds. This agreement could be a step in that direction for Europe.


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