After a volatile start to the year, European markets have shifted from opportunity to caution. Maya Bhandari, CIO – multi-asset EMEA at Neuberger, explains how evolving valuations and risks are prompting a recalibration of equities, fixed income, and currency positioning across Europe.
When the facts change, we change our minds. The ‘liberation day’ sell-off increased the value proposition of non-US markets, particularly in Europe and Asia. This is no longer the case.
When markets fell out of bed and volatility soared, as investors feared the worst in the immediate aftermath of ‘liberation day’ tariffs, we made three key high-level shifts.
First, we leaned into non-US equities, particularly European and Chinese stocks that were among the heaviest (price) casualties. We subsequently leaned into Japanese equities, where both fundamentals and valuations were and still are firmly supportive. Second, we upgraded non-US developed bonds, with a positive tilt towards Bunds in particular. We later rotated into US fixed income, taking advantage of relative valuation opportunities. And third, we took the US dollar down to underweight, hedging our dollar exposure where appropriate and tilting instead in favour of the euro.
Fast-forward two quarters, and we are cashing in on the European-focused liberation day risk trades, neutralising our call on both European stocks and the euro, where returns have been handsome and have come through with greater gusto than expected. We are also reestablishing longs in broader European fixed income – in German Bunds, UK gilts and European investment grade credit.
At its simplest, every risk has a price and while for riskier European assets – such as equities and the euro – both risks and prices have increased, they have moved oppositely and more favourably in fixed income. We are keen to capture this ‘20,000-foot premium gap’ between equities and bonds in our asset allocation recommendations. In reviewing strategies, one possible way to address this could be to consider increasing exposure to European fixed income and holding a neutral stance on the region’s equities, among other potential approaches.
Recalibrating European equities positioning
The famous John Maynard Keynes quote “When the facts change, we change our minds. What do you do, sir?” encapsulates how we are responding to evolving market dynamics, particularly in Europe.
In the dark days of early April, around the announcement of initially punitive tariffs ranging between 20% and 49% for individual countries, European stocks suffered significantly and ahead of global equities. Depending on the specific index, they shed 13-14% of their value over the course of the following week in an 11-12 standard deviation move. Turning long European equities was on our radar at the time – an asset we liked just got materially cheaper – and we moved European stocks to overweight, endorsing unhedged exposure by moving the euro to overweight – vs. the US dollar – in tandem.
There are broadly two reasons why we ever change our medium-term asset allocation views: either our assessment of the fundamental investment drivers of an asset or sub-asset class shifts or valuations/sentiment move such that a position turns more or less attractive. Both were strongly favourable on 2 April. But more recently, they have each shifted in a less appealing direction – favouring an at target rather than overweight stance towards European equities.
A breakdown of what has changed:
A similar set of factors, in addition to robust shareholder reforms, underpinned our optimism towards Japanese stocks, where we have recently increased our overweight position.
Different perspectives on fixed income and currency
At the same time as adjusting our equities positioning, we also turned more constructive on European fixed income, notably Bunds, gilts and investment grade credit. The unusual gap between equities and fixed income assets is one way in which we seek to capture this relative premium opportunity. To be sure, as long-dated eurozone bond yields – proxied by Bunds – have soared in both real and nominal terms, and earnings yields have fallen considerably (per above), a ‘premium’ gap – last seen around the early days of the Covid pandemic – between broad equities and fixed income has opened up, tighter credit spreads notwithstanding. This in real and especially nominal terms.
Importantly, from both an asset allocation and fixed income perspective, European yields should converge at a lower level; currently elevated yields jar with an increasingly soft growth and inflation outlook. For example, eurozone GDP growth is expected to remain sluggish, with both consumption and exports weak. Household pessimism is also poised to weigh on services, with political turmoil in countries such as France dragging down broader activity. Risks are skewed to the downside if German – and other prospective European – fiscal stimulus is slow to be implemented.
Less fiscal easing should also dampen upward pressure on term premia. On balance, and with inflation likely to fall in a broadly weak macro environment, the European Central Bank is expected to deliver additional easing and not stand pat as currently priced in by interest rate markets. The same general themes hold for the UK, supporting a positive stance on gilts.
And while the dollar remains more fully valued than it has been historically, it is not clear that these conditions will support further strength in the euro, which has already moved from near-parity to a whisker away from our ‘target’ of 1.20. Note that we stay long of gold as a way to capture wider dollar weakness, with important fundamental support.
For riskier European assets – such as equities and the euro – both risks and prices have increased. They have moved oppositely and more favourably in fixed income, widening the already significant ‘20,000-foot’ wedge between equities and bonds. As active investors, when the facts change, we change our minds.
By Maya Bhandari, CIO – multi-asset EMEA at Neuberger
