ECB Preview: European Equities
An Overview Of The Assymetrical Setup In European Equities
So Powell signed out, Warsh is signing in and oil is trading above $100 again.
Now Warsh signing in is not a nothing event. So the question everyone asking is wrong… "is Warsh hawkish/dovish", the question should be "are Warsh’s theories accurately priced?". The market has had months to price this transition, anyone acting like this is a fresh catalyst is operating off misinformation.
Before we get into this report, I highly recommend you read these reports below as we have moved directly in lockstep with those views and it relates to this idea that I’m laying out today:
Straight into it, the MOST important thing I’m watching right now is how cross-asset pricing of stagflation has shifted into a reflation style pricing. Now for everyone who is saying, “well oil above $100, hikes priced so equities will probably crash” are forgetting how markets work. Crashes are caused by an asset-liability mismatch that is almost ALWAYS not priced. We’re literally not seeing that, GDP nowcasts across the board are showing how strong growth is despite this energy tail-risk, but not only that, European equity markets have already priced the ECB forward curve.
Now for equity markets to move LOWER (particularly European), there needs to be a FURTHER extreme priced (I’ve spoken about this a bunch of times in previous reports how markets price things VERY fast, they also price extremes). So now we need a tail-wind to FURTHER push European equities lower, which I don’t see as my base case.
Let's say the ECB across the next month double down and basically say they're going to hike 3 times, the markets have already priced that so the markets will just trade the growth data because they want to see if this energy shock has transmitted into any reasonable slowdown.
This is the setup that is causing tail risk to European equities (fully priced in).
And this is how the DAX has responded to that, 6% off ATHs:
Ok so where do I see value? Well there's no doubt that if things don't materialise anywhere in the ECB forward curve (highly unlikely in my view, I don't even think 75bp of hikes will be realised let alone more). I also think that when it comes to this type of shock, growth matters more than anything. So people will get caught up in watching inflation (very important of course), but if that inflation doesn't feed into lower growth then markets can brush it off until inflation is high enough for long enough that it negatively drags growth, then equities will melt down.
But the simple fact is that coming to the market assuming mispricing ALL the time is operating from a place of superiority, which we don't have in markets honestly. Like if you are to assume that your thesis is correct and the market is always mispricing something, then you may get caught offside a lot (I used to struggle with this issue). So instead what I tend to do is have a thesis, look at market pricing and then look at the gap between the two and see if there's actually value to extract between the two, or is my thesis/timing completely off? (you could say both).
I’m also not saying that the market can’t misprice stuff or at least price things that are unrealistic (it can, and does a lot) but to assume that it’s always mispricing a completely different regime all the time is not the way to start.
I like monitoring the risk curve when I hear things surrounding growth crash, recession etc. Do we think that there is some imminent recession or growth crash when the Russell is outperforming ES like this? No. Indices like Russell feel the hit first and by the way, markets price things BEFORE we get data because everyone is ALWAYS nowcasting things. So unless everyone is nowcasting things completely wrong and there is some extreme tail risk we don't know about that isn't priced, it's HIGHLY unlikely we're going to see some type of imminent growth crash or recession, it'd be at least beginning to be priced in my view.
My view is that holding risk being long DAX here makes more sense than being exposed to US equities, I think if the ECB come out today and double down on 75bp, yes it may cause a shakeout but it’s heavily priced, hedges unwind around catalysts and it’s unlikely to push a market down massively considering it’s priced. Remember, energy shocks are almost always seen as transitory if it’s supply led.
Look at every supply-led oil shock in the last 30 years that wasn’t accompanied by a demand collapse, 1990 Gulf, 2011 Libya, even the initial 2022 Russia spike, the equity drawdowns were SHARP but short, 2-3 months max, and then markets re-rated higher once it became clear demand wasn’t breaking. The shocks that actually killed equities (2008, 2020) were demand-led or had a demand-collapse component. So the question I’m asking myself constantly is, is there ANY evidence demand is breaking? PMIs, payrolls, retail sales, credit card spend, none of it is rolling over. Until that changes, this is a supply story and supply stories get faded.
There’s very much the same setup in the UK and it wouldn’t be a silly idea in my view to be exposed either directly to SONIA to trade an unwind in the forwrad curve, or FTSE futures. I just think European equities are a better expression.
There's obviously a tail risk to this. If growth data across the next month meaningfully trades lower (whether that's from energy or not doesn't matter) then I'd expect DAX to start moving lower. If oil trades ABOVE $100 for the next 2 weeks I'll also start getting a little concerned about the timing of my longs because of the Eurozone's energy dependence.
And the reason I'm picking DAX over CAC or Eurostoxx is because the DAX is the most cyclically geared of the European majors, heavy industrials, autos, chemicals, so if the growth data holds up like the nowcasts suggest, DAX gets the biggest beta to that. CAC is more luxury/defensive weighted and FTSE is basically an energy/miners proxy at this point so it trades its own thing. if my thesis is "ECB hawkishness is priced and growth is fine", DAX is the cleanest expression of that, you want the index that's been punished the most on the growth fear and has the most operating leverage if growth data comes in fine.
So to put numbers on it, my line in the sand on DAX is the recent swing low (23,486), if we break that on growth data deterioration (not on an ECB headline, those get bought back) then I'm out and reassessing. On oil, sustained above $100 for 2-3 weeks is my warning, sustained above $110 and I'm cutting regardless of what equities are doing because at that point the Eurozone energy dependence math stops working. Thesis is thesis, but you have to know where you're wrong before you put the trade on otherwise you're just hoping.
Thanks
Alfie