Data Assets & Alpha Group: Underperformance in European equities

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Eloise Goulder: Hi, I'm Eloise Goulder, head of the Data Assets and Alpha Group here at J.P. Morgan. And today, I'm so pleased to be sitting down with both Federico Manicardi, head of International Market Intelligence, and also, Jigar Vakharia from our Global Positioning Intelligence Team, and we're here to discuss dynamics in European equities. So Federico, Jigar, thank you so much for sitting down with me today.

Frederico Manicardi: Thank you for having me, Eloise.

Jigar Vakharia: It's great to be back here, Eloise. Thanks.

Eloise Goulder: So European equities are up 7% or 8% year-to-date, but they have been pretty soft recently. The major European indices are down around 2% since their peaks in mid-May. And more significantly, European equities have really sharply underperformed US equities in recent weeks.

While US equities have continued to rally and to hit fresh all-time highs, European equities, on the other hand, have underperformed their US peers by about 5% over the last month. So the key question, I think, is what's going on, both on the macro fundamental and the political front here in Europe? Federico, can we start with you? How would you characterize the backdrop for European equities right now?

Frederico Manicardi: Yes, of course. I'd argue the first leg lower, which occurred in the week of June 10, was primarily driven by French election risk. We saw quite clearly that the announcement of snap election on Sunday, June the 9th, triggered an increase in risk premia across Europe.

I would note here the EGB spreads have generally widened, with 10-year OAT bonds spiking to 80 basis points, a level that will last so before the French election in 2017. Stoxx 600 underperformed US equities recently, as you noticed. And the underperformance of [INAUDIBLE], French domestic, and French banks have been even more pronounced. And the spread between V2X and VIX widen above 5 basis points, which is really close to the higher end of the trading range. Bear in mind France will go to the polls on June 30 and July 7 via two-round system. Based on the polls, there are two scenarios that are likely at this point. The first is cohabitation, or [FRENCH], i.e., a backdrop where an absolute majority outside of Macron's party will emerge and form a government while Macron will stay at President. Le Pen's party, [FRENCH], seems the most likely to achieve this based on the polls. When the election were announced last week, market discounted the [FRENCH] 2022 platform, which was heavy on fiscal. But the more positive developments recently is that the party has softened its tone on the fiscal side, and more clarity has emerged on costings of each party manifesto. The other likely scenario is gridlock, i.e., a situation where no coalition obtains an absolute majority. In this case, there is many potential outcomes which could be without precedent. For example, cohabitation with no majority or a technocratic prime minister. We think this scenario could be market-friendly on French assets near term because concerns around fiscal should diminish as new spending will face headwinds in this situation. And tactical risk premia are present. For example, OATs are double A minus rated, but the spread to bond is currently trading very close to single A corporates. That said, the impact on French fundamentals, including deficits and debt to GDP outside of the immediate will be less clear.

Eloise Goulder: That's interesting. Thanks, Federico. So that's the politics in France. And, as you said, it was just after that French announcement of snap elections on Sunday, June the 9th, that markets sold off, that OAT spreads widened, and European volatility picked up relative to US volatility. So that French elections risk really does seem to be the primary driver of market weakness in recent weeks in Europe.

But what about the fundamental or the macro backdrop, Federico? Growth in PMIs had been gradually improving across Europe, admittedly from a low base over the last six months or so. So what does that picture look like today?

Frederico Manicardi: Macro fundamentals in Europe have improved relative to the start of 2024, as you said, but I would still categorize the backdrop as mixed. After a big improvement in the first quarter, the trend in economic surprises has moderated. And last Friday, PMIs in the euro area, Japan, and the UK were notably softer than expected. In the euro area, particularly, the composite PMI remains above 50. But the month-over-month drop was quite significant, as the new orders component dropped 2 and 1/2 points to now 49.2. Meanwhile, the manufacturing sector has remained below 50 in 2024, and it's now back to levels that we last saw in January. On the inflation side, headline has been normalizing further in 2024, but inflation has been more sticky on core services and wages. The silver lining is probably that central banks have started to cut rates. ECB has made a first cut earlier in June. The Swiss National Bank surprised the market last week with a 25 basis point cut, while the BoE has remained on hold but signaled willingness to cut despite the April and May CPI surprise.

Eloise Goulder: So between the French political risks and the incrementally less supportive PMIs, the backdrop across Europe has certainly deteriorated. But then the silver lining that inflation, at the headline level at least, is moderating and the ECB has now made its first cut. So before I ask for your views, Frederico, both at a market level and a sector level, can we turn to Jigar now on the positioning front. Jigar, how much have hedge funds been selling Europe in the context of all of these risks?

Jigar Vakharia: Sure, Eloise. Looking at overall European flows and positioning, we have seen quite a lot of selling by hedge fund clients in our prime book for a six-week period from last week of April to first week of June. In fact, around mid-May, Europe was one of the most sold regions globally, with five-day rolling flows down over two standard deviation and four-week rolling flows down over 1.6 standard deviation, driving positioning levels down to neutral versus our close to 10-year history, well below the more elevated, close to 70th percentile levels, we saw around early March. Most of that selling was across continental Europe rather than the UK. Outside of our hedge fund flows, if we look at CTA specifically via our structuring teams CTA models, we see positioning in Europe having fallen from very stretched levels in mid-May, around 95th percentile, down to close to neutral levels at around 65th percentile. Interestingly, we did see hedge funds start to buy the dip across global markets, including Europe, over the last week. But given the weakness in Friday's PMI, that buy the dip mentality may not be here to stay.

Eloise Goulder: So hedge funds had already somewhat reduced exposures to European equities going into the period of underperformance that we've seen over the last couple of weeks. And Jigar, what about France, in particular? Have we seen particular selling in French equities around this elections news?

Jigar Vakharia: Actually, hedge funds were in net long French equities to start with on our data. So we haven't seen incremental selling in this space over the last two weeks. Based on our flows, it looks like many investors have hedged French election risk with Europe as a whole, rather than specifically in French single stocks.

Eloise Goulder: Interesting. And it's worth noting that about 40% of the euro stocks is actually made up of French stocks. So hedging with the euro stocks has probably been seen as a more liquid way to hedge these risks than in French stocks in particular. So what about sector views then, Jigar? You mentioned that positioning across Europe as a whole is looking relatively more neutral now versus our 10-year history. But there must be sectors where positioning is looking heavier or lighter.

Jigar Vakharia: Sure. On the heavy side, we still see positioning quite elevated across many cyclical sectors. In aggregate, we see hedge fund net risk to cyclical versus defense views are near two-year highs, though remain below the 2021 to early 2022 levels. But we see positioning particularly high across cap goods, aerospace, and defense, materials, luxury goods, and also [INAUDIBLE] within tech. On the flip side, positioning looks much lighter across defensive sectors, such as utilities, pharma, staples, and telcos.

Eloise Goulder: Thanks so much, Jigar. So I guess the key question is, what's next? Can European equities bounce back, or will they continue this period of underperformance, especially post the weaker PMIs on Friday? And also the, question is, which pockets are we more bullish on? So Federico, can I turn to you on this one first?

Frederico Manicardi: Sure. The market intelligence view has been bullish on US equities in 2024. But when it comes to Europe, we have been a bit more cautious. Right now, we would maintain our neutral stance and continue to focus on long, short ideas. We have longs in travel and leisure and energy versus Stock 600. Spaces that we are watching though, considering political risk and the change in the PMIs, include becoming potentially more bullish on defensive, given the rates view and evaluation dislocation to cyclical, as well as the positioning argument that Jigar just mentioned. Our potentially more bearish view on banks, considering the sector is a year-to-date consensus long, which has benefited from the high for long narrative this year, which could change. And finally, potentially looking at assets more exposed to French political risks that could reprise in a gridlock scenario that we described earlier. In the UK, election are approaching too and will take place on July the 4th. The 20 percentage points lead that the Labor Party has in the polls suggests a Labor majority is quite likely. Our flagship trade since mid-May has been a long in FTSE 250 versus FTSE 100. We have motivated this preference for mid-caps on deep value considerations, positioning, and some macro tailwinds coming from BoE easing and the outcome of the UK election.

Eloise Goulder: Well, there's so much to watch there, and thank you for providing all of your sector views. So Jigar, do you have anything to add on these points?

Jigar Vakharia: Yeah, sure. I want to add something on performance. As European markets have generally underperformed over the past month, we have seen hedge fund add gross led by multi-strat funds. And this regrossing has generally correlated with improved alpha. That is, long-short spreads and better performance in EU momentum factor.

And lastly, on UK elections, UK equities has been less volatile, being bought for five months now. Positioning, too, has risen to 2.5 years high, currently at 82nd percentile. We have seen buying of labor potential winner baskets versus selling in labor potential headwinds baskets since the general elections has been announced.

Eloise Goulder: Those are interesting points. So thank you so much, Federico and Jigar. I think it's been a really timely discussion on Europe, given the sharp underperformance in European equities recently and those weaker PMIs on Friday. And, of course, given upcoming elections across both France and the UK in the coming weeks, it's certainly not all looking rosy. I had been putting the European equity underperformance down to French elections risks alone, but Friday's weaker PMIs really do point to potential cracks in the macro picture, too. But, of course, as you say, there are opportunities. And if positioning is particularly light across defensive sectors, these could be interesting as the possible outperformance from here. And it is worth noting that our equity strategist Mislav is overweight defensive sectors in Europe. It's going to be fascinating to see how this all unfolds in the coming weeks.

So thank you, once again, Federico and Jigar.

Frederico Manicardi: Thanks, Eloise. It was great to be here.

Jigar Vakharia: Thanks, Eloise. Glad to be here again.

Eloise Goulder: Thanks also to our listeners for tuning in to this biweekly podcast series from our group. If you have feedback, or if you'd like to get in touch, then please do go to our website at jpmorgan.com/market data intelligence, where you can reach out to us via the Contact Us form. And with that we'll close. Thank you.

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