December 14, 2016, by Dr. Christian Witt (YCAP Asset Management)
Ever since Donald Trump has been elected as the new President of the United States on November 8, 2016, European equity markets have soared (+5.9%). European Equities? This sounds odd given that Trump ran on a distinctly protectionist platform. Europe, with its chronic economic weakness and dependence on exports for growth, thus seems an unlikely beneficiary of the so called « Trumponomics ». Moreover, political risk is still piling up as elections loom in four major Euro Area countries (France, Germany, Italy, Netherlands) next year. So are European equity markets just spiraling out of control or is there more to the rally?
In order to approach an answer, we start by looking at the performance of three different investment styles within the MSCI Europe index universe, Minimum Volatility, Growth and Value (see Figure 1). It turns out that all styles were negative for the year up until the US presidential election. But since then the Value theme has vividly turned positive, while both the minimum volatility and growth strategies remained in the red. In fact, by the time of this writing, Value has outperformed the two competing strategies by about 11 percentage points. The sudden outperformance of Value also constitutes a rather abrupt reversal of fortunes since the Minimum Volatility strategy has consistently delivered the best returns over the last couple of year (see Figure 2).
To complement our analysis, we next examine the co-movement of excess returns relative to the benchmark. As Figure 3 demonstrates, the excess returns of the Minimum Volatility and Growth strategies are predominantly positively correlated in Europe. The reverse is true for the excess returns of the Minimum Volatility and Value strategies. Hence, the Minimum Volatility and Growth strategies apparently share some common characteristics, which in effect make them behave very similar to one another. This is why we have a further look into the composition of the three strategies (see Table 1). One major distinction stands out. While the Value theme is heavily invested into the financial and energy sectors (43.6%), the Minimum Volatility and Growth styles both considerably underweight them (16.5% and 6.0%).
And, indeed, the sectors weighting scheme appears to well explain the diverging performance ever since election night. For the financial (+12.2%) and energy sectors (10.1%) are the best performing ones within the MSCI Europe. By contrast, consumer staples, a favorite allocation of both the Minimum Volatility and Growth has been negative (-0.9%).
So what has changed since November 8, 2016 that would justify such a sudden divergence? Lobbyism and OPEC. First, already prior to the elections, European banks had lobbied heavily for watering down the Basel III capital requirements which had been introduced as a response to the 2007-08 financial crisis. They preferred a more relax regime given their struggles to comply with the rules making it difficult to compete with international rivals. However, until election, US officials had blocked all attempts for changes. But with Trump, an outspoken critic of stricter bank regulation, being elected into the White House their chances have considerably improved. Every ex-Goldman Sachs executive taking a seat at Trump’s cabinet table is a case in point. Second, since crude oil prices hit a multi-year low in February of this year most large oil exporters, both inside and outside of OPEC, have been busy to agree on production freezes or outright cuts to support prices. But it was only in late November that their joint efforts finally bear fruit when a deal was struck to cut production. Crude oil prices and the stocks of energy companies immediately soared in response. Hence, the European financial and energy sectors rallied because their respective fundamentals markedly improved.
In a nutshell, the MSCI Europe Value style has largely outperformed its Minimum Volatility and Growth peers since election night. This is because the Value strategy overweighs the financial and energy sectors which have soared over the same period. For their respective fundamentals have markedly improved. Financials directly benefitted from the outcome of the US presidential election because the likelihood of less strict bank regulations has improved. Meanwhile, in the energy sector, a widely shared agreement of oil exporting countries to cut production has sent the crude price soaring. Despite these potential game-changers European banks remain poorly capitalized and the oil price might fall again if US shale oil producers were to raise production on higher prices and efficiency gains (see Table 2). But the balance of opportunities and risks has markedly improved since November 8, 2016.
Figure 1: Performance by Strategy.
Figure 2: Performance of Different Investment Styles (2011=100).
Figure 3: Correlations of Excess Returns.
Table 1: Breakdown of Sector Weightings by Subindex.
Figure 3: Performance of the MSCI Europe by Sector since the US Presidential Election.
Table 2: .