In the spirit of lessons learnt in 2016, potential risks should not be left completely unmitigated simply because opinion polls suggest they’re unlikely to come to fruition. While we can only speculate about the impact of a populist government seizing power in France and the likelihood of a very quick Frexit, its potential to tear at the very fabric of the eurozone would be unprecedented.
Nobody is suggesting that we should prepare for the impending round of European elections with extreme measures, such as buying up properties with natural gas wells, digging bunkers and burying several years’ supply of bottled water . However, we do need to be cognisant of the speed and aggression with which modern financial markets price in macro and geopolitical events. The growth in algorithmic trading means that there are increasing numbers of heavy baskets looking to buy and sell within seconds.
In the second-half of last year we witnessed how markets can move in advance of a shift in macro indicators, especially when a particular story gains popular credence, as it did with the so-called reflation trade. Our response to such an uncertain backdrop has been to actively reduce the underlying volatility of our potential returns as we head into the European election cycle. This means constraining our gross exposure and ensuring that we don’t build up significant net exposures in individual sectors.
It’s also important, however, to focus on the opportunity set. In the aftermath of Trump’s election victory, we witnessed a huge rotation into, and re-rating of, all that could be seen as cyclical. While on the other hand, everything that was deemed to be defensive or a bond proxy was left behind. Such wholesale shifts occurred completely independently of reported earnings statements.
This all points to differentiation making a strong comeback. Cyclicals that fail to meet inflated expectations are likely to suffer, while defensives that can demonstrate they have been unjustly punished should rally strongly. Indeed, we are already seeing the beginnings of a reversal in the so-called ‘Trump trade’. Furthermore, the scope for exploiting inefficiencies has increased as new regulations from MiFID II exert a direct impact on the structure of brokerages across Europe. A reduction in stock coverage clearly enhances the potential to benefit from under-researched opportunities.
Share price momentum (as measured by the Morgan Stanley European Momentum basket) suffered during the 2016 rotation, but has delivered positive returns in 10 of the last 12 years. It is logical that momentum does not tend to fail for two consecutive years, simply because major turning points in equity markets do not typically arise on an annual basis. We therefore look forward to the challenging period ahead with considerable optimism. Should we get through the European election cycle without risks materialising, the stock picking environment should prove more fertile than we have seen for some considerable time.
As the extreme dislocations stemming from the reflation rotation continue to correct, we should move from a backdrop in which it has been difficult to add any value from bottom-up security selection to one that is highly conducive to long / short alpha generation.