German Bunds Suggest a Defensive Stance is Warranted in EuropeJuly 07, 2014
There are 10 economic sectors in the MSCI World index, and we assemble them into four basic combinations to understand trends in the stock markets.
The four basic baskets are:
1) Counter-cyclicals: Utility, Telcom, Health Care and Consumer Staples
2) Early Cyclicals: Consumer discretionary
3) Hyper Cyclicals: Financials and information technology
4) Late Cyclicals: Energy, Basic Materials, Industrials
From there we can create derivative combinations to dig deeper in equity performance. For example, we combine all the cyclical baskets into a basic All Cyclicals basket.
Focusing on the MSCI Europe index, all the cyclical sectors represent roughly 75% of all the names in the index, while counter-cyclicals are just 25% of the total number of companies.
Bond yields in Germany have been on the decline this year, with rates near to breaking out to new lows. This is an important variable when thinking about asset allocation in Europe. Over the last five years, European counter-cyclicals have outperformed cyclicals by almost 21%, and the relationship with German Bund yields is quite strong at -93%. In the chart below, we overlay the relative performance of MSCI Europe counter-cyclicals to all cyclicals compared to German Bund Yields. If Bund yields continue to decline, a defensive stance on European stock selection seems warranted.
Over a longer period of time the relationship holds up quite well. For most of the 1990s and early 2000s, while interest rates were mostly stable, the relative performance of counter-cyclicals vs. cyclicals oscillated in a somewhat narrow sideways channel. In 2007, when German Bunds began a descent from around 5% to the current 1.27%, counter-cyclicals experienced a two-fold relative performance surge.
Needless to say, this has made stock selection in Europe very difficult as only 25% of the companies have been dramatically outperforming the other 75% of companies.