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Long America, Short Europe

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A few months ago, we published an article titled β€œLeading Indicators Are Deteriorating; It’s Time To Sell The Indices,” urging readers to consider trimming their positions in global equities due to the worsening economic landscape worldwide.

Since then, markets have remained flat or even declined, and the latest leading economic data continues to paint a concerning picture. Today, we will explore the significant changes in the global economic landscape, their implications, and strategies for capitalizing on emerging trends.

In brief, while there have been some improvements in the outlook for U.S. equities (NYSEARCA:SPY), the European Union (EU) (NYSEARCA:VGK) continues to face challenges. This dynamic creates an interesting opportunity for a pair trade in an otherwise volatile and uncertain environment.

Now, let’s delve into the details!

Before we proceed, let’s recap some crucial points from our earlier article that shed light on how markets operate today. This understanding is essential to grasp why we emphasize macroeconomics so heavily.

Traditionally, investors analyzed individual stocks, focusing on specific companies and their earnings drivers. However, the rise of indexing and passive investing has resulted in thinly traded stocks and a reversal of the cause-and-effect relationship.

We introduced the β€œ50/30/20” rule, which suggests that 50% of order interest in any given stock is influenced by market index fund flows. Another 30% is influenced by industry or sector fund flows, leaving only 20% influenced by individual or institutional trading interests. In other words, macroeconomics dominates over single-stock efficiency.

Given these dynamics, we advocate for a β€œtop-down” approach to investing, aligning with broader economic and industry trends. Understanding the direction of the global economy is crucial for successful modern investing.

Now, let’s examine the main economic regions across the globe.

The United States

Overall, the outlook for U.S. GDP is mixed. Manufacturing showed a modest improvement in September, but the soft landing narrative persists, suggesting a weaker economy. Services and consumer sentiment indicators have declined, with consumer sentiment reaching β€œContractionary” territory. Additionally, the negative yield curve adds to the concerns. However, housing and junk credit present more favorable signs. In light of these factors, we prefer defensive stocks and remain uncertain about the possibility of a recession.

Europe

Recently, the Eurozone has decoupled from the U.S. as the region struggles to mirror the strength seen in American services and housing. Manufacturing and consumer sentiment indicators are weak, and EU services have dipped below the contractionary threshold. The yield curve remains inverted. Given these leading indicators, we maintain a bearish outlook on EU cyclical stocks and recommend defensive investments until we see signs of improvement.

The United Kingdom

Similar to the EU, the United Kingdom has decoupled from the U.S., with leading indicators continuing to worsen. Manufacturing is contracting, and services took a turn for the worse in July. Although consumer sentiment improved slightly in September, it remains within a neutral zone. Housing is the only bright spot. Considering these factors, we expect the UK to be a drag on global GDP growth and favor defensive stocks in this region.

China

China’s economic picture is mixed and somewhat bearish. Manufacturing recently entered an expansive phase, while services remain strong. A significant concern is the slowdown in housing starts, which may indicate lower demand for commodities and impact global GDP growth. Although some anticipate government stimulus, we do not expect it to be highly effective due to demographic and supply issues. Considering China’s credit challenges, we are monitoring the situation closely. Overall, China’s debt-fueled growth may have consequences for the country.

Japan

Japan stands out as one of the more bullish economies globally. While manufacturing remains in contractionary territory, services and housing indicators are relatively strong. Combined with a strengthening yield curve, this paints a positive picture for cyclical equities in the region.

India

India continues to maintain a favorable global position. Manufacturing is robust, services indicate significant growth, and housing continues to expand year over year. Although consumer sentiment remains below its midpoint, it has been gradually improving. The yield curve remains positive, albeit relatively flat. Considering these factors, both India and Japan seem like interesting places to find refuge from the economic challenges faced by the EU.

Based on our analysis of global economies, the most apparent trade is to go long on solid U.S. companies and short weaker EU counterparts. This strategy leverages the strength of U.S. companies with robust fundamentals and positions against weaker EU companies with greater earnings exposure to the economic cycle. Even if executing this trade in detail is not feasible, the broader theme remains intact: Long the U.S. economy (SPY) while shorting the EU one (VGK). We expect this trade or a similar one to outperform significantly over the next six months, offering lower volatility compared to directional positions in other regions. We hope you found this analysis valuable, and if you did, don’t forget to share it with others.

Cheers!

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