Kirsten Longbottom
Welcome to the EPFR Exchange Podcast. My name is Kirsten Longbottom and today we welcome another partner for our Nowcasting series where we discuss economic issues in real-time through fund flows and other high frequency economic indicators. Each month, the EPFR team invites a partner to join us in a discussion on the latest themes and trends in the global financial landscape. Today we have Huw Roberts from Quant Insight to share his perspective alongside EPFR’s Director of Research, Cameron Brandt. Huw, thanks for joining Cam and I today. Want to tell us a bit about yourself and Quant Insight?
Huw Roberts
Absolutely. Firstly thank you for having me. Quant Insight is a company with a bit of a difference really because there is a sea of research out there from the sell-side, from the buy-side that is predicated off a lot of very clever people's opinion. We have lots of experience in financial markets. But the keyword there is it's all opinion and we think there is a gap in the market for a rigorous quantitative framework that relies on mathematical techniques rather than subjective opinion. So, we have built models across asset classes: equities, bonds, currencies, commodities, credit, etc. globally, US, Europe and Asia and it takes a bunch of macro factors broadly growth, levels of financial conditions things like that, the shape of the yield curve, the level of real yields, the strength of a currency, what the central bank is doing and then various measures of risk appetite. And distills it down into a macro warranted fair value. So people can basically get a sense of whether an asset is in a macro regime or to the EPFR point is being driven more by flow and sentiment. And if it is in a macro regime whether it is rich or cheap relative to prevailing macro conditions and that is how our client base use it and it's great to be on here today talking to Cam and yourself.
Kirsten Longbottom
Great, so in the latest headlines I've noticed that the ECB and the Fed have been coming up a lot just talk about kind of what decisions they're going to be making in the next couple of months and even weeks coming up. So the ECB has definitely appeared to have turned hawkish. What do the QI models think does that mean markets are turning to a risk-off scenario?
Huw Roberts
Yes, yeah, interesting question because obviously we're well aware the Fed pivoted hawkishly several months back that’s a known known in Rumsfeld speak. The ECB pivot has been more recent and just last week obviously we had the governing council meet. They confirmed the end of QE and with that they confirm they'll have the first rate hike in July. So what was probably the standout from yesterday's ECB meeting was that Governor Lagarde left the door open for a 50 basis point rate hike which is more than is being discounted- or at least was prior to last Thursday- was more than was being discounted by money markets. So I think it's very fair question. I think the ECB have pivoted more hawkishly. In terms of what it means for European equities at the broad level. There's a subtle but very important distinction that needs to be made when you look at our models and the reaction function of European equities. ECB hiking rates and ECB unwinding their balance sheet are actually positives for equities. That would be surprising for many people to hear. But the mathematical relationship actually shows that rate hikes and quantitative tightening are positive sensitivities. But and there is a big but. All the other aspects of financial conditions are pointing in the opposite direction. So European equities need lower real yields, they need tighter credit spreads, critically they need BTP-BUN spreads or more generically southern European peripheral bond yields relative to northern European counterparts to be well-behaved and they need risk appetite to be well-behaved vixed to remain low etc. So it’s a slightly nuanced answer for which I apologize but it's a very important point because the ECB obviously has direct policy levers hiking rates, unwinding their balance sheet that they can control and they want to tighten financial conditions. But what they don't want to do is release a wholesale shift that tightens financial conditions across every metric credit spreads, BTP-BUN spread etc. If we get that combination then that is worrying from a European equity market perspective.
Cameron Brandt
Just in a bit of context, it's worth noting that if the ECB makes good on its hints of a 50 basis rate hike at some point in the third quarter. That will only lift the base interest rate into positive territory by 25 basis points and that will be the first time I think in over six years that eurozone- the key eurozone interest rate has been in positive territory. So we're looking at what seem like very low orders of magnitude but it is still a major shift. One thing Huw touched upon is the potential split between the more credit-worthy northern tier European nations and markets like Italy and Spain. Certainly in the fund flows, we're already beginning to see those reservations play out. In the latest week, redemptions from Spanish bond funds were the largest we've seen since late fourth quarter of 2019 and the drumbeat of redemptions from Italy equity and bond funds are definitely beginning to pick up. Huw are you seeing any interesting market specific signals in relation to Europe and this changing or potentially changing monetary environment?
Huw Roberts
So on the equity side. What is actually interesting is that although we saw a sell-off yesterday in response to the ECB headlines and we now actually have Euro stocks at the kind of Pan-European level almost 3% below our macro warranted fair value. If we were to look at the equivalent, say the FTSE MIB for Italian equities. That is also cheap but only in inverted commas 1.5% below. So actually, the selloff hasn't kind of fell through to Italy in the same way as you might expect. So what we don't do at Quant Insight, we don't do predictions or forecasting. We're more about observing current patterns and relationships and then allowing clients to kind of impose their views and look forward. But if I could hazard a guess and go over my skis a little, marrying together what you've just said and what our models are showing would suggest that there is scope for more outflows ahead and the valuation gaps that we're seeing on both Euro stocks and the FTSE MIB, they are notice upon but they are by no means extreme relative to historical ranges i.e. there is more to bear.
Kirsten Longbottom
So what are the critical things to be watching and what are certain Quant Insight indicators that you have found that give you insight into what the ECB's hawkish notes are telling you?
Huw Roberts
Yeah, absolutely. And in fact, that was a really telling point in the price action yesterday afternoon as Lagarde was speaking. Because if you notice as she kind of left the door open to a 50 basis point rate hike you got an immediate kind of repricing at the front end of the European bond market, makes sense. The arrival of prices in more rate hikes. Initially that was deemed to be Euro positive and the Euro rallied if you look at something like Euro dollar. And then Euro dollar kind of immediately turned tail and legged lower. Why was that? It was because the market was hoping we were going to get some noises, some detail from Governor Lagarde with regards to what they might do to preempt what they call fragmentation risk. Fragmentation risk is just a classic bit of ECB jargon that basically means the difference in yields between BTPs and BUNs specifically, but more generally as Cam talked about the high deficit Southern European economies versus the more disciplined northern European countries. So, the yield spread between tenure BTPs and tenure BUNs is a key metric that the market watches for signs of stress in that area. And it is interesting that on QI, European peripheral spreads – well we monitor BTP spreads but also Spanish government bond spreads and Greek Bond spreads, those were the three that really moved during the European sovereign debt crisis nine-ten years ago. To all three of those are indicators in our models and they have really started to feature more and more prominently. So in the chart we can show on the screen now what this is showing is Eurostoxx 600 sensitivity to those spreads and the way that we capture the spreads is actually an assets-hoc spreads. So the way to think about this is if that sensitivity is going up that means that they want calm and the European equities want calm in peripheral bond spreads. That's a good thing for European equities. If we start to see stress spreads and that's going to pull European equity values lower and what this chart shows you is that sensitivity has increased a lot in the last few weeks and has become a key driver. So if this pattern were to continue that would be very much bad news for European equities. And just as a quick aside before I finish, this is not a purely European phenomenon although it's playing out in Europe if I was to show you the same chart for the S&P 500 you'd actually see the same pattern. So stress in Europe is actually an important fact - they're driving US equities as much as it is European.
Cameron Brandt
You're actually talking to us today from the United Kingdom. At least emotionally outside the core Europe after Brexit but still linked to Europe by multiple economic channels. Is the shift in the ECBs signaling having an impact on models that you have dedicated to the UK and its economics?
Huw Roberts
Well since you mentioned Brexit, which unfortunately you can’t avoid these days even now some six years after the event. At the moment, as we mentioned at the top of the podcast, our models pull in exclusively macro factors and as I said they fall into three broad buckets: economic fundamentals growth and inflation, financial conditions measures and risk appetite measures. But there are times when model confidence falls below our threshold for a macro regime. So what that basically means is the asset in question is no longer being driven by macro fundamentals. And if you look at the FTSE 100, if you look at sterling FX crosses, our model confidence are all hovering around 50% which essentially means that we can explain around half of the variation in that asset. But the other half is being driven by something else. What is that something else? Well, more often than not it would be your area of expertise and I think it would be flow and positioning and sentiment. Sometimes it could be you know trend and momentum if there's a big you know CTA program going on that's driving short-term price action. It could be politics. You know there are other non-macro factors that come to play here and at the moment I guess Brexit is probably front and center. I fear, I suspect that the closeness of the confidence vote in Prime Minister Johnson last week means that he might be tempted to double down in terms of some of his more controversial strategies. I think the political strategists call it throwing red meat, don’t they, to their loyal fan base. And if that was to involve for something like the Northern Ireland protocol for example then that's going to be a dynamic that our macro models simply don't capture, and I suspect and unless you have a strong angle that you guys are picking up on the flow side which would be interesting to hear about. But at the moment we can't say that we have a strong signal of because we're below that threshold for a macro regime for a lot of UK assets.
Cameron Brandt
You ask about the flows, I think the phrase of a “plague on all houses” might be the best way of describing current investor sentiment towards pretty much all of the European markets. What I'm hearing is that while the flows are being pretty uniformly negative and you can pick a number of drivers. We've gone from Russia's invasion of the Ukraine to the one that we're discussing now which is the ECB's definite shift in tone. But the one I'm starting to pick up in terms of fund manager commentary and concern is the possibility that Europe will face energy rationing when we move into the next winter's heating season. As I said flows have been so negative and there've been so many reasons why that is that you know it's hard to isolate a dominant theme. That in itself has actually been a regular theme of fund flows and the ways they've been driven over the past eighteen months. But it does seem like energy could be kind of the next cricket bat shall we say to come whacking down on the shins of European fund managers I don't know if energy is beginning to resonate at all in terms of your modeling and indeed if it's a macro factor that you pursue, but certainly be curious to hear if you're getting any early indications that that's moving you fundamental models.
Huw Roberts
Yeah, obviously it dominates the front pages and conversation I can completely relate to that. In terms of the mathematical relationship we're picking up at the moment, you can see its effect in a kind of a none derivative type way. I'm sorry to backtrack to answer your question. Yes, we have an energy factor in all our models. We include West Texas Intermediate Crude energy prices as a driver for a lot of models. It does feature as a driver but it's not as prominent as you might expect, especially if you're someone who fears a scenario whereby crude is heading to $150 a barrel for example and that's a scenario, a tail risk that you're thinking about for the second half of 2022. Where you do see it is via inflation expectations, we use inflation swaps in the relevant currency to show the asset in question’s relationship with inflation expectations. And that remains a very prominent driver. So, the degree to which you see crude push inflation higher, you know, Friday's CPI number was supposed to - on paper - support the peak inflation theory but didn't really pan out to that degree. But I think that forecast is still around for a lot of people but the more crude oil marches higher the more it's going to challenge that. So we will watch energy very closely, I suspect it will move up in terms of sensitivity. But at the moment we're capturing via those second derivatives like inflation expectations.
Cameron Brandt
Thanks well I'll wrap up with what I think is probably the real burning question for you which is how many games do you think the Welsh Rugby team will win in their upcoming tour of South Africa?
Huw Roberts
Well of course the obvious answer to that Cam is hopefully more than Ireland and New Zealand.
Cameron Brandt
Touché.
Kirsten Longbottom
Great. Well thank you both so much for your insight I think that's all we have time for today but to our viewers who have any questions or would like to learn more you can check out the links in our episode’s description. And like always, please join us for next week for our usual recap of EPFR data and keep an eye out for our next partner podcast. Thank you.
Cameron Brandt
Thank you, Kirsten. Thank you, Huw.
Huw Roberts
Cheers Cam, thank you both.
