The Catch-Up Trade

Summary

• Historically, a larger than 3 percent gain in the S&P in December is followed by solid January.
• There is relative value between the S&P and the Eurostoxx, specifically in energy, financials, and semiconductors.
• A relative value is a good portfolio strategy for 2022.

Vladimir Sukhachev/iStock via Getty Images

The January effect has started as the Santa Claus rally passed on the baton. The risk on tone was brisk, driven by strong manufacturing PMIs out of Europe. Up until last spring, the Eurostoxx outperformed the US in anticipation of a robust reopening across the Eurozone. Markets are looking at a potential repeat because Europe has reacted with harsh lockdowns to omicron.

The European PMI survey shows an alleviation of supply chain pressures as inventories are rebuild. Sector data revealed that consumer goods makers drove the slower improvement in manufacturing conditions, with intermediate and capital goods producers registering marginally quicker upturns.

Indeed, the Eurostoxx' one percent gain was mostly driven by staples, industrials, healthcare, and utilities. A similar defensive-bullish tone that the US markets displayed into year-end.

Yet, the European reopening trade has more fuel because of lockdowns and travel bans. Europe’s VIX index -“VSTOX” - is still elevated compared to the VIX (see Figure 1). There is potential for a catch-up rally for European stocks given the 10 percent performance lag in 2021 to the S&P.

Figure 1: VIX and VSTOX

Source: CBOE

The reopening stocks in Europe have drastically under-performed in December but are staging a faster comeback than US counterparts. Above all, European value, and small cap ETFs - which consist mostly of pharma, financials/banks and REITs - are outperforming the US’ IWM and IWN (see Figure 2).

The year 2022 could be the year of the “catch up trade.” The US outperformance was driven by stimulus and near fully reopened economy. Elsewhere, lockdowns and restrictions persisted, and dragged down emerging markets, China and emerging-Asia and European markets. A relative value is a good portfolio strategy for 2022. But that does not mean to be completely out of US large and small caps.

Figure 2: Europe vs. US: value and small caps

Source: I-shares

Rather, the underweighting of stocks works differently than bonds. In broad terms, US Treasuries are overvalued to German Bunds because of a likely earlier liftoff in rates by the Fed. The move in Treasury yields is a first sign the market is readying for the first hike right after March. The FOMC Minutes are likely to shed light on the sequencing from tapering to tightening, which includes a balance sheet strategy. Treasuries are catching up to a tighter Fed reality.

Figure 3: Europe vs. US: Semis

Source: S&P, Eurostoxx

European stocks, however, are ‘undervalued’ to the US’, specifically in energy, technology, automotive and financials. On other hand, Europe’s semiconductors and industrials could be ‘overvalued’ to the US (Figures 3 and 4).

It underscores a portfolio that can be positioned in sector relative value in Europe and the US large caps. As for the catch-up trade, Europe’s energy index has scope to perform, given the lag of Brent to WTI and as such, the underperformance of Europe’s bigger cap energy stocks.

Figure 4: Europe vs. US: Energy

Source: S&P, Eurostoxx

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.