A blue world good for risk assets

It is clear by now that we are trading in what we call the blue phase of the business cycle. In financial market terms, blue is an upbeat state. It is the phase where global growth is recovering while the output gap is negative leading to low cost pressure and very accommodative monetary policy. In this phase, we have historically seen very strong returns in stock markets. This is also the case this time. Being up 10.5% this year, Euro Stoxx has been the star performer supported by accelerating growth and significant QE from the ECB. Our expectation of trading in the blue world has been the main reason we have been positive on risk assets for a while.

So how long will the good times roll? Our models suggest we will continue to be in the blue world for at least the next couple of months. At the same time, there are some tentative signs of moderation when we go into summer. Our medium-term lead models for the OECD’s leading indicator, which predict the leading indicator with a three to six month lead, are starting to lose momentum. So, maybe sell in May and stay away will prove right again? However, for the coming months they point to a continued positive environment for risk assets. We also look for more upward revisions of euro area growth for this year (we have an above-consensus estimate of 1.5% for 2015, consensus 1.2%).

The main risk in the short term is uncertainty about Greece and that euro stock markets are moving into stretched territory on short-term momentum and thus risk-reward is not as good as it has been. However, the tailwind from stronger data and ECB easing is expected to dominate for the coming quarter and we still see more upside.

The surprise index in the US, which has fallen substantially, may also be close to a bottom as bad weather may have played a role in weak retail sales and fundamentals are still solid for the short-term picture in the US. We see signs of stabilisation in regional business surveys from Philadelphia and New York (Empire index) suggesting that the downward move in demand towards the end of 2014 will come to an end soon.

EUR/USD stabilises as euro surprises beat US

EUR/USD has taken a breather lately following a very steep decline on the back of the ECB QE announcement. A couple of factors have given more support to the EUR. First, technically the cross is very oversold, so it is only natural to see a pause. Second, euro data has by far beaten US data lately. Indeed, over the past 10 years, there have been only two instances when the euro area surprise index had such a big gap to the US surprise index (see chart next page). Finally, equity flows have increasingly favoured Europe over the US recently, which is also reflected in the clear outperformance of euro stocks over US stocks.

However, we continue to believe that relative monetary policy will be the dominant driver for EUR/USD over the coming quarters. With the Fed lift-off moving rapidly closer and ECB pushing the QE button in March, we expect to see a further decline in EUR/USD.