What’s in store for the summer of 2024?

Volatility is low and the markets have been hitting historical highs – so why the long faces?

We just hit the halfway mark and market risk is well below the historical median and investors are reaping the returns. Volatility has also declined YTD thanks to both a drop in this market risk but also owing to greater diversification as investors spread their investments across all sectors, defusing last year’s concentration risk. So then, isn’t that all good news? According to the always insightful Olivier d’Assier from the Applied Research team, investors should stay on their toes.      

We put a few questions to Olivier to learn more about what he means and what the implications are for portfolio managers, risk managers – and the market at large.  

Q: Before we jump in, can you tell me what your team does?  

A: The Applied Research team at SimCorp plays a consultative role with clients, focusing not on the provision of investment recommendations but rather on guidance related to their investment process. We examine real portfolios without recommending alterations to the investment thesis or the portfolio itself. Instead, we highlight disparities, leaving the portfolio manager to determine the appropriate course of action. 

Q: So when you look back on the initial five months of 2024, what are those disparities you’ve observed between the implied investor thesis and how reality unfolded?  

A: There has been a significant deviation from the investment thesis made at the start of the year, which were predicated on the anticipation of three interest rate cuts by the European Central Bank (ECB), and where we are now, after having just seen the first and likely only rate cut in 2024 last week. Despite this stark divergence from their initial projections, investors have largely maintained their original portfolio compositions. The persistence of factor returns exhibiting minimal reversals suggests a steadfast adherence to their initial investment rationale. 

As noted, market risk has been on a consistent downward trajectory for the past two years, while returns have escalated, reaching successive historical highs. This unrealistic combination of low risk and high return suggests that leverage has increasingly been employed within these portfolios.

Q: Yes, we saw this with the STOXX Europe 600, which surpassed the performance of the S&P 500, marking the first such occurrence in three years. What has contributed to this shift in market dynamics? And, do you expect this trend to last? 

A: We note the formidable influence of the GRANOLAS — a term introduced by Goldman Sachs in 2020, representing a cohort of 11 pivotal European stocks: GSK, Roche, ASML, Nestle, Novartis, Novo Nordisk, L’Oreal, LVMH, AstraZeneca, SAP, and Sanofi. These stocks have become a cornerstone of the European market, now constituting a significant 25% of the STOXX Europe 600's weight and contributing to an astounding 24% of its year-to-date returns. The concentration may not mirror the US Magnificent Sevens' level, as my esteemed colleague Diana Baechle articulated in her blog, yet they bear a heightened susceptibility to country-specific and currency-related risks. 

Now in June, the urgency escalates as we approach the typically tranquil summer months of July and August in Europe – historically characterized by diminished volumes and trading activities. However, the current year presents an exceptional scenario. An unprecedented number of 13 critical events loom on the horizon over the ensuing three months, each possessing the potential to catalyze significant market volatility. These events could precipitate a state of heightened alertness, possibly triggering an overreaction from investors who are already demonstrating bearish tendencies. It is important to remain vigilant and prepared for the turbulence that may ensue in the European markets during this period. 

Q: So what concerns you most about this ‘low-risk-high-return’ environment that we’re in?  

A: Prolonged low volatility encourages hubris. Lower volatility usually means low returns and so investors compensate by adding leverage to their strategies. Low volatility also translates into smaller expected drawdowns which can lure investors into a false sense of complacency and encourages them to remove hedges in their portfolios. There has been a precipitous decline in European investor sentiment throughout May, culminating in a predominantly bearish outlook at the start of June. This shift heightens the potential for an exaggerated downward market movement in response to adverse news. The urgency of monitoring these developments and preparing for potential market fluctuations cannot be overstated. 

Q: Let’s talk about those volatility triggers a little more as there seems to be more than usual. What are those events that are really keeping you up at night? 

A: Absolutely, the stakes are incredibly high at this moment! We're not just contending with the standard volatility triggers like earnings reports, economic shifts, and monetary policy changes. We're witnessing a surge in non-traditional factors that are rapidly escalating tensions. Domestic political dynamics, international relations, and climate change are all converging to create a powder keg of instability. 

We're on the cusp of two pivotal elections – the European Parliament and the UK General Election – plus the first of the high-stakes Presidential debates in the US between Donald Trump and Joe Biden. As expected, the Far Right has made strong headways in key places – France, Germany, and Italy. Except in Italy where the right was already in power, the Far Right displaced the ruling party in both France and Germany, prompting French President Emmanuel Macron to call a snap election for the National Assembly via a two-vote process, both taking part ahead of the Paris Olympics. The Far Right will be hoping to leverage their European success into a large seat gain in France and influence policy for the rest of the term until the 2027 Presidential Election. In short, the Centre held in Europe, but is severely weakened and will have to accommodate some of the Far Right’s demands on immigration and the economy. 

All this is to say that European investors are already on edge and anxiously awaiting any pronouncements related to NATO, trade tariffs, and assistance to Ukraine. This month and the coming months of July and August are packed with critical events, including both the Republican and Democrat National Conventions, with the latter set to take place in a politically charged atmosphere in Chicago. 

Moreover, major international sporting events like the UEFA Euro 2024 and the Paris Olympics loom on the horizon, posing significant security risks. On the geopolitical front, the ongoing conflicts in Ukraine and Gaza are exacerbating tensions, while the US-China relationship teeters on the brink of further deterioration, likely to be collateral damage in the US Presidential campaign. The level of concern for this summer is unprecedented — there's an enormous amount to be vigilant about. 

Q: Given everything we’ve just discussed, how do you think the markets will evolve for the remainder of the year? 

A: The markets are heading towards the summer with a dangerous level of unpreparedness. There's a glaring disconnect, with market risks grossly underpriced, even as returns hover near record highs. We're witnessing an alarming level of crowding in certain stocks (GRANOLAS), coupled with a concerning absence of hedging strategies. The prevailing investor sentiment is starkly bearish, setting the stage for a highly volatile market that's poised to seize any pretext for a sell-off, while demanding substantial justification for any new investment inflows, skewing the balance towards a pronounced downside risk in the immediate future.  

Even with the European Central Bank implementing a rate cut at its June 6 meeting, it's likely to be an isolated event until the year's end, offering little incentive for investors to engage at such inflated valuations. At this juncture, it's prudent to question the wisdom of maintaining high-risk positions through the summer, a period that could trigger a liquidity crisis. We think prudent investors will either hedge market risk or reduce portfolio exposure before July and August, and plan to revisit strategies in September once they have a clearer picture based on fundamental economic and inflation data, as well as the outcomes of the 13 risk events previously discussed. While the outcome of the pivotal US Presidential election may remain unknown – potentially even more so if the results are contested – by September, we should have sufficient information to predict the trajectory of interest rates for 2025 and strategize accordingly. Until that time, we can expect nothing less than a surge in uncertainty to be factored into market prices. 

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