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Summary of "Hedging Event Risk in Europe"

Core Content

This document discusses the current state of equity and derivatives markets in Europe, highlighting the underestimation of event risk and suggesting hedging strategies to mitigate potential drawdowns in eurozone equities. It outlines key geopolitical and economic risks that could impact market stability and provides two specific trade ideas to hedge against increased volatility and downside risk.

Main Viewpoints

• Equity Market Complacency: Equity markets are overly optimistic despite significant upcoming event risks, creating an opportunity for hedging strategies.
• Earnings Revisions: Earnings expectations for eurozone equities are seen as overinflated, with a 5% downward revision since 2019, yet still above realized growth since the financial crisis.
• Event Risk Outlook: Several key events are expected to drive volatility and negative returns in the eurozone, including Brexit, Italian elections, Middle East tensions, and ECB policy changes.
• Volatility Disconnect: European equity volatility remains low, not pricing in event risks, and is currently cheaper than U.S. volatility.
• Central Bank Policy: The ECB is expected to cut the deposit rate by 10 basis points in September, and the 10-year EUR swap rate could decline below 0.11%, supporting the use of contingent puts.

Key Events

• Brexit: A no-deal Brexit could lead to a 7–10% correction in the SX5E and increased volatility.
• Italian Elections: The budget process and potential elections could create a challenging environment for Italian assets.
• Middle East Geopolitics: Escalation in tensions could weigh on global risk sentiment, particularly with U.S.-Iran sanctions in place.
• ECB Policy Uncertainty: The absence of the Spitzenkandidat system post-EU elections increases uncertainty about ECB policy direction.
• Trade Wars: Ongoing U.S.-China trade tensions may delay any agreement and negatively affect global growth expectations.

Key Information

• Volatility Strategies:
  • Trade Idea 1: Long VSTOXX Aug19 20/25 call spread for 0.35c. This strategy benefits from a potential spike in volatility.
  • Trade Idea 2: Long SX5E 1-year 95% put contingent on EUR 10-year swap rate < 0.11% for 2.2%. This is a 46% discount to the vanilla put.
• Volatility Context:
  • The VSTOXX/VIX spread is in negative territory, indicating lower European volatility.
  • Eurozone equity volatility is currently low, suggesting potential upside for volatility plays.
• Economic Indicators:
  • Earnings and revenue growth expectations are above historical levels.
  • Eurozone manufacturing PMIs have fallen to 2013 levels, and we do not expect a significant rebound.
  • Inflation expectations are near all-time lows, and the Euro STOXX 50 volatility is not pricing in the event risk.
• Geopolitical Risk Index: The index has risen, but equity volatility has remained subdued, indicating a potential disconnect that may not last.

Conclusion

Given the current event risk and the underpricing of volatility, the document recommends hedging strategies to protect against potential drawdowns in eurozone equities. It emphasizes that while the market has rallied, the underlying economic and political risks suggest that volatility and downside protection could be attractive for investors.