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Trading Ideas February 2010: Increasing the equity weight by buying Banks

ASSET ALL

IDEA of the month: Increasing the equity weight by buying Banks

This month we use the equity sell off to increase the equity weight of our ETF portfolio from 40% to 55% and buy the Stoxx600 Banks with 15% weight and we see this as a short term trading position. At the same time …….

we sell our 15% exposure in long-duration bonds. Our scorecards see equities as the most attractive asset class and Banks as the most attractive sector in Europe.

The developments around Greece and peripheral Europe continue to dominate the financial markets and overshadow otherwise good economic data. The European Commission endorsed the Greek Stability Programme, viewing it as ambitious but achievable. The European Commission specifically requested compliance with the 3% deficit-to-GDP target by 2010 via a reduction of the public sector wage bill and other measures and will keep Greece under permanent surveillance. Given the scale of the required policy adjustments, the credibility gap (including the uncertainty about the precise state of Greek public finances) and the potential lack of political consensus in Greece about the implementation of such measures, the real test will come in the implementation of the required measures. The market remains unwilling to provide Greece (and now other fiscally vulnerable sovereigns) with the benefit of the doubt and seems intent on testing the resolve of the European Union.

The current dynamic is increasingly reminiscent of the spring and summer of 2008, when the market tested the resolve of the US Treasury to recapitalise the GSEs (Government sponsored Enterprises). Given the significant cross-border banking exposures to peripheral Europe highlighted last week and, more importantly, the (increasing) risks of contagion, it is likely to be in the EU’s interest to ensure that Greece gets at least an opportunity to demonstrate its ability to bring its finances back in order. The market reactions were quite clear: risky assets fell strongly, while safe havens such as US treasuries and German bunds performed well.

The sovereign debt crises are currently concentrated in the euro area. Thus, the euro has depreciated strongly against the major currencies. However, going forward we believe most of the bad news has been priced in by the markets. If the unfavourable news flow ebbs off in the next few weeks and Greece’s announced austerity measures bear fruit, some kind of “relief rally” in the equity markets cannot be ruled out. The ongoing debt crisis could also become a burden for the European bond markets. In particular, bonds with a longer duration seem more vulnerable in view of the rally in this bracket.

Overall, we therefore stick to our constructive assessment for risky assets after the sharp correction. Our more defensive positioning at the beginning of the year has worked quite well, as our portfolio outperformed the MSCI World in the last few weeks after having underperformed in the weeks before. In order to participate in a possibly more positive market reaction in the next few weeks we increase the stake of risky assets in our portfolio and invest 15% of our portfolio in the European banking sector. At the same time we sell our 15% exposure to long-duration bonds. This positioning should help to participate in a market recovery after the sell-off in the last few weeks. However, in the medium term we remain sceptical about the banking sector’s ability to outperform the broad market, seeing that regulatory changes have been announced which might be a burden for the banking sector in the future. Our ETF portfolio benefited from the stronger Dollar via the MSCI USA and Currency valuation ETF which both have Dollar exposure. In addition, our portfolio benefited from the long bond position. These positions helped to nearly compensate the negative effect of the declining equity markets on the portfolio.

Trading portfolio
This month we bought the ETF “db x-trackers DJ Stoxx 600 Banks” with 15% weight and sell “IBOXX € Sovereigns €-ZONE 15+ TR Index ETF”. The trading portfolio below reflects the changes discussed above. The portfolio targets absolute return and has the EONIA index as benchmark.

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Source: Bloomberg, Deutsche Bank
* Performance shown represents the absolute performance of the ETF and not its contribution to the portfolio
The full record of data and results for the model is available upon request.
Our performance calcualtions do not include relevant transaction costs or taxes.
Past performance may not be a reliable guide to future performance.
Inception date of the trading Portfolio: 8th December 2008
– Last price for the closed position represents the price as on the exit date

Source: Trading Ideas ETF: Ideas and Flows – Deutsche Bank AG

rated “BB”. 13% of the basket is rated “B” and this is one issuer, Venezuela. So the country
with the biggest weight in the index is also the country with the lowest rating. While
Venezuela is clearly a high risk country with 13% weight in the index, the remaining countries
are clearly more solid (for more details on the “MSCI USA TRN” ETF see ETF: Ideas and
Flows, 25 November 2009).
“db x-trackers Currency valuation” ETF 20% weight
In currency markets the majority of the participants are “liquidity seekers”. “Profit seekers”
are a minority in currency markets and can generate returns on the expense of the “liquidity
seekers”. Profit-seekers can generate returns by buying “under-valued” currencies and
shorting “over-valued” currencies. A widely used measure to determine “under-valued” and
“over-valued” valuation for currencies is the concept of “Purchasing Power Parity” where
“fair” exchange rates are calculated by comparing the prices of a basket of goods in different
countries. The ETF “db x-trackers Currency valuation” buys each quarter the three currencies
with the “lowest” valuation out of the universe of the G10 currencies and sells the three
currencies with the “highest” valuation using the PPP concept. In addition, the correlation to
equities and bonds is very low and therefore the currency valuation index helps to diversify
our ETF portfolio. The index is currently long in the US Dollar, New Zealand Dollar, and the
British Pound whereas the index is short in the Swiss Franc, Swedish Krona and the
Norwegian Krona. Risks to the investment include that currencies movements become less
rational again. Especially increased uncertainty about the economic development could
trigger a flight back into expensive currencies like the Swiss Franc (for more details on the
“db x-trackers Currency valuation” ETF see ETF: Ideas and Flows,12 June 2009).
Trading portfolio
We have kept the portfolio unchanged this time. Earlier we bought the “Emerging Markets
Liquid Eurobond Euro Index” ETF with 10% weight and sold the “db x-trackers DJ Stoxx
Global Dividend 100 ETF”. The portfolio targets absolute return and has the EONIA index as
benchmark.