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Monday, July 05, 2021

Germany Tech 30 - Norway 25 Consequences of a Hawkish Tilt

By Century Financial in 'Investment Insights'

Germany Tech 30 - Norway 25 Consequences of a...
Germany Tech 30 – Norway 25 Consequences of a Hawkish Tilt

*Trading in financial markets carries risk and can result in loss of capital
*This performance is only observed with historical backtests and not traded by the company

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

The yield curve started to flatten in the second quarter of 2014 and resulted in the outperformance of Tech sector, along defensive stocks such as utilities and healthcare. Sectors such as financials, energy and industrials performed poorly. US Federal Reserve Chairman Jerome Powell’s hawkish tilt on transitionary inflation has led to the flattening of the yield curve. Along with US treasury spreads narrowing, the Germany Bund (benchmark for European yields) spreads also narrowed along the same period.

Germany Bund 30 Yr & 5 Yr Spread ( Source : Bloomberg | Date : 23rd June 2021 ) Germany Bund 30 Yr & 5 Yr Spread ( Source : Bloomberg | Date : 23rd June 2021 )

A Multi-Month Trend

Economic forecasts released by the Fed in the latest FOMC showed that 11 of 18 policymakers expected at least two interest rate hikes by the end of 2023. The prospect of those earlier-than-expected moves have soared short-term yields higher while keeping longer-duration yields subdued as market fears of out-of-control inflation subside.

Presently, the economy is expected to witness a similar wave like it did in 2014 and the tech dominated indices in the EU zone should fundamentally outperform the indices that are dominated by the financial sector. This could be a gradual and a multi-month trend.

Germany Tech 30/Norway 25 ratio from 2020- present Germany Tech 30/Norway 25 ratio from 2020- present

The Pair Trading Strategy involves going long on Germany Tech 30 increasing in value and simultaneously holding a short position on Norway 25.

Almost half of the Germany Tech Index is dominated by the IT sector which is expected to surge the most. The technology-based companies are anticipated to benefit from lower long term interest rates implying a higher present value of future cash flows. A higher chunk of the index is composed of companies from the healthcare sector which is defensive by nature and are dividend paying companies.

Whereas the Norway index is formulated of the Energy sector, succeeded by the Financials. The banking sector will logically witness reduced net interest margins due to narrowing yield spreads in a flattening yield curve scenario. Additionally, the Energy and Industrial sector may foresee lower profit margins since a cap on inflation implies a cap on sales price.

Macro View on Holdings of Germany Tech 30 & Norway 25

Germany Tech 30 Sector Constituents

Sector € Market Cap (In Bln) Market Cap %
Information Technology 224.21 48%
Health Care 124.57 27%
Communication Services 106.22 23%
Industrials 9.54 2%
Total 464.54 100%

Date: 23rd June 2021
Source: Bloomberg

Norway Sector Constituents

Sector € Market Cap (In Bln) Market Cap %
Energy 765.5 26.2%
Financials 535.5 18.3%
Communication Services 497.5 17.0%
Consumer Staples 383.3 13.1%
Materials 269.2 9.2%
Industrials 250.2 8.6%
Information Technology 96.3 3.3%
Utilities 42.0 1.4%
Real Estate 36.2 1.2%
Consumer Discretionary 24.2 0.8%
Health Care 20.8 0.7%
Total 2,921 100%

Date: 23rd June 2021
Source: Bloomberg

However, it is important to note that Trading pairs is not a risk-free strategy. The jeopardy comes when prices of the two securities move contrary to the positions taken resulting in losses. Thus, it is important to adhere to strict risk management rules when dealing with such adverse situations.

Disclaimer: Individual stocks in the index are subject to both weightage recalculation & recomposition risk. As a result, certain stocks may be added or removed from the index upon index recalculation. Consequently, the performance of the relative index may deviate from the one specified above.

Note: Trading Timings (subject to change) -
Germany Tech 30 - 11.00-19.30 GMT+4
Norway 25 - 11.00-18.20 GMT+4

Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Date: 27/6/2021

Arun Leslie John
Chief Market Analyst

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