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Thursday, March 24, 2022

GT-EX | German Tech - IBEX | Bull Steepen scenario to benefit the pair

By Century Financial in 'Investment Insights'

GT-EX | German Tech - IBEX | Bull Steepen...
EGT-EX German Tech - IBEX Bull Steepen scenario to benefit the pair

* Trading in financial market 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.

Risks & Assumptions

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Past performance is not indicative of and does not guarantee future results. Please read the complete disclaimer carefully.
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Holding cost is subject to change impacting the trade either negatively or positively.
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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.

History tends to repeat itself?

The yield curve started to steepen in the third quarter of 2019 and resulted in an outperformance of Tech sector, along defensive stocks such as utilities and healthcare. Sectors such as energy and industrials performed poorly. Markets now anticipate that US Federal Reserve Chairman Jerome Powell’s 25 to 50 basis point rate hike in 2022 may not be sufficient to tame inflation. Higher percentage rate hike and at potentially faster pace may reduce the already stalled GDP estimate for 2022 just like in 2019. In this scenario, the yield curve will begin to bull steepen i.e., the short-term rate will fall more than the long-term rates as anticipation of rate hikes reduce. Investors during this time look for long term growth opportunities as current growth estimates would be slowed down, giving technology a big push. Along with US treasury spreads widening, the Germany Bund (benchmark for European yields) spreads also widened during the same period.

Germany bund chart

Graph

Germany Bund 10 Yr & 2 Yr Spread
Source: Bloomberg
Date: 23rd March 2022

Multi-month trend

High prices and economic disruptions from the war in Ukraine are dimming the global outlook on the recovery. The Fed raised interest rates by a quarter-percentage point and cut its GDP estimate for 2022. It now sees the economy expanding by 2.8% this year, down from the 4% it had predicted in December. Whereas ECB stated there would be extra space between the planned end of its money-printing program this summer and the first interest rate hike in more than a decade. The ongoing geopolitical tensions between Russia and Ukraine has stalled Europe’s growth outlook resulting in the front-end bonds increasing in value. Thus, even a 1-2 rate hike in 2022 may not be well accepted by European investors leading to a bull steepening German bund yield curve.

Presently, the economy is expected to witness a similar wave like it did in 2019 and thus the tech dominated indices in the EU zone should fundamentally outperform the indices that are dominated by value. This could be a gradual and a multi-month trend.

In 2019, as the yield curve started to steepen due to declining yields, the German Tech Index rallied and outperformed the Spain 35. The ratio between the two indices increased from 0.3072 to 0.335.

Ratio chart

Graph

Source: Bloomberg
Date: 23rd March 2022

The pair trading strategy involves going long on Germany Tech 30 increasing in value and simultaneously holding a short position on Spain 35.

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 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 Spain 35 is formulated majorly by financial sector. Spain’s largest banks Banco Santander, Banco Bilbao & CaixaBank’s revenue and EPS growth for 2022 & 2023 is stalled enough that could bring the financial sector down in the region. Additionally, the Industrial sector may foresee lower profit margins since the companies may not be able to pass on the higher prices to the customers.

Sector Composition

Germany Tech 30 Sector Constituents
Sector Name € Market Cap (in Billions) Percentage based on market cap
Information Technology 205.11 44.59%
Health Care 124.78 27.10%
Communication Services 119.73 26%
Industrials 6.38 1.39%
Energy 4.46 0.97%
Total 255.35 100.00%

Source: Bloomberg
Date: Date : 23rd March 2022

Spain 35 sector constituents
Sector Name € Market Cap (in Billions) Percentage based on market cap
Utilities 133.68 23.65%
Financials 131.61 23.29%
Industrials 73.47 13.00%
Consumer Discretionary 69.4 12.28%
Communication Services 53.46 9.46%
Materials 31.54 5.58%
Information Technology 27.89 4.93%
Energy 17.84 3.16%
Health Care 16.94 3.00%
Real Estate 9.37 1.66%
Total 565.2 100.00%

Source: Bloomberg
Date: 3rd March 2022

How to take the trade?

Spain 35 sector constituents
Position Instrument No. of units Price as of 23rd March 2022 Exposure Price when ratio increases to 0.4138 Potential profit when ratio increases to 0.4138 Price when ratio increases to 0.4286 Potential profit when ratio increases to 0.4286 Price when ratio reduces to 0.37 Potential loss when ratio decreases to 0.37
Long German Tech 15 3281 € 50,000.00 € 3,454.00 € 2,636.39 € 4,454.94 € 2,650.79 € 3,171.64 € (1,666.57)
Short Spain 35 6 8369 € 50,000.00 € 8,347.03 € 131.162 € 8,061.00 € 1,910.43 € 8,572.00 € (1,184.09)
€ 100,000.00 € 2,768.01 € 4.561.22 € (2,850.65)
2.77% 4.56% -2.85%

As shown in the above table, the German Tech is priced at €3281 while the Spain 35 is priced at €8369 implying a ratio of 0.39. Long German Tech and short Spain 35 could result in a potential profitable trade when the ratio between the two increases further irrespective of price movement on the upside or downside. On the other hand, it could result in potential losses, if the ratio reduces further. For example, by going long €50,000 of German Tech and simultaneously short €50,000 of Spain 35, would result in a potential profit of ~4.56% if the ratio were to increase to 0.4286. On the other hand, if the ratio were to decrease to 0.37, it would result in a potential loss of 2.85%.

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
Data & Prices as of: 23/03/2022

Arun Leslie John
Chief Market Analyst

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