Pimco Buys Bullish Europe Stock Options on Brexit Mispricing Bet

  • Polls show vote a close call, but odds point to U.K. staying
  • Investors became “overly cautious,” Pimco’s Sundstrom says

Pacific Investment Management Co. has been buying up bullish European equity derivatives ahead of tomorrow’s U.K. referendum and may increase its allocation to stocks should Brits decide to stay in the European Union.

The $1.5 trillion global money manager has been purchasing Euro Stoxx 50 Index call options in the last two weeks, according to Geraldine Sundstrom, the firm’s head of European asset allocation. The contracts, which allow investors to profit from a rise in prices without committing as much money as they would in an outright equity bet, looked like a bargain as concern about Brexit intensified, she said. Calls are now the cheapest they’ve been since Lehman Brothers Holdings Inc.’s collapse in October 2008.

The latest polls have shown the vote is too close to call, though the odds of secession have fallen at betting shops since Thursday. According to those, the implied chance of the U.K. leaving is now about 25 percent.

“At this juncture, we like Europe,” Sundstrom said in an interview in Zurich. “There is some dislocation in the pricing of calls versus puts and we’re trying to take advantage of that. It’s gradual and incremental, because this is not a market where you want to make huge moves. People probably went extremely cautious, even overly cautious.”

European stocks, which have fallen almost 9 percent this year, may post one of the biggest rallies among global assets in the second half of 2016, as earnings growth hits “double-digit” levels and the European Central Bank’s stimulus supports the region’s economy, Sundstrom said. Analysts still expect earnings for Euro Stoxx 50 firms to decline by 1.7 percent this year.

At the end of last week, Pimco forecast that the Euro Stoxx 50 would jump as much as 6 percent on Friday if the U.K. votes to remain the EU -- an outcome to which the fund manager ascribes a 60 percent chance. Given the market rally of the past few days, the gains following the referendum may end up being smaller, Sundstrom said during Tuesday’s interview.

Pimco has been cutting exposure to credit and inflation-linked securities -- a reversal of its strategy earlier this year of favoring corporate bonds over equities, according to Sundstrom. Even as the market looks set to rally in the second half, she sees bank stocks -- the worst performing sector this year -- continuing to lag. Pimco is therefore buying additional Tier 1 notes, in particular focusing on British and Spanish lenders, and will continue after Thursday’s Brexit vote and Sunday’s Spanish election, she said.

“We feel Brexit is not a systemic event; it’s not the best news for the U.K., but those capital securities wouldn’t trigger,” Sundstrom said, referring to a level at which the notes would get converted into stocks. “It would take a deep recession and a steep fall in house prices for these to trigger, so we think this has gone too far and we’d like to step in.”

The ECB may also provide an additional fillip to the stock market as it may eventually extend its asset-purchase program to include equities, Sundstrom said. 

“The inflation forecast is too low so it would seem that the ECB needs to do more,” she said. “I’m not calling for the bull market of all times, but European stocks are down significantly year-to-date despite better growth, super-accommodative monetary policy and fairly high dividend yields. If Brexit is out of the way that should help.”

Before it's here, it's on the Bloomberg Terminal.