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Position: Long Germany (EWG); Short Italy (EWI), Euro (FXE)

While Estonia made news joining as the 17th country to use the Euro as a common currency in the New Year, Europe’s economy continues to be centered on its sovereign debt and deficit issues, with the bailouts of Greece and Ireland in 2010 functioning as mere fiscal band aids. As we’ve pointed out for over a year, we see these fiscal issues plaguing Europe over the next 3-5 years; in the near to intermediate term we’re tasked with managing risk around the volatility throughout the region.

Currently we’re playing Europe’s Sovereign Debt Dichotomy with a short position in Italy (we re-shorted the etf EWI yesterday on strength), a short position in the Euro (FXE), and continued long exposure to Germany (EWG) in our Virtual Portfolio.

However, the data that’s new on the margin is two-fold:

1.  Inflation is rising throughout the Eurozone, including the Eurozone CPI average that rose to +2.2% in December Y/Y (versus 1.9% in November), the first time it’s been above the ECB’s 2% target since November 2008; and Eurozone PPI that rose +4.5% in November Y/Y (versus 4.4% in October).

In the chart below we show the growing divergence of CPI across select countries. We continue to emphasize that inflation should rise globally on an absolute basis. When it comes to an investment decision in Europe, we like Germany’s low inflation outlook given the set-up for slowing growth in the region in 2011. (Germany too saw a rise in CPI to 1.9% in December Y/Y versus 1.7% in November, see chart below).

Europe’s New Year’s Update - mhh1

Further, it’s worth note that the inflationary pressures are real (out of pocket expenses) for consumers – the highly publicized and debated austerity programs included measures to raise VAT, and the New Year marked the official increase: the UK from 17.5% to 20%; Spain boosted to 18% from 16%; and Portugal plans to raise its VAT to 23% this year.

Also, weakness in the Euro versus major currencies due to the debt and deficit imbalances could spur inflationary pressures in 2011. We’re currently short the Euro etf FXE with a TRADE (3 weeks or less) range versus the US Dollar of $1.32-$1.35. Certainly, given the magnitude and duration of Europe’s sovereign debt issues, we could foresee significant downside to the common currency that would create its own inflationary pressures.

2.  Germany, despite our bullish outlook, is showing signs of “topping” from a fundamental perspective vis-à-vis the Manufacturing and Services PMI.

As the historical PMI chart below shows, from a mean reversion standpoint we see the probability of a move to the downside in these numbers far outweighing the upside over the next months. The 60 line is historically a heavy resistance level. A downturn in the data however isn’t a huge conceptual surprise given that the German economy should slow in 2011 versus 2010: Bloomberg currently estimates GDP at 2.55% in 2011 versus 3.60% in 2010.

Europe’s New Year’s Update - mhh2

Finally, it’s worth refreshing our charts of sovereign bond yields and CDS as a proxy for risk. The takeaway is that both indicators are confirming a continued heightening in the risk trade, and in some cases all-time highs. Interestingly, today’s sovereign bond issuance from Portugal of €500 million found sufficient demand, however at a significantly higher yield demonstrating the increased risk premium that is demanded by investors.  The 6-month paper yielded 3.68% (versus 2.04% in September!).

Europe’s New Year’s Update - mhh3

Europe’s New Year’s Update - mhh4

As yields have raced higher over the last year particularly for the PIIGS, and this despite bailouts of Greece (May) and Ireland (December), the equity performance of the periphery also showed marked underperformance.  Greece’s Athex was the worst performer globally year-to-date at -35.6% and is down -10.2% since 1st wk of December. And Spain’s IBEX 25 and Italy’s FTSE MIB tumbled -18.1% and -12.4% respectively ytd, to round out some of the worst performing indices globally ytd.

In 2011 we’ll be picking our spots in Europe. We have long biases on countries like Germany and Sweden and short biases on Spain, Italy, and Greece.

Stay tuned,

Matthew Hedrick

Analyst

Europe’s New Year’s Update - mhh5