Position: Short Italy (EWI); Short Euro (FXE)
In a post on 1/27 titled “Playing Europe’s Mismatch on Duration” we noted that our short positions in Italy (via the etf EWI) and the EUR (FXE) were working against us as three catalysts were giving a boost to European equity markets (especially the PIIGS) over the immediate term:
- Japan and China buying European debt
- Bullish speculation on a “comprehensive package” to tackle Europe’s sovereign debt crisis
- Hawkish commentary from ECB President Jean-Claude Trichet on inflation
In the note we also cautioned that over the intermediate term TREND our negative outlook on Europe, especially for the countries with high fiscal imbalances (Italy, Spain, and Portugal), remains intact.
These positions remain unchanged, and due to recent uprisings in Tunisia and Egypt European markets have received the proverbial hall pass on headline risk, and its equity markets, especially from the PIIGS, have outperformed. The threat now is significant mean reversion risk!
After all, the top 3 global equity indices year-to-date are:
- Greece Athex = +17.7%
- Italy FTSE MIB = +11.7%
- Spain IBEX 35 = +11.2%
Also, some of the fundamental data we follow to gauge the region’s “health” is showing signs of slowing, a concern over the intermediate term. We’ve hit on the pressing threat of inflation in our work, but forward looking indicators such as PMI surveys are signaling a topping, particular Germany, THE country “supporting” the region and divergent from Europe’s sovereign debt issues.
Final January PMI Manufacturing figures were released today from Markit (see chart). Although we’ll be more focused on the services numbers (released on Thursday 2/3), both Manufacturing and Services are indicating a slowing on the margin (despite the majority of countries reporting Manufacturing PMI improving month-over-month). Importantly there’s a heavy line of resistance at 60 that Germany is bumping up against, and increasing the mean reversion risk.
Although a lagging indicator, unemployment rates across many nations, but in particular in Spain and Ireland are moving in the wrong direction. Germany remains the exception, falling 10bps month-over-month to 7.4% in DEC. Beware that austerity programs throughout Europe, which include job strikes, wage reductions and freezes, and consumer tax hikes could further bolster these figures.
The EUR and ECB Catalyst
On Thursday (2/3) the ECB announces its refi rate. We do not expect a hike from the current 1.0% rate, despite Trichet’s recent hawkish rhetoric, which could pare back recent gains in the EUR-USD. We’d be shorting the currency (again) at its current level of $1.38 and covering it at $1.35 for a TRADE.
Matthew Hedrick
Analyst
