Positions in Europe: Long Germany (EWG); Long Sweden (EWD)
Geopolitical risk is back, or did it ever leave? As we look back at last week’s market performance in Europe little has changed regarding the region’s sovereign debt soap opera. The incremental news, including Moody’s downgrade of Portuguese credit rating four notches to junk (Ba2) on Wednesday, contributed significantly to the strong underperformance from the peripheral capital markets, while the spotlight on fiscal imbalances appears to jump from one nation to the next. Of the equity markets, Italy’s FTSE was the worst performer across the region, down -7.2% last week on a week-over-week basis, followed by Spain’s IBEX (-5.3%), and Greece’s Athex (-4.4%).
Our risk metrics of bond yields and CDS spreads continue to trend up and to the right, reflecting that little has been done to address the solvency issues of the PIIGS. We’ve named the bailout packages for the PIIGS mere ‘band-aids’ for they’re just that—short term fixes to much larger fiscal imbalances. Repairing years of government overspending, oversized government sectors, and a lack of tax collection on a backdrop of weak growth prospects and under the rigid constraints of the ECB’s unilateral monetary policy, change in the fiscal standing of the PIIGS will not happen overnight—yet investor patience is short and the actions of the main ratings agencies are impactful. Expect more foot power (riots and demonstrations) on the ground. The nearest major catalyst is a mid-September date to finalize a second bailout package for Greece (est. €70-120 Billion).
As headlines sway markets, “new risks” have surfaced from Italy. We’ve long since warned of elevated debt and deficit levels of Italy and Spain, two economies that make Greece, Portugal, and Ireland, even when combined, look like small fries, with exponentially more banking counterparty exposure to the rest of Europe. News out today that Italian regulators are ordering a new short-selling rule on Italian-listed securities until September 9th, not only sent banking stocks across the region plummeting [in some cases halting the stock (Unicredit)], but took down entire indices as well. Italy’s FTSE had its largest one-day drop in more than a year! Helping the tumble was talk about Italy’s public debt—the second highest in the Eurozone behind Greece’s—at 119% of GDP at a meeting of Eurozone finance ministers today in Brussels as Italy’s parliament still needs to finalize a new three year austerity program worth €47 billion in tax hikes and spending cuts next month.
While Eurozone leaders, including Chancellor Merkel, voiced confidence in Italy’s ability to pass austerity and trim its debt, it was nevertheless a bloody Monday, with neither the equity, debt or currency markets un-phased. The worst equity performers day-over-day included:
The EUR-USD, which has largely held up in the $1.40 to $1.45 range over the last weeks, touched $1.39 intraday today (the first time since late May) and is trading at $1.4022, or down -1.70%. The EUR-USD is now squarely through our intermediate term TREND line of $1.43, an ominous signal that we’ll be looking for confirmation of before issuing a new target. We continue to maintain that Troika’s mandate to step in to bailout any Eurozone member will help support the EUR-USD, but not in perpetuity.
All-Time is a Long Time!
With yields continuing to blow out across the periphery, our focus is on Spain and Italy, both of which flashed all-time highs in spreads over German bunds today. This ominous signal was countered by the relative safety trade in the Swiss Franc, a haven as Europe works through its issues. The CHF-EUR reached its own all-time high at 0.8539 EUR today!
Banking Risks Pop
Ahead of this Wednesday’s (7/13) announcement of the European Bank Stress Tests, Part II, and with respect to Italy’s move on short sales today, risk blew out significantly week-over-week. Our European Financials CDS Monitor showed that 32 of the 38 bank swaps were wider week-over-week, and 7 were tighter, and one unchanged. Should the estimated 15-22 of 95 banks fail the test, expect more downside ahead!
We remain very cautious on owning European countries on the long or short sides. To the latter, we think there’s more downside from here for the capital markets of the periphery. We remain long Germany (via the etf EWG) in the Hedgeye Virtual Portfolio and added Sweden (EWD) on the long side on 7/8.