Positions in Europe: Short UK (EWU); Short EUR-USD (FXE)
Keith shorted the UK via the etf EWU in the Hedgeye Virtual Portfolio yesterday. Our thesis remains intact: the UK economy is in stagflation that should persist for at least the next two quarters in an optimistic scenario. Real growth should remain impaired from domestic austerity programs that weigh on confidence and spending, and sovereign debt contagion across continental Europe that enhances banking counterparty risks (think French and German banks as well) and a reduced appetite for UK goods and services considering Europe is its largest export partner. Further, we’ve yet to see any meaningful improvement from the housing sector or elevated unemployment picture.
More specifically to our point on stagflation, GDP grew a mere +0.2% in Q2 quarter-over-quarter with Services sector growth at +0.5% slightly offsetting the -0.3% drag in Manufacturing. [July data also showed a notable inflection in the Manufacturing PMI to 49.1, or below the 50 line indicating contraction]. GDP grew +0.7% on a year-over-year basis, and we think 2011 growth could come in lower than +1.2% consensus.
While today’s Inflation Report from the BoE recognized growth challenges over the intermediate term, it stated that inflation, as measured by the CPI, should meet the BoE’s 2% target in 2012 and 2013. We’ll take the other side of this trade, and note there’s still just under five months left in 2011 and CPI has remained sticky above 4% year-to-date (currently at 4.2%), which will remain an added tax.
The inflationary effect of energy costs give us pause, especially considering the country’s dependence on foreign sources. Further, looking at UK PPI as an indicator, we expect to see the pass-on effect of higher consumer prices (output costs) as input costs (materials and fuels) remain elevated (see chart below).
In short, we see elevated inflation pressures and weak to negative growth prospects into year-end. We’ll short into that view.
As another piece of ammo to fight sovereign debt contagion across the region, the ECB announced today it will lend Eurozone banks €49.75 billion in emergency 6 month cash. While we don’t agree that concurrent bailout packages will stem all the fiscal imbalances across the region, we do think that these “band-aids” help give the common currency support. Additionally, bond yields have come in across the periphery since this weekend’s announcement of the resumption of the ECB’s SMP bond purchasing program. While it’s by no means a foregone conclusion that yields will “normalize” over the near to intermediate term, especially given the uncertainty on the size and scope of the EFSF facility to be voted on in mid to late September, such measures could help give support to the EUR versus major currencies over the near term.
Over the last four months we’ve outlined an immediate term TRADE range of $1.40 to $1.45 versus the USD, which has held strong. The pair continues to dance around our immediate term TREND of $1.43. Should both TRADE and TREND be violated to the downside, our quantitative models suggest the next line of support doesn’t come until $1.38.