Positions in Europe: Short EUR-USD (FXE); Short UK (EWU); Short Italy (EWI)
We’ve titled this week’s European Risk Monitor “Summer’s Uncertainty” for it’s the continued lack of resolve on a credible plan to mitigate sovereign debt contagion that perpetuates uncertainty on the region’s economic outlook—and here the core is just as exposed as the periphery. This uncertainty is further enhanced by the lack of near term catalysts: ratification on the terms of the EFSF—which doesn’t include expansion of the €750 Billion facility—won’t come until late September/early October. Never mind that we think this facility needs to be enlarged—we’d expect pushback on the terms from Finland, Netherlands, Austria, and Slovakia, and therefore continued volatility across European capital markets, with a bias to the downside.
Notable callouts over the week include: Q2 GDP reports; Switzerland’s handcuffed currency intervention; proposals of a French austerity package; tempered remarks from Merkel on Eurobonds, and the slide in equity markets:
A.) EU-27 GDP fell to +0.2% in Q2 vs +0.8% in Q1 quarter-over-quarter, or +1.7% vs +2.5% year-over-year. Importantly, German GDP, the country thought to be “carrying” the region, fell considerably in Q2 as compared to Q1 (+0.1% vs 1.3% Q/Q; or +2.8% vs 4.6% Y/Y). The report reflects our call in late Q1/early Q2 of the slowing high frequency data in Germany.
B.) While the initial announcement by the Swiss National Bank to curb the strength of the CHF on 8/10 sent it tumbling versus major currencies, uncertainty remains to the extent the SNB can make a dent in the CHF’s +15.8% year-to-date gain versus the USD, or +9.2% vs the EUR, especially as Europe’s sovereign debt contagion pushes onward. Week-over-week the CHF-USD fell -1.2% and the CHF-EUR weakened -2.4%.
C.) France will unveil austerity measures this Wednesday, which will include budget cuts and higher taxes on the highest income earners. Critically, the terms of the package are essential to monitor for they could limit threats to a downgrade in the country’s AAA credit rating, an important point we’ve highlighted in our research, in particular as it relates to the EFSF.
D.) Finally, over the weekend German Chancellor Angela Merkel reaffirmed her resistance to the issuance of Eurobonds, saying that “they lead us into a debt union, not a stability union and each country has to take its own steps to reduce its debt.” Yet she left a slight window open in saying “euro bonds at this time would further undermine economic stability and so they are not the answer right now.”
E.) The DAX and CAC led European equity indices to the downside week-over-week at -8.6% and -6.1%, respectively; the equity markets of the PIIGS followed, down -4 to -5%, and we saw massive declines across European banks. As we look further out, expect no country to be immune from contagion risk.
Continuing on the point of Merkel’s stance on Eurobonds, it’s noteworthy that recent polls suggest 75% of Germans are against issuing Eurobonds. The real position at hand is the lack of fiscal accountability for the Eurozone member states and German resistance to a go-at-it-alone approach in which its borrowing cost move higher to subsidize its neighbors, in particular those without fiscal discipline. Germany’s finance ministry has calculated that the burden on the federal budget by issuing Eurobonds would be an extra €2.5 Billion in the first year, €5 Billion in the second year, and €20-25 Billion over the next 10 years. One issue to consider is that issuance of Eurobonds does NOT comply with the terms of the Lisbon Treaty. While an amendment could be passed, keep in mind that such an amending clause could take considerable time (years).
A look at 10YR government bond yields shows that Italy and Spain are trading just below 5%, or around 100 bps below our critical breakout line of 6%. We think this level is supported by the re-activation of the ECB's SMP bond buying program, however we do not see the SMP involvement as a long term solution to arrest yields as the ECB's mandate is solely to maintain price stability through monetary policy and not fiscal policy. Hence the importance on the EFSF decision.
Our European Financials CDS Monitor shows that Bank swaps in Europe were mostly wider last week: 28 of the 38 swaps were wider and 10 tightened. We expect downside in European banks so long as sovereign threats remain in the forefront. The lack of resolve on a credible plan to limit contagion, the ability to punish fiscal excesses, and allow banks to fail, are all points that need to collectively be addressed. We don’t think that the EFSF, even if it is resolved in its current state in late September/early October, is a panacea for the region’s ills.
We shorted Italy via the eft EWI today in the Virtual Portfolio. We remain short the UK and its sticky stagflation via the etf EWU. We are also short the EUR-USD via FXE. Our immediate term TRADE levels are $1.41 to $1.45.