Thursday, July 18, 2013

A better way to buy Europe?

I have been constructive on Eurozone equities for some time. The imbalances in the region are healing slowly. Ed Yardeni, on his Fed Blog, highlighted a speech by ECB Vice-President Vítor Constâncio who indicated that the competitiveness gap between the North and South is narrowing:
They are achieving greater sustainability by moving towards an economic model based less on external borrowing and more on internal competitiveness. Indeed, according to harmonised competitiveness indicators based on unit labour costs have all registered significant improvements since 1999, Ireland (-19% since 1999), Spain (-9.5%), Greece (-9%), and Portugal (-6.6%). The loss of competitiveness accumulated until 2007 has been totally offset since the beginning of the crisis. As a consequence, the EU Commission forecast for this year is that all stressed countries will show a surplus on current account with the exception of Greece with a deficit of just 1.1 % of GDP.
What's more, the solutions have turned away from the popular perception of "all austerity, all the time" to a greater focus on growth. The recent Berlin summit that Angela Merkel held on youth unemployment is just one signal that the Eurozone leadership is now focusing on greater stimulus measures.

Political risks?
Meanwhile, nagging doubts remain. In particular, the political situation is crumbling and, under such circumstances, the likelihood of an anti-EU leader taking power or achieving enough power to become kingmaker, such as a Beppe Grillo in Italy or Marine Le Pen in France are increasing. Euroskeptic Ambrose Evans-Pritchard documented the political problems in Spain, which is hindering the government's ability to act:
Spain’s crisis has a new twist. The ruling Partido Popular is caught in a slush-fund scandal of such gravity that it cannot plausibly brazen out the allegations any longer, let alone rally the nation behind another year of scorched-earth cuts. El Mundo says a “pre-revolutionary” mood is taking hold.

A magistrate has obtained the original “smoking gun” alleging that Premier Mariano Rajoy accepted illegal payments as a minister. The Left is calling for his head but so are members of the Consejo General del Poder Judicial, the justice watchdog.

“Citizens cannot tolerate a situation where the prime minister has received undeclared payments,” said José Manuel Gómez, a Consejo member. Much of the ruling party appears tainted by a network of covert funding. If proved, said Mr Gomez, it poses a “very grave” threat to Spanish democracy.
Then there is the political crisis in Portugal:
Portugal is slipping away. Professor João Ferreira do Amaral’s book - Why We Should Leave The Euro – has been a bestseller for months. He accuses Brussels of serving as an enforcer for Germany and the creditor powers.

Like Greece before it, Portugal is chasing its tail in a downward spiral. Economic contraction of 3pc a year is eroding the tax base, causing Lisbon to miss deficit targets. A new working paper by the Bank of Portugal explains why it has gone wrong. The fiscal multiplier is “twice as large as normal”, or 2.0, in small open economies during crisis times.

What is new is that Vitor Gaspar, the high priest of Portugal’s shock therapy, has thrown in the towel. He blames the fainthearted for refusing to slash with greater vigour. Needless to say, he still refuses to accept that a strategy of wage cuts and deflation in a country with total debt of 370pc of GDP was always likely to fail.

Britain a better way to play Europe?
There may be a way to get exposure to the Eurozone economies without the drama - Britain. The UK is a relatively large and diversified economy that is part of the EU and trades principally with its partners on the Continent. However, it does have the advantage of being able to adjust competitive differences through the exchange rate mechanism instead of being locked into a single currency like the euro.

More recently, the outlook for the British economy is looking up. The UK June PMI beat expectations as the British economy posted its fastest growth in two years. Business confidence is surging and hit levels last seen in January 2008.

Take a look at this ten year chart of the relative returns of UK stocks (EWU) against Eurozone equities (FEZ). Both are ETFs trading in USD so that any currency effects are already factored in. UK equities had been in a trading range against its Eurozone counterparts until the adjustments after Lehman Crisis and the EWU/FEZ ratio has been in a relative uptrend ever since. As the ratio has retreated to test the relative uptrend line, it may be a good entry point for this trade.

Indeed, the UK market may be a better way to gain exposure to Europe, but without the drama.

It is also a cautionary tale for the gold standard cheerleaders who believe in a rigid exchange rate regime (like the euro) compared to the flexibility of floating exchange rates, but that's a post for another day.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Anonymous said...

Hi Cam. Like EZ equities too. Look at a chart of SPX, DAX, Estoxx, CAC and UKX since the lows of early 2009.
The problem with UK equities as you will see from this chart is that they have pretty much tracked SPX through the recovery. Same with DAX.
The real value seems to be with Estoxx and CAC which are still extremely low compared to SPX, UKX and DAX (some 37% lower).
Now Estoxx has a significant proportion of Spanish/Italian blue chips (especially banks) so I kind of get why it trades there. But what about France (CAC)? Would be interested to know what you think there... For now I think if we get this proper recovery in the US Europe will most certainly follow, and I certainly see better prospects in CAC than in SPX at this juncture. So slowly building a long in SX5E (Estoxx) and CAC.

Anonymous said...

Sorry Cam me again - my first comment not that smart as I should have converted all indices to USD for better comparison.
Doing this we get 1. SPX almost tied with DAX 2. UKX 25% underperf 3. CAC and Estoxx 40% underperf.

So your post makes more sense. The cost of taking the EUR risk is 15% though...

Anonymous said...

The monetary folks who keep telling us they'll do "whatever it takes" are hard money now? come on, cam

And btw, we've had nonstop every day, relentless weisenthall articles telling us "austerity" was destroying england. You know that.

Iesha said...

This is cool!