Yesterday saw a complete meltdown in global credit markets, with Spanish CDS hitting new closing wides. This is not good at all.
Click to enlarge
As you can see, Spanish equities have followed suit, essentially following the lead of CDS.
Thinking aloud, I am wondering who is next, or better said, which country could be the best to short? Looking at today's action, I do find it interesting to note that while Spanish credit may be making new wides, it was German credit that had the worst day in percentage terms.
Source: Bloomberg (CRIS page)
So while EWP has been the preferred short by many, I think that EWG may in fact now be the better short because of the positive convexity in German CDS to a European crisis (translation: while both can widen, it's easier for a widening in German CDS to have an exponential impact). Personally, I think that Germany is dammed whether the Euro breaks up or not, so paying under 100 basis points for credit protection is a relative bargain.
While CDS is the playground of my hedge fund brethren, if you circle back to what is happening in Spain, you can see there is a clear correlation in the direction of a country's Sovereign CDS and that country's stock market.
Now, looking at the price ratio of German stocks to Spanish stocks, it appears Germany has essentially decoupled from Spain. A reasonable thesis on the face of it: over the past six months, German CDS has been cut in half and currently implies a very low probability of German default. On the other hand, Spain is obviously on the brink of crisis. However, looking at the below chart, I wonder if that news is priced in by this point.
Hence, this is why I am advocating shorting Germany, because I think German stocks are about to catch the Spanish contagion.
Looking at the action last year, once the market had fully punished Spain (relative to Germany), Spain actually outperformed from mid-July to October. These relative conditions are even more extreme today.
However, I think the German short has another dimension. German stocks have, at any given time, two drivers that cause their directionality: European Sovereign Risk and Global Economic outlook. I believe that much of the decoupling in German stocks over the last six months has been as much ECB actions as it has been a function of a perceived improvement in the global economy (of course, the two rationales are also correlated to each other).
As you know, with respect to the global economy, I believe we are at the precipice which has only just now been recognized (and barely so) by the broad investment community.
So when I put it all together - the contagion effects from Spain, the extreme overbought condition of German stocks versus Spanish stocks, and finally, a global economy that is rolling over - make the German stock market one of the investment world's least appreciated shorts for now.
Additional disclosure: I am currently net short the market, with shorts in Emerging Markets and Small Cap stocks against defensive U.S. longs.