Europe 2013: The Song Remains The Same

Includes: EWG, EWQ, SPY
by: David Urban

2012 will go down as a tumultuous year for Europe. It is no surprise that Greece continues to have problems and Europe is running out of options. Private investors have taken a haircut, 30-year bonds were issued with a 2% interest rate, and the bonds have been bought back at 30 cents on the dollar, but there remains the issue of an unsustainable debt to GDP ratio. The only option left is a haircut by the European pension funds holding the debt, and that is unpalatable in the current economic climate. Imagine a state employee being told that now their pension fund will take a massive writedown on Greek debt, which will affect the ability to fund pension benefits going forward.

Spain continued to flounder with unemployment over 25%, as Italy and France changed governments and the continent fell back into recession.

For 2013, the song remains the same. The EU Central Bank has cut their growth forecast for 2013, once again indicating the double dip recession will continue to grind on the continent.

The Bundesbank has lowered German GDP forecasts to 0.4% next year with a warning that the German economy will contract in the fourth quarter of 2012 and the first quarter of 2013.

Efforts will be made to kick the can down the road past the German elections in September. Until then, everything needs to be pushed under the rug or else Germany risks the election becoming a referendum on Greece and the EU, something nobody wants.

A potential wildcard is the possible rise of former Italian Prime Minister Berlusconi, as the pro-European Prime Minister has resigned and elections are expected in early 2013.

Until a growth compact is found and successfully implemented, it is hard to make an investment case for any of the southern countries from Portugal to Spain to Italy and Greece. All four have serious structural problems that will require hard decisions to be made sometime in the future. Continued monetization of debts is not a solution for the structural problems of high unemployment, high budget deficits, and high debt loads. It just continues to kick the can down the road.

In terms of a Greek solution after the German elections, you might have to wait since Greece takes over the rotating Presidency of the Council of the EU on January 1, 2014.

In terms of investment opportunities, European ETFs will remain a trade and only a trade for investors until the situation comes to a resolution, and that may be longer than anyone anticipates.

The FTSE may offer some of the best value for investors looking for European exposure, as the index appears primed for a run at old highs from 1999 and 2007 and may be the proxy for the market. The last two peaks in the FTSE came ahead of similar peaks in the DAX and CAC meaning that if history is a guide, this index will flash an indicator before the rest of Europe. Investors looking to go long the UK market should consider the iShares FTSE 100 (NYSE:ISF) and the iShares FTSE UK Dividend plus (IUKD) ETFs.

The key for the DAX is breaking out to a new all-time high next year on strong volume. It is hard to believe, but if that happens, it will complete a massive ascending triangle pattern going back to 2000. Failure here sets up the possibility of a triple top in the market and a pullback to the 6,500 level. The German iShares ETF (NYSEARCA:EWG) is a possibility, but only if the German market is significantly overbought and due for a pullback.

The French CAC has broken higher off of a low and may have another 10% before some serious resistance levels set in. Given the malaise setting in over France and Germany, it is hard to believe that both indices will set new highs in the coming year. Investors considering France should consider the iShares MSCI France ETF (NYSEARCA:EWQ), although it is technically overbought, but not to the extent of the German DAX.

In terms of Southern Europe, it would be best to just avoid the troubled areas altogether until a resolution can be found. The combination of high unemployment, contracting economic growth, and lack of a cohesive plan to correct the structural imbalances makes those areas unattractive for investing purposes.

While the indices are close to new highs, there remains the potential for problems. S&P has threatened Italy with a cut in their credit rating if the economy remains in recession during the second half of 2013.

The muddling along will continue until after the German election, when there may be some hard choices made. If the European governments are serious about getting Greece's finances on a solid track, they will have to accept something that to this date they did not want to touch -- a writedown of Greek debt by European governments and pension funds.

Until the EU admits that they need to take a massive writedown on Greek, Spanish, Portugese, and Italian debt and they actually do so, the Southern European countries will remain a drag on the continent as a whole, risking a potential collapse in sentiment.

For the next six to nine months, Europe should be in the clear but if things turn south, things will get ugly very quickly as all eyes focus on the German elections. If so, investors will likely rush out of Europe and head towards the U.S., rushing into the S&P 500 (NYSEARCA:SPY) as US economic growth, although tepid, remains positive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.