Eurozone: Is It Too Late?

Includes: BBVA, SAN, UVXY, VXX
by: Michaël Niessen

As expected by many economists, the newly released figures for the Eurozone show a GDP growth in the second quarter of 2013. The 0.3% growth rate was in fact higher than anticipated, as the consensus estimate was for a 0.2% increase. This marks the end of an 18-months long recession in the Eurozone area and is a further sign that the worst might be behind us.

Eurozone fragmentation

The overall picture looks good. France's economy has also grown 0.5%, more than the 0.2% estimate. In the rest of the Eurozone, the figures are also getting a little better.

Germany has also done well, expanding a higher than expected 0.7% (estimates were for 0.6% increase). According to the German Federal Statistics Office, the second-quarter growth was primarily driven by domestic demand, and exports rose faster than imports. Detailed data will be available on August 23.

There is, however, a huge fragmentation of the Eurozone. Indeed, while figures are better in many countries, GDP still decreased in a few other economies, albeit at a lower rate than in the first quarter. In the periphery, GDP grew 1.1 % in Portugal (vs. -0.4% in Q1) and declined in Italy (-0.2% vs. -0.6% in Q1), in Greece (-4.6% vs. -5.6% in Q1) and in Spain (-0.1% vs. -0.5% in Q1).

The unemployment situation is one other area where there continues to be a huge difference between the stronger and the weaker economies. And even within individual countries, there is a big difference between the younger than 25 and the rest of the population. In Spain, the unemployment is 26.3%, but 56.1% for people under 25. In Greece, those figures are 27.6% and 58.7%, respectively. In Italy, 12% and 39.10%, and in Portugal, 17.4% and 41%.

So yes, on average, it is getting better, but we are far from seeing the light at the end of the tunnel in this crisis. What we are witnessing (once again, it is nothing new) is a Eurozone that is split in a few strong economies, a few really bad ones, and the rest in between.

Germany is the main driving force behind the Eurozone GDP growth, there's no doubt about that. The economies of the so-called "Club Med countries" really have to improve for the Eurozone to stay in one piece. And on all fronts: not just GDP, but also unemployment, banking sector, etc… It remains to be seen if they will be able to do it at all, how long it would take (probably many years), and how much it will cost the stronger economies to bail them out of the crisis.

And then there are the other Eurozone countries, many not doing too good either, such as the Netherlands, still in recession, or Belgium, barely growing.

Is it too late, anyway?

Since some fundamental indicators are improving, is it safe to assume that the Eurozone economies are on the right track and will find their way out of the crisis? I would like to say yes, but it is definitely too soon to tell.

In their very interesting paper Cross of Euros, published in the latest issue of the Journal of Economic Perspectives, Kevin H. O'Rourke and Alan M. Taylor analyze economic history and try to draw lessons from it in order to answer a few questions regarding the current state of the Eurozone and whether it is likely to survive in the long run. I highly recommend you to read the complete paper, but I'll do my best to resume some of their main points in a few lines.

First, they explain why likening various "monetary unions" (for instance, the Eurozone and the United States) doesn't help much because, despite their apparent similarities, they are in fact quite different on several key points. When comparing past and present systems, such as the gold standard and today's situation in the Eurozone, we should remember that global economic and political conditions have evolved a lot. To cite a few examples, back in the eighteenth and early nineteenth centuries, wages and prices were more flexible, it was easier to ignore the interests of the working class because of limited voting rights, and there was great international mass migration, which helped relieve labor market pressures during hard times. The changing times, though, don't mean that there is nothing to learn from other monetary systems.

The United States created and then refined their banking union over a long period of time, and usually important crises spurred change. Those crises range from the Civil War to frequent financial crises, recessions and depressions in the late 1800s and early 1900s, to the Great Depression. Also discussed is the creation of the fiscal union, essentially starting in 1913 with the federal income tax and then slowly evolving into what we know today.

The main point here is that "the United Stated took perhaps 140 years to fully develop an appropriate institutional structure". More importantly, they did so based on a secure political union, developing monetary and, after major crises, banking and fiscal unions.

On the other hand, neither the Eurozone nor the European Union have real political unions. They also lack common debt and central fiscal authority. Kevin H. O'Rourke and Alan M. Taylor argue that the short-term problems are so great in the Eurozone periphery that it might already be too late to solve the long-term issues because the Eurozone may well have collapsed in the meantime. They then assert that even extremely fanciful scenarios might be the last thing Europe may ultimately find itself clutching to, "if the Eurozone doesn't move rapidly towards a different macroeconomic policy mix and at the very least a meaningful banking union".

It couldn't get much more pessimistic than that…

Eurozone banking union

Greece's finance minister Yannis Stournaras recently reiterated that a banking union and common debt market is needed in the Eurozone, echoing similar statements from Eurozone leaders in recent years. However, Germany is understandably opposed to debt mutualisation.

So what has been done so far? Well, a lot of talking, that's for sure, but not many actions have been taken yet. A vote on the Single Supervisory Mechanism (SSM) has been scheduled for its plenary session on September 9-12. It is considered a key step towards a banking union and would place 130 European banking groups (covering 85% of the Eurozone assets) under the supervision of the ECB. If passed, the text would then have to be cleared by the European Council and could then take effect in the fall of 2014; it was originally planned that it would begin to operate in March 2014.

Heightened risk in the fall

As I argued in my previous article (Eurozone: Be Ready For The Fall), there is substantial risk for the stock markets in the fall, due to a variety of factors. In it, I mentioned the expectation of a growing GDP for 2013Q2; this is thus not a surprise and doesn't negatively affect my opinion. In fact, it might even reinforce it, given that, should the stock markets keep rising to new highs in the very short-term, it will be even more likely that a correction will take place. The market performance this last couple of days, though, seems to indicate that the nervousness regarding a possible tapering of QE3 by the Fed overweighs the better-than-expected GDP from Europe.

The inevitable, continued strains between Eurozone countries will also most certainly move markets in the next few months. Indeed, when we simply compare Germany to the PIIGS, it is clear that there is a large gap between the best performers of the Eurozone and the periphery.

Finally, whatever happens in the short term, the grim analysis from Kevin H. O'Rourke and Alan M. Taylor is a reminder that, at the very best, the road to recovery in the Eurozone will be very long and bumpy. Despite my bearishness in the short-term, I actually think that further down the road, there is a possibility for improvements in the Eurozone and inevitably, more opportunities for the savvy investor. I also really hope than we won't have to endure such apocalyptic a scenario as a messy break-up of the Eurozone, but I will certainly continue to be very cautious and reassess the situation on a regular basis. More than ever, it remains important to closely follow the political and economic environment in the Eurozone.

If nothing else, remember the words written on Wednesday by Olli Rehn, the EU's top monetary official, in his blog: "I hope there will be no premature, self-congratulatory statements suggesting 'the crisis is over'."

How to position yourself?

In light of the coming volatility, my first recommendation is to carefully reevaluate your current investments and take some profits, in order to raise some cash and reenter the market at cheaper prices after the expected correction. If you are risk averse, it might be preferable to mostly stay on the sidelines for the moment, unless you are in for the long-term and can accept a drop without losing your sleep over it.

If you are not against taking some risk, there are many European ETFs available to short the European markets (including these) whether as a whole or for individual countries. As always, be careful especially with leveraged ETFs, as the market may be resilient for longer than you would expect before a correction occurs. My favorites are ETFX-DAX 2X SH (DE:DES2) to double short the DAX30 in Frankfurt (I currently have a small position in it) and CAC 40 X2 SHORT GR (FR:CAC2S) to double short the CAC40 in Paris. Outside of Europe, a possible tapering of QE3 by the Fed, which is one of the causes for concern this fall, would cause volatility. You might thus also want to consider iPath S&P 500 VIX ST Futures ETN (NYSEARCA:VXX) or ProShares Ultra VIX Short-Term Fut ETF (NYSEARCA:UVXY) to take advantage of it.

The European banking sector will likely continue to be highly volatile and thus will offer many opportunities, albeit with a relatively high risk in the short-term. For most of the past year and a half, I've been long Banco Santander (NYSE:SAN), but Banco Bilbao Vizcaya Argentaria (NYSE:BBVA) would also be a good choice. Both banks do very substantial business in Latin America, thus reducing somewhat their exposure to the crisis in Spain and the Eurozone. However, as most European banks, they are still risky investments and their charts over the past 12 months alone look like rollercoaster tracks, so don't bet your house on any of them. Because of that volatility, though, they regularly offer opportunities to buy in. Good entry points are around $6.70-$7.00 for Santander and $8.10-$8.60 for BBVA; at those levels, they present significantly lower downside risk and substantial upside potential. My preference for Banco Santander is in part due to the dividend rate of 8.24% at the time of writing (BBVA currently offers 4.17%), which makes it a good long-term investment; anytime it comes close to the aforementioned entry point, I buy some more and take some profits when it goes back to $7.75 or $8.00. As always, it is impossible to time the market exactly, so I did miss a couple of tops and bottoms, but overall it has been a very good investment strategy. I expect there will be new bottoms in both banks within the next couple of months.

Disclosure: I am long SAN. 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.

Additional disclosure: I am double short DAX 30 in Frankfurt (DE:DES2)

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