Continued Weakness In Europe, And How To Position For It

by: Efficient Alpha

By Joseph Hogue

Bloomberg reported Thursday that PIMCO’s Mohamed El-Erian is expecting the European Central Bank to cut interest rates and puts the odds of a recession in the region at 50 percent. This would be a reversal of the bank’s previous movements, raising the interest rate twice this year, but understandable given growth in the second quarter of .2% in the 17-member Euro group. This slower growth compares to a reading in the first quarter of .8% and second quarter growth in the U.S. of one percent.

In other news out of the E.U., Spain’s auction of bonds was extremely soft. The ECB has had to support the market for Spanish and Italian bonds for weeks by buying on the secondary market. Given the weakness in the Spanish auction, this will need to continue. El-Erian actually raises the idea that the ECB may need to raise capital in the event of a E.U. government bond default because the bank now has so much of this debt on its balance sheet. There is some hope within the region, last week the former head of the Israel Central Bank told Bloomberg that the Euro Reserve Fund (currently at 440 billion Euros) has enough to cover debt interest payments for two to three years, though problems to long-term stability still exist.

El-Erian’s odds of a European double-dip are higher than the odds that PIMCO’s Bill Gross puts on a U.S. recession of 40 percent. Though the economy in the United States is not something to gloat over, I am generally more optimistic on our prospects relative to our neighbors across the Atlantic. While non-farm payroll numbers have been week over the past few months, the initial claims activity is showing a positive trend. Thursday’s reading came in at 417k versus the previous week’s report of 422k. On the downside, the new orders minus inventories measure on the August ISM Manufacturing Index dropped to -2.7, which is the lowest since September 2010. Debt auctions for the U.S. have been relatively strong though, even after Standard & Poor’s reduced the credit rating.

There are a couple of ways to use this information. One, economic data from the U.S. and Europe continues to unfold on the weaker end of expectations. The risk averse investor with near-term liquidity needs may take this as reason to protect capital within their portfolio. I recently wrote an article outlining ways to protect your portfolio from a possible recession. Gold through the SPDR Gold Shares (GLD) continues to be a favorite of investors, but I generally prefer the gold miners, available through the Market Vectors Gold Miners ETF (GDX) as a more stable bet.

The relative data coming from the U.S. and Europe may present the opportunity for a pair-trade. Europe entering into a new recession may not necessarily mean the U.S. will experience negative growth. I believe, however, that a new recession in the U.S. would almost certainly mean the same for Europe. Shorting assets tied to the European economy while staying long those in the U.S. may provide returns while hedging for possible outcomes. Most notably financials are at the forefront of the situation and stand to gain or lose the most given different results. I am long the SPDR Select Sector Financials (XLF) and would consider a short of the SPDR S&P International Finance ETF (IPF) as a pair trade against the European banking situation. The XLF holds 97% of its fund in U.S. banks while the IPF has approximately half of its holdings in European banks. Banks in the United States have consistently reported lower rates of delinquencies on their loan portfolios and are starting to see revenue gains from key banking functions. While banks on both sides of the Atlantic continue to hold shady assets on their balance sheets, the European banks hold a much larger exposure to their peripheral countries.

I would also consider a short exposure on the Euro through the CurrencyShares Euro Trust (FXE) and a companion long position in the dollar through the Powershares DB US Dollar Index Bullish Fund (UUP). If the economic fundamentals in the U.S. do weaken further, the Fed will almost certainly carry out some form of aggressive liquidity program. Dare I even say, “QE3?” If this happens, then emerging market currencies will continue to strengthen relative to the developed economies and investors should add exposure, possibly through the WisdomTree DreyFus Emerging Currency Fund (CEW).

Though a case can be made for taking unhedged bets on either side of the economic debate, I prefer pair trades against possible outcomes. At these levels, I do not see the market as significantly over- or under-valued, meaning there is a strong possibility for movement in either direction.

Disclosure: I am long XLF.

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