From time to time, global markets create big anomalies, most of which offer great investment opportunities. Such an egregious anomaly currently lies in the lagging behavior of German shares with respect to their U.S. counterparts', evident since Q1 2015. This opens up an opportunity for investors to take advantage of the potential outperformance of German over U.S. equities, due to the more favorable positioning of the German versus the U.S. economy. In fact, Germany seems to be approaching in an overheating situation much faster, and with less risk to the downside, than the U.S. economy does. The euro has gained enormous competitiveness in relation to the U.S. dollar in the last few years, and Germany has taken bold steps to open up its economy to international trade, taking full advantage of its cheap currency. These dynamics coincide with an acceleration of the global business cycle and a potential coordination of fiscal policies across the continents, all of which Germany is in a position to take full advantage of. This opens a window of opportunity for a spread trade consisting of a short position in S&P 500 (NYSEARCA:SPY) coupled with a long position in the MSCI German Index (NYSEARCA:EWG). Except the excellent risk-reward profile of this trade setup, its performance is not predicated on a singular macro scenario. Rather it can potentially benefit from optimistic as well as pessimistic global macro outcomes; a characteristic which makes it weatherproof. However, first and foremost, it is the extremely different positioning on the German economy which lies at the heart of this trade.
Germany Vs. U.S.: Differences in Macro Positioning
Despite the fact that according to recent estimates the U.S. economy seems outpacing the German in terms of real GDP growth, their positioning reveals a different story. The German economy approaches closer to the point of overheating than the U.S. does, and it is better positioned to take advantage of either a global trade pickup or even the dichotomy of the world due to U.S. protectionist action.
As a matter of fact, Germany has made great progress in the last few years in opening up its economy to global trade, while the U.S. has moved in the opposite direction. Germany was always a much more open economy than the U.S. in terms of its share of exports as a percent of GDP. Since the launch of the common euro-area currency, though, German exports of goods and services as a share of GDP have increased steeply, almost doubling as a percentage of the country's output. The U.S. economy, on the other hand has witnessed only a mild increase in its exports as a share of GDP since 1970, with an ominous downturn in this percentage lately. In particular, between 2011 and 2015 the U.S. exports as a share of GDP have shrunk from 13.6% to 12.6%, while Germany has managed to drive its own share to new highs, from 44.8% to 46.8%. This occurred at a time that German unemployment level was falling to multi-year lows.
Source: World Bank
Currently, Germany experiences its lowest unemployment level in decades at 4.1%, despite the sizeable inflow of immigrants coming mostly from Middle East. The U.S., on the other hand, exhibits its lowest unemployment level in only the last nine years at 4.7%. This rate is higher than the troughs reached in previous decades, diverging from the multi-decade tight pattern of German job market.
In addition to that, the structural long-term unemployment level in the U.S., which has drifted down over the last few years towards 24%, still seems very elevated with respect to its historical patterns. Such a level of U.S. long-term unemployment, indicating labor force participants who are unemployed for 27 weeks or more, is quite high with respect to the lows experienced before the Great Financial Crisis, and even more so with respect to the single digits evident before the 90's.
Source: St. Louis Fed
Apart from its ultra-tight labor market condition, Germany experiences inflationary pressures which systematically prove forecasters wrong. In five out of the last six months, the German consumer price index has surpassed analysts' expectations, reaching a three-and-a-half year high at 1.7% YoY. This is the fastest inflation increase in the last twenty years or so. In contrast, the U.S. inflation rate has barely touched a two-year high, involving fewer surprises along the way.
Turning to the assessment of economic activity, a closer look at the PMI indices of both economies will reveal the same story of divergence. The average outperformance of the German manufacturing PMI figures versus their preliminary expectations, in the last six months, was about 1%. In the U.S., the ISM manufacturing index readings managed to beat consensus expectations only by about 0.2% on average. In simple terms, Germany's manufacturing activity has surprised experts five times more than the U.S. did.
These facts reveal that the German economy accelerates faster, consistently, and more unexpectedly than the U.S. does, increasing the probabilities to produce positive surprises in the future as well. This goes against the generally accepted premise that the U.S. economy acts as the locomotive of the latest global acceleration cycle. Yet, Germany's exposure to the world economy not only can benefit from this global acceleration more than the U.S. but it has one powerful tool at its disposal; a highly competitive currency, in trade weighted terms. As a matter of fact, the euro trade weighted index against 21 most important trading partners of Germany has devalued by about 5% in the last three years, while the corresponding USD trade weighted index has risen by more than 25%. This makes their relative difference skyrocketing more than 30%, i.e. makes the German economy more competitive in currency terms than the North American economy by about one third. This significant gain in competitiveness of the German versus the U.S. economy in the last three years, coupled with the increased openness of the former against the latter, creates a big cushion against any euro revaluation. In other words, there is much more room for euro to strengthen before it starts to bite the German exporting machine than it is for the greenback before it starts hurting the U.S. economy.
Weatherproof Trade Profile
This favorable positioning of the German economy against the macro backdrop of an accelerating global business cycle opens up the opportunity for a spread trade betting on the outperformance of the German over U.S. equities. This spread trade can be executed by opening a short position in the S&P 500 index coupled with an equally weighted long position in the MSCI Germany index, and can be represented by the ratio of EWG over SPY. This ratio needs to rise in order for the trade to deliver gains. The remarkable fact is that this ratio currently rests close to its thirteen-and-a-half year lows, after completing a sizeable and long-lasting outperformance of U.S. equities. This coupled with the favorable position of the German economy, raises the probabilities that the ratio EWG/SPY has moved away from its cyclical bottom, and it is about to reverse to the upside ahead of a new cycle of German outperformance.
That said, the EWG part of this ratio entails exchange rate risk, since it invests in German shares denominated in euro. This means that any further drop in EURUSD (NYSEARCA:FXE) will curtail the performance of EWG when measured in USD terms. However, with the German economy potential entering into an overheating dynamic the ECB will most certainly be pressured to take some money off the table, i.e. to start tightening its ultra-accommodative monetary policy at some point further down the line. Should that happen, the interest rate differential between the U.S. dollar and the euro will start closing in again. In fact, the gap between 10-year U.S. Treasury yields and 10-year German Bund yields peaked and started moving down again; a possible indication of such a monetary policy convergence.
Whatever the case may be, sooner or later the European monetary policy will begin to align with the Fed and the excessive pressures on the shared European currency will subside. This prospect will definitely support the EWG price; especially if we consider the big cushion German exporters have to absorb a possible euro revaluation.
Putting any exchange rate considerations aside, the core of the trade rests on its ability of its positions to benefit from two opposing global macro scenarios, an optimistic and a pessimistic one. Under the optimistic scenario, President-elect Donald Trump manages to maneuver sufficiently through Congress "corridors" and delivers a truly pro-growth policy mix, without embarking on any excessive protectionist moves. This makes the Global Fiscal Rotation, i.e. expansionary fiscal policy coordination among China (NYSEARCA:FXI), U.S., and the U.K. (NYSEARCA:EWU), which might be followed by Germany ahead of its own critical elections this year, to materialize. This planetary policy setup, if accommodated by a gradual normalization of monetary policy in the U.S. and later on in Europe, will be able to lift the global business cycle, and re-ignite cross-border trade growth. Under this optimistic scenario, German stocks are optimally positioned to benefit and the German economy to move faster towards an overheating cycle. A rise in global shares with the German segment outperforming in USD terms will most certainly ensue, pushing the ratio EWG/SPY significantly to the upside.
If, on the other hand, the pessimistic scenario prevails, then the new U.S. president will fail to deliver on his electoral pledges and will succumb to a highly introversive economic and foreign policy. Should that happen, the dollar (NYSEARCA:UUP) will plummet and investors in German shares will refocus their attention towards Germany's trade links with Asia Pacific and emerging Europe. China and Germany, though Eurozone, might attempt to build closer relationships and pick up the slack from the downsizing of U.S. imports.
Even in the case of a more adverse macro scenario such as abrupt yuan (NYSEARCA:CYB) devaluation, or another liquidity draining global shock, the trade could still work in investors' favor. If such a case, the Fed would be forced to flood the world with bucks through its swap lines, and to abandon its rate hike plans. This would revalue the euro against the greenback due to the shrinkage of their interest rate differential, as interest rate expectations in the U.S. are reversed.
What are the main risks to this spread trade between the U.S. and Germany? Basically, any events which lead to the disintegration of the Eurozone and the European common market. Such events could derail the exponential growth of Germany's international trade, evident in the uptrend of its trade balance towards new all-time highs. Despite the fact that there is no way for investors to predict the timing of such political and economic developments, a proper stop-loss strategy must be implemented in order to account for the risk of a European downfall. This stop-loss should be placed in the event that the ratio of EWG/SPY breaks to the downside its cyclical lows of July 2016.
Overall, the huge anomaly evident in the relative high valuation of the U.S. versus the German equity indices, presents a great opportunity for correcting itself. Germany is one of the most open economies on the planet which runs on all cylinders, positioned to benefit the most from any uptick in global economic activity. This has not attracted enough investors' attention possibly due to the fact that Eurozone's imbalances and structural problems overshadow Germany's own internal macro dynamics; a kind of halo effect. This investor's bias was possibly responsible, at least in part, for fueling the great anomaly between the S&P 500 and the MSCI Germany index in the first place. Maybe the time has come for the Germans to take their long-awaited investment revenge.
Disclosure: I/we 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.
Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.