Here’s a fantastic chart showing the performance of the various equity markets in Europe. Hedgeye analyst Matthew Hedrick warns of a “contagion drag” and how as Germany is forced to foot the lion’s share of the bill for European bailouts, the situation will continue weigh on Germany’s capital markets.
Hedgeye: As part of our Q2 theme Sovereign Debt Dichotomy, we advised that one possible play on sovereign debt risk in Europe is to be paired off long Germany and short Spain. Our bullish thesis on Germany included a tighter fiscal balance sheet than many of its European peers, the advantage of a weaker Euro for an export-heavy economy, low inflation, and a stable rate of employment. While we’ve seen significant divergence in the underlying German and Spanish equity markets over the last weeks, including a spread as wide as 2000bps between the DAX and IBEX 35 on May 7th, the increasingly larger share of the ‘bill’ that Germany will bear for the Eurozone’s collective bailout is bearish for German capital markets (see chart 1 below).
While the German unemployment rate remains positive, declining in the latest reading to 7.8% (versus the Eurozone average of 10% and 20% in Spain) and is underpinned by the government’s successful part-time labour programs, contagion from European sovereign debt risk persist despite the $1Trillion European loan/debt buy-up facility issued on 5/9. Additionally, Germany’s unilateral ban on naked short selling on 5/25 is adding fuel to the fire and enhancing market volatility.
On the margin, the fundaments we’re following in Germany and the broader stock market suggest a downward reversion to the mean, especially as risk in Europe (and globally) is pushed further out. One area to look to for confirmation of this is the bond market (chart 4), where we’re starting to see German yields rise.