Wednesday, January 9, 2013

Why Is Europe Rallying? Or, The Power Of Central Bank Jawboning

Consider the following charts of European ETFs:

Both the Italian (top chart, weekly time frame) and Spanish (bottom chart, weekly time frame) ETFs have formed an upside down head and shoulders formation.  We see rising momentum in both charts.  The Italian market is right below the 200 week EMA while the Spanish market is right at the 200 week EMA.  All of the shorter EMAs are rising and are bullishly aligned.  Both markets are also right at important technical support levels.

The French ETF was trading between the 17/18 level and the 22 level for most of the last year.  However, prices also staged a rally starting at the end of last summer and are now above the 200 day EMA.  We also see a rising momentum reading and decent CMF.

The German market has now rallied through the 61.8% Fib level established from the 2011 sell off.  Prices are above the 200 week EMA, and the shorter EMAs are rising.  The CMF is very strong, while the MACD is rising moderately.

And yet, when we look at the fundamentals of the region, we see a recession.  As I wrote in mid-December regarding overall GDP growth:

1.) The EU 17 has been contracting for three straight quarters.
2.) The EU 27 has bee contracting for two straight quarters.

In other words, the entire continent can be described as in a recession according to one of the standard definitions of recession (two straight quarters of contraction).

Also note the following.

1.) Three countries have been contracting for two straight quarters: Belgium, Denmark and Finland

2.) Four countries have been contracting for three quarters: Czech Republic, Spain, UK and Hungary

3.) Six countries have been contracting for at least four quarters: Italy, Greece, Cyprus, Portugal, Netherlands and Slovenia.

That means that of 27 countries in the EU 27, a little under half are in a technical recession.

And yesterday we learned that unemployment has increased: 

Eurozone unemployment hit a fresh record of 11.8 per cent in November, official statistics showed on Tuesday, highlighting the dire state of the bloc’s economy in spite of hopes for a gradual recovery this year.

Across all 27 members of the EU, more than 26m people were out of work in November, or 10.7 per cent of the workforce, according to Eurostat, the EU’s statistical office. The seasonally adjusted unemployment rates for both the eurozone and the wider EU jumped significantly from a year earlier, when they were 10.6 per cent and 10 per cent, respectively.

So -- despite this terrible economic record, why are we seeing strength in the EU markets?  There are several reasons.

1.) Equity markets are a leading indicator: traders are betting on future growth.  They saw the bottom last summer and started buying when shares were cheap.

2.) Belief that strength in the US will help to pull the EU out of recession.  When the US reached the fiscal cliff deal worldwide markets moved higher.  Europe was no exception.

3.) Cheap money and minimal return on safe assets.  Consider this chart from Ed Yardeni's blog:

French and German bonds are offering investors nothing in terms of return after considering inflation.  Buying those assets would lead to a return of capital not a return on capital.  As such, people looking for return are forced into the equity markets to obtain that return.

4.) The Draghi Speech on July 26, when he made this statement:

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

Notice that all of the markets noted above started rallying at the end of July/early August time period, when the above statement was made.  Also note in the chart from Dr. Ed that yield on the more speculative EU credits started to drop around the same time.

It's important to remember the markets have not meaningfully tested the Draghi  statements yet.  They are simply relying on his good faith to follow through on his promises.  There is also the assumption that programs put in place will be enough to avert a continent wide disaster if implemented.  I'm not stating they are not -- just that they are untested as of now.