As Americans were heading back to work from the long Memorial
Day weekend, Europeans were fretting about a looming banking crisis
that threatened to take down major banks in Ireland and Spain.
Europe went on to dodge that bullet, and its equity markets have
rebounded +30% in the last five months, as measured by the
Vanguard European StockIndex Fund (Nasdaq: VEURX)
That move is even more impressive than the rebound seen here in the
United States. Part of the gain stems from a projected +35% rebound
in 2010 profits among Europe's largest 500 companies, according to
UBS. The bank anticipates an additional +10% gain in profits next
year as well.
But even as Europe is no longer on the cusp of a crisis, it remains
far from healthy. A host of factors will likely conspire to deliver
muted economic growth at best. And there's also a reasonable chance
the continent slides back into recession.
Germany's false dawn
The troubling budget deficits, unfavorable demographic trends and
inflexible labor stances have been widely-chronicled impediments to
any major economic rebound in Europe. Yet the German
has remained remarkably resilient, thanks to robust exports of
industrial equipment, autos and precision machinery. On a
continent-wide basis, 40% of large European companies' sales go to
exports outside of the European Union (
changes everything. Back in early June, when the European markets
started to rebound, the euro was worth about $1.20. A euro now buys
about $1.40, which means that European exporters are roughly -15%
less competitive than before. Adding insult, the Chinese yuan is
pegged to the dollar, so the euro is surging against that currency
So what does a +15% gain in the euro really mean? For starters, it
gets harder to compete with goods made elsewhere. Volkswagens made
in Europe quickly become less competitive with vehicles made in the
U.S. or Asia (outside of Japan) -- which explains why VW is
desperate to expand manufacturing capacity in North America and
build more vehicles here. That also spells fewer European jobs from
Secondly, a rising currency reduces the value of export profits by
a commensurate amount, so major European companies are likely to
face increasingly stiff headwinds on the profit front.
The United Kingdom made recent headlines with plans to sharply
curtail government spending. The country plans to run budget
surpluses to start to bring down very high debt loads, which means
that the government becomes a net drag on the economy as it takes
in more revenue than the services and entitlements it doles out.
Other countries will need to move in that direction in coming years
to bring down deficits as well, most notably in the
countries (Portugal, Italy, Ireland, Greece and Spain).
And as we've seen recently in Greece, economic contraction is the
result. Yet the PIIGS have historically served as key export
markets for France and Germany, Europe's stalwarts. Shrinking
economies mean reduced demand for French and German goods. To make
up for lost regional demand, major European companies will need to
seek out new markets abroad to offset that drag. But as a high-cost
region, that may be hard to pull off.
To be sure, the major European economies have proven resilient in
the aftermath of the global economic crisis, and no one is
suggesting that Europe is going to experience a sudden economic
plunge. But current economic data and corporate profits look good
in 2010 simply because they are being compared to the dismal
results of 2009. Serious headwinds -- especially in the form of a
surging currency -- imply that 2011's year-over-year comparisons
will be far less robust. And this summer's impressive +30% rebound
could well look like a false dawn.
Action to Take -->
If you own shares of European-based companies, profit-taking seems
like the right move at this time. You can even look to go short
against Europe by buying the
ProShares UltraShort MSCI Europe (
exchange-traded fund (
, which moves at twice the rate in the opposite direction as the
MSCI EuropeIndex . The bearish fund has lost half of its value
since late May, but has posted a solid +5%
in the past two sessions. That may be a harbinger of things to
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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