The Strange Death of DAX
… or Europe
In a week that saw China welcoming possible new trades talks, but confirmation of the original $200Bn tariff package, European rate decisions and general good news on Brexit, and hurricanes in the US drive up Oil, we continue to see divergence between markets and in particular between US and European markets. While Donald Trump’s tax cuts and promises of fiscal expansion continue to drive a less than uniform US stock uptrend partly due to the uneven impact of trade tariffs, European stocks and most notably the German DAX remain consistent underperformers. In fact DAX has consistently lagged SPX for much of this uptrend.
Indeed the continued correlation break down between US and European stocks and recent DAX weakness has created a divergence and knock on effect in sentiment. On the one hand relative DAX weakness has encouraged some to believe Germany is leading a turndown in the US. Whereas on the other hand many see this underperformance as temporary—a time lag in a global economic cycle that will see DAX with many other European stocks catch up. In our opinion neither is true. The reality lies somewhere in between. The general European downtrend (versus the US) will remain in force but subject to sizeable but not sustained recoveries. Today’s newsletter explores the reason for this possibly strange death of DAX and indeed Europe and the likely consequences.
Recent DAX, European and even Euro underperformance has been attributed to problems with Italy, Turkey, Brexit, less German politics but more an increasing Chinese fallout over the trade war. Although the news and its impact about these issues often appears temporary it does not mean the overall effect is not lasting. There has been a steady flow of funds out of Europe.
This begs the question why and whether the reasons will be sustained. Certainly investors remain worried that political upheaval in Italy and elsewhere could derail Euro area economic growth.
Sentiment for the European economy dropped this year to its lowest point ironically since August 2012, when the region was last embroiled in a debt crisis that threatened to break up the bloc. Ironic if consider the risk premium now attached to Italian bonds over US treasuries as the ECB enters Taper and presumably reduces its ability to buy Italian bonds in a bid to support the local economy. Not much to consider.
But uncertain Italian political crises are a quasi-permanent feature of European investment decisions. As Brexit appears to be becoming. The FTSE and DAX are Europe’s worst performing major stock indices in 2018. Although a Brexit agreement does not seem that far away, the outcome from any such resolution is unlikely to be clear until the 2020s—a horizon well beyond many traders’ perspectives. And like it or not real investors hate uncertainty preferring a sure thing to a possible idea. Similarly pressure on the Turkish Lira remains subject to political risk both within Turkey and the global trade war. It is a common trait or mistake of traders to seek (sometimes immediate) fallout from uncertain conditions before that is readily apparent. Indeed, as previously stated, our view is that all these individual threats to the European economy will subside over time even to the extent that a possible abatement of the Trade war. But that does not mean we can or do see sustained European outperformance. The mere existence of some of these problems has already served as a brake on the ECB’s taper programme and subsequent raising of rates—a measure that ironically would be seen as a positive indictment of the European economy and, in our view lead to a relative recovery to European stocks and the Euro. However, the sustainability of any such rebound will be subject to more underlying problems that will not go away until after the global economy is dented by a stock market crash.
The first is Trade War. Although China and the US are at the forefront of trade tensions and their consequences, Europe and particularly Germany are far from immune. The global footprint of German Dax companies has turned a benefit from increasing globalisation prior to 2008 into a disadvantage in a US centric bull market now subject to a trade war.
Carmakers and chemicals account for just under 30% of DAX and help explain the relative recovery in 2017 due to the global economic upswing. In contrast, two of the driving sectors elsewhere, banks and tech companies carry little weight in DAX leaving it more vulnerable to the vagaries of the Trade War. Indeed, this has not only discouraged investment has actively led some funds bet against German corporates. The largest non-sovereign fund, Bridgewater has built up a $22bn short of eurozone companies including Siemens. Continued relative weakness in global bank stocks has also hit European indices and particularly DAX badly with the Euro Stoxx bank index in a technical bear market having fallen more than 20% since January.
With banks and financials comprising a fifth of Euro Stoxx 50 it is hard to European indices outperform without a similar adjustment in financials, a much needed consolidation in the European banking sector, or indeed a significant improvement in European political and sovereign risk. The simple fact is that European (and particularly London) capital markets have still not recovered from the 2008-2009 financial crisis falling 8% (25%) relative to GDP while US markets have grown by 8%. Clearly Britain’s departure from the EU hasn’t helped nor has uncertainty surrounding London’s future as one of if not the pre-eminent world financial centre.
The contrast between Europe’s lacklustre and US’s stellar performance is clear and important. Although European markets are generally not in a bear market the divergence between US and European valuation premiums (PEs) is striking.
In other words the difference between US and Germany/Europe is fundamentally driven and therefore suggests DAX can only sustain any catch-up if European corporates and economy also show a significant relative performance. Given the fiscal expansion of the US, the lack of any equivalent reflation in Europe, the concentration of European indices of underperforming sectors this seems unlikely. In fact this underperformance also featured in the last leg, top and crash in 1987 and highlights a potentially similar characteristic. That DAX will only sustain any improvement relative to the US once global markets have topped.
The underperformance of DAX and European indices may continue to attract short sellers and bargain hunters. But history suggests both will be disappointed.
Here’s to making the very best.
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