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Last week Mike Larson told you how Europe is an economic basket case. And today I want to talk about that a little more.
Why? Because Europe is the epicenter of an earthquake that rocked world markets this month — and the shock is far from over!
Yet amazingly, some investors seem convinced the European Central Bank (ECB) will ride to the rescue, just like the Federal Reserve did here back in 2008-2009. We can see this in ETF and ETN trading activity. If you believe financial markets are always rational and efficient … prepare to think again.
PIIGS at the Trough
Europe’s problems first became evident in the so-called “PIIGS” nations: Portugal, Italy, Ireland, Greece, and Spain. Now the whole continent is in trouble.
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| Pigs are fed well — until slaughter time. |
The “economic unity” that made politicians so proud was always an illusion. The euro common currency let PIIGS feed off the prosperity of Europe’s dominant nations. Bankers in France, Germany, and elsewhere went along because they saw a chance for easy money … and they were right until just recently.
The problem with pigs is they don’t know when to stop eating. They gorge until the food runs out. Greece was the first crisis only because the bankers had to start somewhere.
Italy isn’t far behind. Thanks to out-of-control spending, government debt there stands at 120 percent of gross domestic product. Italy ran out of rope when even sky-high interest rates could not convince investors to buy any more of its bonds.
To see what this has meant for investors, all you have to do is …
Follow the Action
The results are pretty clear in the chart below of PowerShares DB 3x Italian Treasury Bond Futures ETN (ITLT), which follows the market for Italy’s ten-year government bonds.
Launched just this April, ITLT reached an intraday peak of $21.78 on June 3, 2011. In the August 4 panic (barely two months later) ITLT traded as low as $14.93. That’s a loss of almost 32 percent!
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| So much for “safe” European government bonds. |
Yes, the volatility was amplified by ITLT’s built-in 3x leverage. But even the unleveraged version (ITLY) dropped more than 11 percent in the same period.
Now, look what happened after August 4: ITLT shot up as high as $20.76 on August 22 — for a gain of better than 39 percent in less than three weeks!
That reversal came when it was clear the ECB would step in. The prime beneficiaries weren’t Italian, though: It was the banks elsewhere in Europe. The bailout saved their huge bond holdings (which are leveraged way more than 3x, incidentally).
Now let’s contrast this with PowerShares DB 3x German Bund Futures ETN (BUNT). This one tracks a bond index in the same maturity range as ITLT — but these bonds are issued by Germany instead of Italy. Same continent, same base currency, different governments. Look at the BUNT chart below.
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| Investors like Germany better. |
While ITLT was racking up a 32 percent loss between June 3 and August 4, BUNT gained about 21 percent!
In one sense this isn’t surprising. We already knew Germany dominated European finance. The comparison is still a bit startling, though.
I’m not bold enough to say the markets are wrong about either country — but short-term moves can still be exaggerated. I suspect the situation in Italy isn’t as bad as ITLT makes it look. Nor is Germany as safe as BUNT may suggest.
In the bigger picture, neither nation has very good prospects. Growth in Germany is stalling out. And the public is in no mood to keep subsidizing its neighbors — in Italy, Greece, or anywhere else.
What the euro zone probably should do is refinance their debt with “euro-bonds” backed by the entire union. As of now they can’t, because the member nations integrate currencies but not government spending policies. They can’t have it both ways.
Europe will recover, eventually, but meanwhile expect the volatility to continue. Here are a few Europe-related ETFs and ETNs you should watch closely …
- Vanguard European ETF (VGK) is the largest of the Europe ETFs.
- iShares MSCI EMU (EZU) includes only countries in the monetary union.
- iShares MSCI Germany (EWG) covers the dominant country in Europe.
- ProShares Ultra MSCI Europe (UPV) has 200 percent daily exposure.
- ProShares UltraShort MSCI Europe (EPV) has 200 percent daily inverse exposure.
Best wishes,
Ron
P.S. With volatility comes opportunity. At various times, I’ve recommended both traditional and inverse ETFs in my International ETF Trader service. Click here to learn more.
