We are hearing all kinds of headlines and sound bites about why it’s time to invest in Europe.
The political risk has subsided … capital inflows are strong … GDP growth is outpacing the U.S. … the business climate is favorable … European market valuations are attractive relative to U.S. market valuations.
Things like that.
Clearly, one could produce just as many reasons why Europe and its markets are not out of the woods.
I don’t intend to do that. But I will raise the point that Europe has been experiencing capital inflows, yes. But it’s done so despite lingering risks to its economies and future as a common currency system.
I suspect the strength in European markets challenges many traders’ preconceived notions.
So, today, as those expectations adapt to the mainstream narrative that "Europe is OK," let me give you an idea that challenges this narrative …
Investors have little concern for the European financial system right now.
Also right now, I have one chart to suggest now is time to sell European financials.
Here is the iShares MSCI Europe Financials ETF (EUFN) …
The rally from June 2016 unfolded in five waves (A-B-C-D-E) to date. And that represents a 61.8% Fibonacci retracement rebound from the five-wave decline from May 2014.
Together, they suggest EUFN is due for a slide.
I would expect a downturn to take EUFN 12% to 21% lower than its current levels. And I imagine the decline could begin within a week or two. If so, the move is likely to span a couple months.
I think European financials are doomed. And if you would like some other rationales besides just a chart, consider this …
Smart-Money Bets Go ‘Flat’?
When Brits surprisingly voted last year to exit the European Union, we saw a corresponding flattening of the U.S. yield curve. That is, long-term rates declined relative to short-term rates.
This tells us investors do not expect healthy long-term growth prospects. If long-term growth is elusive, then investors cannot comfortably expect to earn higher yields down the road.
A flattening yield curve happens before an inverted yield curve happens. An inverted yield curve tends to suggest that investors are so pessimistic about the future, a recession becomes likely.
Today, the U.S. yield curve is flattening. It’s early still, but longer-term rates are declining relative to shorter-term rates.
Here is a look at the 10-Year/2-Year Spread. It’s on the decline year-to-date …
Watching the curve for more flattening …
Whatever flattening we’re seeing — and will see — is probably not an indication of what’s going on in Brexit negotiations.
And it’s probably not an indication that something is palpably wrong in the Eurozone. (Even though there pretty much is something palpably wrong with the Eurozone.)
It might be an indication that prospects for the U.S. economy have become overdone, and that reasons for optimism are disappearing. Some say the Trump economic agenda is dead after a special counsel has been assigned to investigate Trump & Co.’s dealings with Russia.
So if the yield curve flattens further, does it bode ill for Europe?
Why Europe, and Why Not the U.S.?
Surely, a look at iShares U.S. Financials ETF (IYF) suggests that a decline is due. So why look to EUFN instead?
Perhaps there is no solid rationale. But where U.S. business is 40% leveraged to banks for financing, an estimated 70% of European firms depend on banks for financing. If longer-term rates in Europe follow longer-term rates in the U.S. lower, the margins that banks can earn on borrowing short and lending long will narrow.
For that reason, a decline in European financials could create a feedback loop. One that threatens European economic expectations and then applies deeper pressure on financials.
Are European financials due for a rest?
It doesn’t seem anyone is expecting it, except maybe bond investors.
That’s why I think now is a good time to consider a short position in EUFN.