Will Stimulus Unwinding Crush Europe ETFs?

by on November 23, 2009 | ETFs Mentioned:

In an unexpected development, the European Central Bank announced Friday that it will tighten the standards under which it accepts asset-backed securities as collateral from banks for refinancing tenders after March 1. While this step seems relatively minor, analysts viewed its as the first step towards unwinding the massive stimulus plans put into effect to save the struggling financial system in the wake of the global credit crisis.

ECB Headquarters In FrankfurtFollowing the collapse of Lehman last year, the ECB enacted several measures to ensure that banks maintained access to credit as traditional sources dried up. One of these moves was allowing bonds with lower credit ratings to be used as collateral, a response to the significant erosion in many existing securities due to the financial crisis. Under this initiative, ABS are eligible to be used as collateral if they were 1) rated AAA at time of issuance and 2) have one current rating of A or higher. Banks have used this opportunity to borrow record amounts of money from the ECB to strengthen their balance sheets.

Under the new rules, securities will need ratings from two separate agencies and the lowest of the ratings will be used to determine eligibility.

What’s Next?

The introduction of increasingly stringent collateral requirements is a relatively small step towards reeling in the stimulus plans implemented in the euro zone. But there are clear indications that it is the first in a series of measures that will be introduced in the near future, perhaps as soon as the ECB’s next policy meeting on December 3. In recent weeks, executive board member Jose Manuel Gonzalez Paramo has multiple times hinted as his frustration with the current state of the ECB, and has indicated that the bank may raise interest rates even as some economies continue to contract.

ECB president Jean-Claude Trichet recently expressed his concerns with allowing the drastic measures to remain in place for much longer. “Emergency treatment and strong medicines are sometimes necessary. But, if their use is prolonged, they can lead to dependence and even addiction, said Trichet. “Eventually, the administration of painkillers must be stopped if patients are to get back on their own two feet.” Trichet went on to note that if signs of inflation begin to appear, the ECB  will have no choice but to push rates higher.

ETF Plays On Europe

With the first step in the stimulus wind-down now underway, the next few months will be extremely for the economies of the Euro zone. While some economies are well on their way to a respectable recovery, others face a much steeper climb, and the task of managing fiscal and monetary policy for a diverse group of nations will be challenging. For investors looking to make a play on Europe’s economies, there are a number of options. From iShares, there is a complete line of country-specific funds, ranging from the MSCI Germany Index Fund (EWG) to the MSCI Belgium Index Fund (EWK). For those looking for more diversified exposure to European equities, there are several more options offering various ways to make a play on Europe (for a complete list of Europe ETFs, see this list).

  • Vanguard European ETF (VGK): With nearly 500 individual holdings, this ETF offers by far the most depth of any European ETF available to U.S. investors. VGK is heaviest in the “big three” economies of the U.K., France, and Germany, but includes stocks from almost 20 different countries.

VGK

  • ProShares UltraShort MSCI Europe (EPV): For investors who are bearish on the short-term prospects of the Euro zone, EPV is an interesting option, seeking to return daily results that correspond to 200% of the inverse of the daily return on the MSCI Europe Index. Of course, leveraged ETFs come with their own unique risk characteristics, and should be frequently monitored.

EPV

  • WisdomTree Europe SmallCap Dividend Fund (DFE): The majority of European ETFs, including the country-specific funds from iShares and the Vanguard fund profiled above, focus primarily on large cap equities. DFE invests primarily in dividend-paying small cap European stocks, offering exposure to a different group of companies that are generally less likely to have global operations. DFE is up almost 50% this year.

DFE

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Disclosure: No positions at time of writing.