Three Long/Short Ideas For Euro Zone Debt Drama

by on November 8, 2011 | ETFs Mentioned:

Since the downgrade of U.S. credit quality in August, investors have turned their attention to the debt drama taking place overseas. Several Euro zone member nations have fallen victim to mounting government deficits, which has inevitably contributed to investor worries over the health of the financially fragile currency bloc. Economic growth has also been lackluster in the region, further contributing to the growing cloud of uncertainty looming over the debt burdened Euro zone [ETFdb Pro members can see the Ex-Europe ETFdb Portfolio]. Ongoing debt woes have taken center stage, fueling volatile trading across equity markets, and likewise putting pressure on investors’ confidence in the global economic recovery.

Greece has been the center of attention lately as EU leaders have taken the first steps to negotiating on a viable rescue plan to restore stability in the debt stricken country. Likewise, all of the ongoing debt negotiations have paved the way for increased volatility across markets, seeing as how investors have been forced to digest new pieces of information day after day. While EU policymakers are undoubtedly moving in the right direction, the day to day news headlines stemming from overseas have been contributing to wild swings in the market, with investor sentiment swaying from euphoric to fearful over the course of a trading session.

Despite talks of a three-pronged “bailout plan”, EU policymakers are still faced with serious challenges that must be addressed going forward as the economic health of the region is far from stable. Considering all of the chaos that has resulted from Greece’s debt woes, it’s hard to imagine just how the markets will react if (and when) other member nations, like Italy and Portugal, come forth with their own set of issues. Amidst the volatility, several opportunities have presented themselves as a means for investors to establish tangential exposure to developments in the Euro zone. Below we highlight three long/short ideas that may prove profitable as EU leaders continue to work on a comprehensive plan and uncertainty remains high:

  • Long CurrencyShares British Pound Sterling Trust (FXB) /  Short CurrencyShares Euro Trust (FXE): This trade recommendation is essentially a bet on the outperformance of the British pound over the euro, since FXB and FXE both track the performance of the respective currency versus the U.S. dollar. The British pound has taken a beating as weakness in the euro has put considerable pressure on the economic outlook for the region as a whole. Depending on how the ongoing debt negotiations progress, the British pound may be well positioned to appreciate if EU leaders undertake an approach that further devalues the euro. Also, persistent weakness in the euro could encourage investors who still wish to maintain tangential exposure to the Euro zone to reallocate capital into pound-denominated assets. 
  • Long MSCI Germany Index Fund (EWG) / Short MSCI Italy Fund (EWI): The thesis behind this trade recommendation is quite simple; it pits the strongest Euro zone member, Germany, versus one of the most heavily indebted nations: Italy. Germany is the economic backbone of Europe and this exporting powerhouse stands to potentially benefit from a weakened euro and increased interest as investors flock to “safer” investments that are still relatively undervalued. Likewise, if Italy comes under pressure as Greece has, investors who still wish to maintain tangential exposure to the Euro zone will likely be encouraged to snap up safe havens like GermanyItaly, meanwhile, seems to be headed towards the edge of a cliff; political uncertainty, record highs for financing costs, and a stubbornly high unemployment rate loom as substantial short-term and long-term obstacles.
  • Long FTSE Nordic 30 ETF (GXF) /  Short MSCI EMU Index Fund (EZU): This trade recommendation pits the Scandinavian region, as represented by GXF, versus the member nations of the Euro zone, as represented by EZU. The fundamental thesis behind this trade is that the northern region of Europe offers a more favorable risk/reward profile than the Euro zone as a whole, given the fiscally conservative nature and historically stable financial systems of Sweden, Denmark, Norway, and Finland. GXF’s underlying holdings are well positioned to hold their ground in case the debt drama intensifies, while also being able to benefit from improved economic conditions as stability is restored. While the Scandinavian nations are economically tied to all of EZU’s constituents, they are not under direct stress from the potential collapse of the euro, since every country in the region (except Finland) maintains currency independence.

 Disclosure. No positions at time of writing.