European Markets

I've been looking into European equities for some time and getting a better feel of the economy over on the other side of the pond. The European Central Bank is fearful of high inflation rates. Eurozone inflation is at 16 year highs at 3.7% as of May and was 3.3% in April. The ECB's target rate is the same as the USA, at 2%.

Right now futures are priced in to represent a very high chance of the ECB raising interest rates by 25 basis points or a quarter of a percentage point to 4.25% in July. In addition, the ECB has issued some statements hinting that inflation is the most feared element in the economy at the moment. What this rate hike entails is an appreciation of the Euro against other currencies; mainly the US dollar. This spells trouble for companies in the Eurozone, because their exports to the US will shrink and diminish their returns. That is because of purchasing power of US citizens decreasing towards European goods, since it will cost more US dollars to buy Euros. The indexes will see a decline in prices in this scenario.

The UK is facing a similar issue with rampant inflation, however, it is also slammed by a bad housing market and a similar mortgage situation that the US is in, except some say it's even worse. Everyone has heard of the Northern Rock downfall and nationalization, but other large mortgage lenders are in trouble as well, such as HBOS. HBOS has recently issued some shares in an attempt to gain much-needed capital, but was slammed by short-sellers around the world. They were sold short so much that they had to lower the issue price. Another recent stock issue by Bradford & Bingley had to also be re-priced due to major short-selling as well. In response to such sharp selling pressure on other financial firms that are trying desperately to raise capital, but are being bogged down by short-sellers, the FSA has issued new short-selling disclosure rules to try to protect those firms and to try and avoid a stock market collapse.

The Bank of England has been talking about inflation troubles, but they are walking a much finer line than the rest of Europe, due to UK's housing market slump and the badly hurting financial sector. The BE is being reluctant on revealing whether they will raise interest rates this summer. Their dilemma is if they raise rates, the economy will contract and the lower and middle classes will really feel the pinch, due to their already-strained wallets from falling house prices (disposable income decreases). In addition to that, they fear a further depreciation of publicly traded companies' stock. On the flip side, the inflation is pushing up every quarter due to rising labor costs and oil prices hitting $139.89 last week. It's a tough decision, yet an interesting one to watch, due to the opportunity being presented for us traders. I will get into the oil situation in a later post. :)

If interest do rise in the UK and the Eurozone, my general outlook is short-selling, especially the financial instutions. There could be some long plays such as renewable energy and agriculture, which has had a nice run in the past several months and will continue to do so as oil and food prices rise, as there are shortages of both all around the world. I am split on retailers as I am not sure how much of a real effect will the interest raise have on disposable income. I would also short the USD-Euro cross for obvious reasons, but seek out US companies to long that primarily do business with Europe, since their incomes will be appreciating along with the Euro.