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Europe Is in Big Trouble: Two Reasons to Watch for Volatility


Market indicators say Draghi's monetary experiment may end up failing.

The difficulty lies not so much in developing new ideas as in escaping from old ones.
-- John Maynard Keynes
Whatever it takes? Tell that to the European financials sector.
Negative rates were heralded as a major step forward. By punishing banks for parking excess reserves at the European Central Bank, Mario Draghi and his colleagues made a bet that lending would increase and deflationary forces in Europe would abate. The only thing that seems to be happening, however, is banks feeling more pain. The market seems to be saying that Draghi's monetary experiment will end up failing.

Let's examine how to define success for the ECB. For reflation to happen, Europe needs to export much of its deflation. Doing this requires a weaker euro. The currency has dipped lower, but not in a major or significant way.  With US data coming in softer, particular on the GDP front, a weak euro has to compete with a potentially weaker US dollar. The jury is still out on what happens here. The history of negative rates, while sparse, does suggest that they can depreciate a currency.
The second way to define success should be sector leadership in banks. That isn't happening. Take a look below at the price ratio of the iShares MSCI Europe Financial Sector ETF (NASDAQ:EUFN) relative to the Vanguard European VIPERs ETF (NYSEARCA:VGK).  As a reminder, a rising price ratio means the numerator/EUFN is outperforming (up more/down less) the denominator/VGK.  A falling ratio means the opposite.  Note that all year, European financials have been weak, and continue to be even after Draghi's recent slew of new stimulus measures.

Put simply, the market believes European financials are in trouble.

Price action is reminiscent, on a relative basis, to early 2011. While a repeat of the summer crash of 2011 may not appear likely, a more challenging third quarter for global equities may be coming. My firm's ATAC (Accelerated Time and Capital) models used for managing our absolute return and equity sector rotation mutual funds and separate accounts are nearing a more defensive stance as intermarket trends turn more negative. With complacency as high as it is, and the failure of European stocks to show any signs of relief post-Draghi, one must wonder if volatility is about to return with a vengeance.
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No positions in stocks mentioned.

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