FEZ ($37.58): A Contrarian Play On Europe

Overview

It’s tough to find someone bullish on Europe and that’s why I like it. The Eurozone has taken a beating recently from financial pundits around the globe pointing to deflation, the inevitable recession, and lack of structural reform. That said, I would like to point out that those concerns are likely why the Euro 50 Stoxx index is trading around 12.2x 2015’s earnings versus the S&P 500’s 15.6x, as well as some less covered topics.

The Eurozone is export driven. Prior to the financial crisis, domestic consumption was financed through debt, with Germany being the key lender. However, as with any deleveraging, credit dried up, which decreased demand and put downward pressure on prices. Going forward, increasing demand will now be a function of the Eurozone’s ability to drive exports, giving governments and businesses additional capital to deploy.

Below is a chart that shows the top 10 countries the EU exports to. As you can see, the U.S. holds a significant weight, which to me is bullish given the recent USD/EUR movement (shown below). We are currently trading at a levels not seen since 2012 and it’s my view that we will see 1.20 or below as the Fed tightens. This significantly increases the attractiveness of EU exports to the U.S., which is just picking up steam. The caveat here is Russia, also holding a strong weight. Given the multiple on the market, I would say the Russian fears are baked in. Could there be more? Sure, but I think the majority is in the price.

 

USD/EUR

The ECB is following the Fed’s footsteps. Over the next two years, the ECB will be buying covered bonds and asset-backed securities, which will increase the amount of capital in system and likely drive asset prices higher. The size of the program has not been explicitly disclosed; however, the ECB disclosed they would expand their balance sheet to 2012 levels, which implies a €700mm-€1T program. While it is nowhere near the size of QE in the U.S., it will likely give the market enough confidence to have a similar effect. Below is a graphic of the S&P 500 during QE1, QE2, and QE3.

QE

Structural reform is taking place. Many doubt the EU will be able to implement structural reform, already being seen in Spain, which had the fastest growing economy over the last quarter. However, I am more sanguine on its prospects in Italy and France. Metto Renzi, elected as Italy’s prime minister in February, understands reform is needed and will get the job done – especially given his nickname “il rottamatore,” the scrapper. As the mayor of Florence, Renzi cut taxes, halved the number of city councilors, and challenged entrenched lobbies. The Florence Chamber of Commerce president said this about Renzi, “when he decides on something, he puts his face on it and does all he can to achieve it, directly…it’s been 40 years or perhaps more in Italy since we’ve seen a politician like that.” I see Italy getting the job done.

The French are moving in the right direction. After bashing business earlier in his term, Francois Holland has opened his socialist eyes. The President recently reshuffled his cabinet to push through his pro-business agenda, which he believes can pass without the rebellious left of his Socialist party. Interestingly enough, Holland appointed Emmanuel Macron, an ex-investment banker, to work alongside Michel Sapin, the Finance Minister. This is very promising, and I believe France will follow Spain and Italy’s footsteps.

Build a position. Europe seems to be an attractive contrarian play given a weaker Euro, structural reforms, and assets purchases. (NYSE:FEZ) offers you exposure to the Euro Stoxx 50, currently trading around 12.2x 2015’s earnings. From a risk reward perspective, there is support around $36 per share, or 4.2% below where it is currently trading. If you are a trader, I would use $35 as your stop and trade it long. Personally, I would play this over the longer-term and average down if the price happens to make its way there.