It's well known that the European Economic and Monetary Union (EMU) is in dire straits. Insolvency plagues the region, with countries like Portugal, Ireland, Italy, Greece and Spain (colloquially called the PIIGS) facing massive budget deficits relative to their Gross Domestic Products (GDP) and rising unemployment. Furthermore, impotent monetary policy as well as a prolonged lack of unified fiscal policy have dampened growth prospects and exacerbated the EMU's problems.
Before considering a specific investment, an experienced investor will make it a point to thoroughly understand the macroeconomic panorama at hand. Solutions addressing the woes of the eurozone are varied. Proposed reforms to the Maastricht Treaty include banking and fiscal union; all the while, eurozone leaders debate the effectiveness of economic stimulus programs. To a certain extent, any legislation to bolster confidence in the EMU would be healthy for the global economy. Inaction is the eurozone's greatest enemy.
Financials and the Euro
From a traditional standpoint, the Financial Services industry is typically a bull-market sector, suffering most when Mr. Market experiences a downturn. Accordingly, European banks have struggled to remain solvent throughout the euro crisis, as their loans have had difficulty performing and their assets have depreciated in value. These symptoms are most evident in the nations hit the hardest by the euro crisis, namely the PIIGS nations. Within the economies of Ireland and Spain, where housing bubbles popped in 2008, the banking system has had an especially hard time getting back on its feet.
Shorting banks in these in high debt-to-GDP ratio countries is an interesting move - if you can do it. While the P/E multiples of European financial stocks, such as Banco Santander or Deutsche Bank, are currently low, the exit of any PIIGS nations from the EMU would trigger a massive sell-off within the industry across Europe. Other industries would surely suffer as well, but a devalued currency would challenge banks with eroding balance sheets and cash flows. More specifically, the inevitable devaluation of an exited nation's instituted currency would result in the further lowering of equity multiples for domestic Financial Services firms.
Exchange traded funds can make capitalizing on this bearish outlook on European financials easier, such as the iShares MSCI EMU Index. For individuals predicting further decline in the euro against the greenback, leveraged ETNs like Market Vectors Double Short Euro ETN are an option.
Shorting Government Bonds
Generally, it's difficult to short a bond, especially one in a continent beyond your borders. Moreover, bond-land is not customarily as volatile as the stock market, making it harder for a short to perform well. In Europe, bond auctions in PIIGS nations are seeing all-time low prices and all-time high yields. Throughout the euro crisis, the results of these bond auctions have been an indicator of investor confidence. Even a cursory examination of the yields in PIIGS nations shows that investors are wary of the risks associated with the eurozone's worst economies. Clearly, the time to short debt offerings in these nations has come and gone.
However, in a more economically robust country, such as Germany, the exit of any PIIGS nation from the EMU would render a short play wildly profitable. If any nation left the eurozone, German national debt offerings might suffer disastrous consequences. Germany's treasury bonds have already been propped up by a "flight to quality." Furthermore, if a PIIGS nation split ways with the euro, confidence in the system as a whole would waver and German bonds would conceivably plummet in price, while yields would skyrocket. A flight from quality, so to speak, can be significantly more rampant and contagious than its inverse. Shorting ETFs, such as WisdomTree Euro Debt Fund, with holdings in German and French bonds might make for one way to profit from this ordeal.
The Bottom Line
As European leaders flounder to reach a consensus on fiscal, monetary and economic stimulus policies, investors can capitalize on the EMU's systemic weakness. While the economic turmoil in Europe opens opportunities for short selling, be advised that some European nations have temporarily imposed bans on short selling individual securities.
Knowing which precise stocks, bonds and other structured products to short is difficult; an understanding of the macroeconomic issues at stake is of the utmost importance. Only when equipped with this knowledge can an investor confidently make investments, especially during tumultuous financial times.