It should be noted that we put this idea forward with more hesitation and caveating than is usual for this space. It was, the report said, a tentative hypothesis about the way Europe is evolving -- one with profound implications for years to come, if true. Nevertheless, as Milton Friedman put it, the test of an idea is its ability to predict. It's time to take an early look at how the theory is working out in practice.
Here is how the stock markets mentioned performed from the close of trading on January 8 (our item appeared early on the 9th, in time to execute trades) through the close of trading on March 13. The figures are in local currency, not adjusted to dollars, but the movement in currencies against the dollar has been roughly similar for all the countries, i.e., adjusting for dollars wouldn't change things much once one looks at the combined position -- long some countries, short others.
Turkey + 4.8 percent
Russia + 7.4 percent
Switzerland - 26.1 percent
France - 18.2 percent
Germany - 35.7 percent
Our worst call was the long on Switzerland, which we have since removed, and the best call was Germany on the short side. A position equally weighted between long and short, divided into thirds on the long side between the first three non-EU countries, and into half on the short side between Germany and France, thus performed as follows:
Long Turkey, Russia, Switzerland: - 4.6 percent
Short France, Germany + 26.5 percent
COMBINED L/S POSITION: + 22.1 percent
Plus 22 percent over two months is not a bad trade. By that logic alone, it may be time to lighten up on one side of the strategy or another. My colleagues at the Emerging Markets Group agreed and have essentially covered the short position on Germany and France. Even after today's surge in European markets -- more than 5 percent in the case of the "DAX" (German) and "FCHI" (French) indexes.
This was not a dig on French and German foreign policy per se, though the countries have played rather rough in recent weeks. Rather, what seemed striking from an investment standpoint was the change in both tone and substance of intra-European statecraft in the EU.
The EU, we observed, was born as a civil group of states trying to achieve greater harmony of policy. Yet in recent months we find Jacques Chirac, to take one example, demanding a strong central government (yet with little direct democratic check) in EU constitutional talks, attempting to bar the door against entry by the Turks, and literally shouting at heads of state from Central and Eastern European countries that they had better "learn to shut their mouth" if they support the U.S. on Iraq.
Whether you think Chirac, or Germany's Gerhard Schroeder, are right about such matters, the point is, their basic diplomatic approach has been just about as swaggering and arrogant as many Europeans perceive George Bush and the United States to be.
On substance, as we noted, the EU has gone from a force for liberalization from its days as the European Community in tandem with the G-7 (in the 1980s and 1990s) to a group that at best trades with would-be entrants, offering membership in the club for acceptance of EU protectionism, high taxes, and other dubious policies. At worst, one might argue that shielding French agriculture subsidies, for example, or sustaining German trade curbs that frustrate competition by goods from Russia, Israel, and elsewhere, has become, in a sense, the group's central, animating raison d'etre.
In short, the European Union appears to have flipped both substantively and stylistically. Once a force for economic liberalism, tax and welfare competition, and free trade, the EU has moved to the opposite side. Formerly an amicable federal arrangement that allowed and even encouraged diversity, its main goal now seems to be enforcing unwanted trucks and big-brother banking restrictions on the Swiss, higher taxes on the Swiss and Russians, neutralism on the states of Eastern and Central Europe, and farming subsidies and trade quotas on technology imports everywhere. The EU is now involved with major World Trade Organization disputes over technology, or dragging its feet on entry, with India, the United States, Russia, South Korea, Japan, Taiwan, and Israel. Are there any technology producers left? Only Mainland China, whom European governments fear they dare not offend.
Why cover the short position now then? What has changed? Two factors -- neither of which will do much for the EU states over the long run, but both of which will be powerful in the short run:
-- 1. Oil prices and U.S. economic growth, are about to return to normal levels. Europe is even more dependent on oil than the United States, and highly linked to the U.S. economy, which will itself rebound in the second half of this year.
-- 2. The United States will try to mend fences after the war in Iraq. Colin Powell is already planning for a visit to France and Germany to secure their cooperation with the occupation regime, and establish a more general detente.
And why not be aggressively long? We think there is merit in a short-term trade on the long side of France and Germany at these levels. But for now we're simply covering our shorts, for two reasons.
1. Nothing fundamental has changed in Europe. Economic policy in Germany and France is still muddled, and what is worse, Mr. Schroeder's proposed half-measures for dealing with rigid German labor markets suggest he won't do anything serious to address the problems. There are far too many countries (Israel, Turkey, Russia, Hungary) that are doing positive things, in and around Europe, to want to concentrate in those that are the laggards.
And even though George W. Bush will ultimately be more inclined to side with Powell and the notion of rebuilding U.S. relationships, there is an arrogant side to his administration that will be inclined to threaten, extend steel curbs, and generally be less than magnanimous in victory. It's highly likely Bush will ultimately lean towards the let's-be-friends-again approach. But it will be a bumpy process.
2. Nothing fundamental has changed within the EU. If anything, for example, U.S. victory in Iraq will only make France and Germany more afraid of an unrestrained American behemoth, redoubling their efforts to oppose American policy. There is a real danger of EU rejection by Hungary in the coming weeks, for example. On January 9, we wrote: "Until the voters in France or Germany... show some Swiss-British-American-Russian style independence, or until Brussels and the other members of the EU consensus are willing to tolerate (or even imitate) the results of a little economic and political diversity -- well, until then, the European Union may remain as much a wet blanket than a growth catalyst. And the investment gains merely for EU entry may stand for 'Essentially, Un-compelling.' "
That's still the thinking here, but it simply leaves us out of EU-core Europe, not short, and in such countries as Russia, Turkey, Switzerland, and Britain. The best opportunities may lie in those states that will be holding elections, or referendum votes on EU entry, later this year -- among them Hungary, Poland, and the Czech Republic. Voters there will have an opportunity to move their politicians in a different direction. About which, more to come. For now, take profits and cover your shorts.
(Gregory Fossedal, firstname.lastname@example.org, manages the Democratic Century Fund, LLC for the Emerging Markets Group in Washington, DC. His firm may hold some of the securities mentioned his articles. Individual investors should contact their own professional advisor before making any decisions to buy or sell these or any related securities.)