European Risk Adjustment Trade (Stoxx)

The European debt crisis seems to have taken the way of recovery and the rates for European government bonds reflect a positive economic outlook in the Euro area. The Euro Stoxx 50 Index includes Europe’s leading Blue-chips companies. Actually, these companies are  considered as safe as AAA European countries (Germany, Finland, Netherlands) and represent an alternative to peripheral bonds. That is why charts show an inverse correlation between the AAA countries’ bonds rates and the Stoxx:

Source: BSIC

The second group is constituted by AA bonds: Austria, France and Belgium, that have very similar yields and also an inverse correlation with the Stoxx index.

Source: BSIC

Source: BSIC

Source: BSIC

(The chart shows only French bonds)

The comparison with peripheral countries is more difficult, yet in this period, for the first time since September 2010, the peripheral bonds are converging to the index:

Source: BSIC

The  main idea behind the trade is that the recovery of the peripheral bonds would likely take out a lot of money from the European Blue chip companies. But shorting the Stoxx 50 would be unwise: the index is very wide and diversified in sector, and usually is highly correlated with the performance of European countries; the systemic risk feared in September 2011, for example, caused a great drop of the index.

Some sectors, less correlated with the center of the crisis, have had an almost continuous growth since the end of 2009: consumer goods and pharma-healthcare. In fact, they have constantly outperformed the index:

Here’s a list of the companies considered:

The P/E ratio (in particular for Healthcare) and the prices (in particular Food&Beverage) are likely to suggest a good opportunity in shorting these sectors while buying the whole index in order to profit from the recovering of the European economy.

For the bonds, we would suggest to bet on the normalization of the spread between AA countries and BBB, shorting French, Austrian and Belgian bonds while buying Italian and Spanish bonds (avoiding Portuguese  and Greek bonds because the situation in these countries is far from normalized). Europe would seem to appear divided in two parts (the AAA countries and the others) rather than three as it is now, as the current spread  (around 180 points between Italy and France) seems to ignore economic fundamentals and to  reward AA countries too much.