Idea of the Day German equities still poised to outperform in Europe

What: The German election may have had a muted impact on the markets even if failed to deliver Angela Merkel the share of the vote that she had wanted, and the rise of the AfD Far Right party spooked some European political commentators. While we think that German politics are fundamentally stable and political commenters and the media are overplaying the difficulties Merkel faces in forming a 3-way coalition, we believe that these fears could be good news for German equities as it is currently weighing on the euro and pushing German bond yields lower.

While we think that the German political fears are overdone, we also believe that the market is using the backdrop of the German election as an excuse to sell the euro after its 15% increase so far this year, and positioning looks stretched to the upside according to the latest CFTC speculative futures positions data, as you can see in chart 1. When positioning look extreme, euro longs are close to their highest level for 10 years, it can be an indicator that a reversal is imminent.  

Chart 2 below shows the Deutsche Bank FX volatility index, which has risen to its highest level since April. Part of this increase is down to a pick-up in volatility in the euro this year, and due to the inverse correlation between the euro and the Dax, a weaker euro can be good news for the Dax.

How: We mentioned before that we believe that the Dax could start to play catch up with the Italian index, which has been the best performer in Europe this year. It did indeed start to outperform the FTSE MIB in early September, as you can see in chart 3. We expect the Dax to continue to outperform the FTSE MIB in the coming weeks due to the Dax’s sensitivity to the euro, and also because of the transferal of political risk from Germany to Italy. Italy is the next major Eurozone country to hold an election, and the rising support for the Far Right AfD suggests that populism in Europe is alive and well, which could embolden the anti-euro Five Star movement in the run up to the Italian election, which must take place by Q1 next year. 13,000 is the next key target on the upside for the Dax bulls.