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Buy German DAX, short French CAC-40

7 May 2012

Financial markets have a Darwinian paradigm, the reason the long DAX (German stock index) against short Ibex (Spain) trade has been a winner ever since February.

The long DAX, short IBEX trade is up 25 per cent in the past three months as Spanish political risk and government bond yields are repriced higher. The near certain victory of Francois Hollande in the French election means the capital markets will price a risk premium into French OAT (government), bank and corporate debt. Higher French corporate spreads means that French equities will take a hit as long as the markets distrust the incoming Socialist government, the second one of the Fifth Republic. The ideal, easiest way to implement such macro theme would be to go long German equities index fund EWG against the French equities index fund EWF.

I see no reason why the long DAX, short CAC trade idea cannot generate another 20-25 per cent in the next six months. After all, not only will French sovereign/ bank systemic risk be repriced higher if Francois Hollande moves into the Elysee Palace (alas, without Segolene, the defeated 2007 candidate, the modern Jeanne d’ Arc of the French left!) but also the growth prospects of French companies will be downgraded even as the German export colossus continues to anchor the DAX index.

President Hollande’s political base will inevitably resist the structural reform agenda that the markets demand from France. The France CAC Quarante is also nowhere near as international/growth biased as the German DAX, making it an ideal basket to be shorted since the valuation metrics of the Gallic and Teutonic stock exchanges are almost the same on 2012 earnings. The plunge in consumer spending in March and fall in export means recession in almost inevitable in France after the election, since the its trading partners include Italy and Spain. Alcoa and Ford have both flashed a European growth SOS that will hit France’s earnings prospects.

French politics have a history of public unrest, even violence — the guillotines and terror of the Great Revolution, the revolutions in 1815, 1830 and 1848, the 1871 Paris Commune, the Dreyfus scandal, the General Boulanger coup, the United Front, Vichy, the 1958 Algerian OAS coup, the 1968 barricades, the 2005 riots in Paris that helped elect Sarkozy. Under President Hollande, I expect France’s politics to become further polarised and trigger another sovereign credit downgrade.

After all, France lost its AAA rating in January. This is not time to bottom fish on the CAC-40, even though the French stock index has lost 50 per cent of its value since the Lehman failure. Diamonds in the Gallic financial merde?. Sanofi, a dirt cheap Big Pharma. Total, a global oil colossus with a six per cent yield, FTE (telecom) even higher. LVMH, Air Liquide, Danone, Carrefour are global companies. What if Hollande raises taxes and pension obligations?. I expect the Communist trade unions to shut France down and French debt yields to rise to at least four per cent or higher. So it makes total sense to short the French OAS government bond market. An ideal long short pair trade would be to buy BMW and Daimler Benz against a short on Peugeot and Renault (though this is not a pure play French auto due to its Nissan link). A 50 per cent return trade is also possible in out of the money puts on BNP Paribas and SocGen.

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