Short DAX position as German fundamentals deteriorate
The DAX is up around 38% from its October 2022 low, perfectly tracking the major 2022 sell-off as European equities became relatively more attractive than US equities with lower price-to-earnings ratios. The ECB has been late in joining the rate hike cycle and has naturally taken a more gradual approach when it comes to tightening fiscal conditions.
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Staying with Europe, see what the third quarter might hold for the euro
Data revisions Germany enters a technical recession in the first quarter of 2023
The broader European economy was buzzing until revised first-quarter and fourth-quarter 2022 data suddenly put not only Germany but also the eurozone into a technical recession. A technical recession is defined as two consecutive quarters of negative GDP growth. However, it was the worse German economic data that led to the overall bearish revisions. Industrial strength followed the fourth quarter’s contraction of 0.5% with another contraction of 0.3%.
German GDP growth
Source: Trade Economics
During this period German exports suffered from slower global growth – a deliberate consequence of tighter global monetary policy aimed at curbing demand to such an extent that price setters have no choice but to cut prices. However, with secondary inflation like we are experiencing now, there is always the risk of excessive stress that could plunge the economy into recession.
The technical recession carried less weight this time due to historically high labor markets, and besides, the United States emerged from a technical recession in 2022 only to record a 3.2% increase in GDP growth in the next quarter. However, lower GDP growth indicates a deteriorating macroeconomic environment as German companies may face more challenges.
The ECB talks hard about inflation but it is close to peaking rates
Reaching peak rates depends entirely on the predictability of deflationary trends. If core inflation in the eurozone declines steadily, the European Central Bank can look to a halt. If core inflation behaves in a similar way to what was seen in the UK with subsequent upward revisions, then it should continue to rise. Tightening the screws in an economy that is already showing signs of distress is not ideal, which is why the ECB is hopeful that past increases will have the desired effects on inflation. ECB members hinted at another 25bp increase in the third quarter with the possibility of one more hike before interest rates are widely seen as restrictive enough. Markets agree, however, pricing is just under 50 basis points into the future, making rates bearable at 4%.
Implied market rates at the end of the year
Source: Refinitiv
Keep in mind, the European Central Bank announced the termination of all Asset Purchase Program (APP) reinvestment operations from July which should remove liquidity from the financial markets. The overall impact of the move on liquidity is uncertain given that reinvestment of securities due under the Pandemic Emergency Purchase Plan (PEPP) is still scheduled to run through the end of 2024. However, the decision does not signify a further tightening of financial conditions.
German manufacturing and the European Union lead the group lower
The deteriorating data continues to emerge as manufacturing PMI data from the EU and Germany fell more than expected in June. This has negative repercussions for the relative services sectors as manufacturing trends usually lead the services sector. Services have, until recently, shown resilience but with less print filtration than expected, the direction of travel appears to have already been predetermined.
Germany leads the global downtrend in the Manufacturing PMI (Standard & Poor’s worldwide)
Source: TradingView
The DAX warning lights will flash red at the end of the second quarter
The German index traded towards the lower side of a rising channel in the latter stages of the second quarter as economic data showed signs of deterioration. Predicting the end of a tightening cycle is a difficult task because inflation does not tend to decline in a straight line, which means that markets can be subject to prolonged periods of up and down price action without settling on a trend.
However, if economic headwinds build up, the DAX could fall in the third quarter of the year. However, the move will be contingent on a move and a close below 15,660 on the weekly chart which should coincide with the breakdown of the ascending channel. 15,660 indicates a level of interest that previously acted as support and resistance. The 3-month average true range is around 800 which means a continuation of the drop highlights 15.070 on the way to 14.815.
If prices continue to rise, resistance at 16,290 could be seen as the level invalidating a bearish setup, ahead of the all-time high at 16,427.
DAX Weekly Chart
Source: TradingView
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The daily chart helps show waning momentum in the run-up to the start of the third quarter as price action printed a higher high but failed to do so on the RSI – something referred to as negative divergence. This means that the bullish momentum is slowing which could indicate a further reversal below the line.
DAX daily chart
Source: TradingView