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2012 European fixed income ETF flows overshadow equity as investors deliberate on Euro zone direction

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Equity markets continued to discount increasing uncertainty during May, largely driven by the Euro zone crisis but also fuelled by news that potentially cast doubt on the strength of the US economic recovery, according to Dutesche Bank’s latest European ETF Market Monthly Monotor.

In Europe, pressure on the region’s financially weakest countries continued to gather pace, highlighting increasing questions about how to best address Euro zone governance changes that can lead to more stable fiscal management across the single currency area.

Equity markets declined across the board over the month of May, while volatility has risen significantly. EuroStoxx50 fell by 6.7% in May, wiping out all of its 2012 gains and finishing down 6.1% YTD. Germany’s DAX lost 7.4% over this month but it still managed to stay in positive territory for the year, registering a YTD increase of 6.2%. At the same time, equity market volatility continued to rise with the VSTOXX – an index measuring Euro zone equity market volatility as measured by EuroStoxx 50 index options implied volatility – rising by close to a third (29.7%) in May.

The Euro zone storm began to gather pace – once more – in early May as elections in Greece on May 6th failed to produce a stable government. The country’s inability to generate a clear commitment towards continuing to support bailout terms continued to raise investor concerns about the impact of a possible disorderly default. At the same time, at the end of May Spain, the Euro zone’s 4th biggest economy, came under increased pressure to recapitalize its banking sector as well as continue towards reforms to modernise its economy. These latest developments came on the back of a number of measures taken by Euro zone countries that have so far failed to ease concerns about the single currency zone’s ability to effectively manage its collective finances.

It has now become clear that with each set of measures taken by European leaders over the better part of the past three years, the latest of which generated the pledge for a fiscal pact supported in principle by 16 countries back in March 2012, the market follows by questioning the currency zone’s ability to manage its way out of the credit crisis. Balancing austerity and taking decisions to spur growth at a country level has become the most recent criticism. The overarching riddle that European leaders are being faced with is how to form an effective and credible Euro zone fiscal governance mechanism.

That is by no means an easy feat as many of the necessary governance changes are perceived in some member states as ceding sovereignty – both by the continent’s financially strongest as well as weakest – towards a central Euro zone fiscal authority, and could therefore prove unattainable politically. Furthermore, clarifying the role of the European Central Bank as well as the tools at its disposal, remain a challenge.

While contagion concerns from a possible disorderly Greek default remain very material ahead of a second election in Greece on June 17th, the bigger issue that seems to emerge relates to governance changes that the Euro-zone will need to take and how those can impact its ability to enforce economic discipline and manage economic growth effectively over the longer term.

While many opinions exist about the relative strengths and weaknesses of each Euro zone country, the large drop in the DAX over May is pointing to an increasing realisation that fortunes of the stronger and the weaker are intertwined. It remains to be seen if the downward pressure from this convergence can lead to decisive measures that could signal turning a corner, or if political differences embedded in systems that were created in isolation over centuries will show the way back to the past.

At the moment, in the European ETF industry, investors seem to be optimistic that that a solution is still possible, given that we have yet to see any significant outflows which could imply a meltdown of long equity positions. European broad equity indexed ETF outflows totalled EUR1.7 billion YTD, this is equivalent to a 6.8% decline of the relevant ETF assets (EUR25.0 billion as of 31/12/11). Total broad European equity ETF assets are down EUR9.1% YTD, reaching EUR22.7 billion as of the end of May 2012. Similarly, DAX benchmarked ETF outflows for 2012 total EUR341 million YTD, amounting to 1.7% of the DAX benchmarked ETF assets at the beginning of the year (EUR19.6 billion). DAX benchmarked equity ETF assets are up 4.2% since the beginning of the year, reaching EUR20.4 billion as of May month end.

The question that remains unanswered is how long more Europe has to convince markets that there is light at the end of the tunnel and not a train coming from the opposite direction.
 

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