A year of weak economic data and the ECB easing monetary policy has weakened the euro. What if the trend in the currency changes? What are the implications for European Equities?
There are some signs the euro could strengthen vs the dollar in the coming year. Below we show the difference in pricing between 12 month call options and put options vs the euro dollar rate itself. This so-called Risk Reversal Rate often leads moves in the currency, but so far has decoupled. The ECB’s rate cut and QE have swamped the option markets’ increased preference for Euro upside risk vs downside risk, so far.
These charts below are easily manipulated with different scales on each side and so must be taken with a pinch of salt, but they can help in assessing the probability of trend changes.
If we take the view that the options market will be proved right, what are the implications?
As Europe is a large exporter, many investors are cautious of euro strength, worrying it could slow the region down. Some worry it could intensify downward pressure on already low inflation.
Below we show long term inflation expectations as measured by the 5 year forward 5-year inflation swap vs the euro dollar rate. There is a loose relationship between the two series but what is clear is that euro weakness seems to coincide with weaker inflation expectations in Europe, not stronger.
There is a similar broad picture for value vs growth in Europe and the euro dollar rate.
Euro weakness appears bad for inflation expectations and broadly bad for value vs growth. This relationship is likely for a few reasons. First a weak euro is usually a sign of weaker European economic growth. This obviously weakens inflation but also acts as a headwind to value strategies since most value indices are dominated by cyclicals today.
Second and perhaps more important is the headwind that occurs with a strong dollar. A weak Euro obviously means a strong dollar. A strong dollar is a meaningful headwind for the global economy as it tightens ex-US financial conditions. Given the large stock of dollar denominated debt, a stronger dollar raises interest costs for the global economy. As the ex-US world economy slows, safe-haven flows into US Treasuries rise, pushing the currency up further. A strong dollar also tends to drive down commodity prices. In this way a strong dollar can act as a deflationary impulse on the rest of the world.
As suggested above, a strong dollar has self-reinforcing drivers supporting it. When the dollar rises, the tightening of ex-US financial conditions makes the domestic US growth outlook appear relatively more attractive, driving further strength. The existence of this feedback loop is why we have seen co-ordinated action to weaken the dollar in the past.
Turning this around, a weak dollar can have the opposite effect, easing global financial conditions and driving a reflationary impulse to the world economy. This tends to lift inflation expectations both in Europe and globally and act as a tailwind for value vs growth.
Large dollar repatriations from US corporates have supported the dollar over the last 18 months. Since US tax reform was signed into law in late 2017 nearly $1tn of the $1.7tn of corporate cash balances held outside the US have returned home. This has acted as a strong support for the dollar over the period. Whilst repatriations are continuing, the pace is slowing down. This may reduce some of the upward pressure on the USD going into 2020.
Predicting the euro-dollar is notoriously difficult. Instead we can at least be prepared for a possible trend change. We know Donald Trump wants a weak dollar. He berated the Fed on interest rates and now they have cut. Will he succeed in talking the dollar down? If global growth expectations improve next year his job will become easier. Either way a weaker dollar, which also means a stronger euro, has the potential to provide a significant positive stimulus for the global economy.
Bloomberg, US Treasury, BEA, Lightman, October 2019
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