The region risks falling back into a spiral of
lackluster growth, higher deficits and weak investor confidence.
The rescue of Banco Espirito Santo in Portugal sends a warning
sign on lingering financial fragility in the periphery despite the
record tightening in spreads. The EU’s stand-off with Russia over
Ukraine also looms large over the euro zone economy, with the
impact already apparent in weak order books and industrial
production in Germany.
Against this backdrop of negative news flow, the Euro has not
weakened as much as we would have expected, with the single
currency holding steady around USD1.33-1.34[1] for the first two
weeks of august, following a move down from USD1.37 since
June.
We are underweight the Euro versus the USD in our tactical
asset allocation, and believe the fundamentals are firmly aligned
for a further depreciation in the single currency – in that respect,
we agree with European Central Bank President Mario Draghi
who, unusually for an ECB President, attempted to talk the euro
lower in his latest press conference in August.
While the US has characteristically led other regions in the
recovery, the divergence between US and EU zone economic
conditions has been unusually wide. While the US posted very
strong Q2 GDP growth of 4 per cent (annualized)[1], parts of
Europe are contracting. We have cut our 2014 and 2015 growth
forecasts for the euro zone, and now expect economic activity to
expand by 0.8 per cent in 2014 and 1.2 per cent in 2014 (against
the ECB’s more optimistic 1 per cent and 1.5 per cent
respectively). Not only is inflation far behind the ECB’s target at
0.4 per cent [1], it also appears that the market has lost faith that
the target is even achievable, with breakeven inflation
plummeting across Europe.
This US-EU zone economic divergence has been reflected in a
widening rate differential, with the bund yield moving to an all-time low. The gap between 2-year rates in the US and Europe has
widened to 44 basis points from 17 basis points[2] at the beginning
of the year as the US Federal Reserve moves closer to hiking rates
in 2015 and the ECB moves in the opposite direction.
The differential in rates is even wider in the long end of the
curve, where the gap between US Treasury and bund yields has
widened above 140 basis points, a 15y high[2]. While we expect
the Fed to wrap up its QE program by October, the ECB is
expected to expand its balance sheet through the deployment of
its tLTRO initiative and potential purchases of asset-backed
securities. Although weak economic momentum and the growing
probability of inflation remaining below target make it
increasingly likely that the ECB will embark on a program of
quantitative easing, we do not think this is likely in the near term- the central bank is awaiting further information on measures
which have already been announced. Even excluding full QE –
the sum total of other measures (including the payback of
previous LTRO tranches) – we expect the ECB’s balance sheet to
grow by around EUR 300-400 billion through the end of 2015,
even as the Fed’s balance sheet contracts. Thus, while European
fixed income appears to be tracking monetary policy cues, a
weaker EUR remains the missing part of the puzzle.
While a major support for the currency has been strong capital
inflows into Europe – especially portfolio flows – there are early
signs that they are ebbing.
A combination of geopolitical risks,
tepid corporate earnings and deteriorating macro momentum, as
well as the expectation of a weaker euro, has triggered equity
selling on the mutual fund and ETF side for the past eight weeks
according to data from EPFR global, with an outflow of USD 7
billion this quarter following steady inflows over the year prior
of USD 94 billion in total (equivalent to 15 per cent of net assets)[1]. Bond flows still continue to be supportive, however.
Given
that a key source of total inflows has been US investors looking
to increase their exposure to Europe, evidence that this source of
external demand is fading is another justification to go short the
Euro from here.
Besides private capital inflows, the Euro owes its relative
strength to at least two other factors. One, its steady current
balance of around 2.2 per cent of GDP[1] externally, alongside
greater rebalancing occurring among individual countries.
Second, there is anecdotal evidence of the diversification of
central bank holdings favoring the Euro. While we expect the
trade surplus to stay in place despite a hit to Russian exports, the
second is more of an unknown quantity, and thus harder to
factor into our calculations. Regarding valuation, our fair value
models point to an equilibrium level for the EUR at USD1.38, but
this long-term model does not preclude a weaker EUR – in fact,
the currency needs to be close to 1 standard deviation cheap –
equivalent to just over 1.25 to the USD – in order to have a
significant impact on the economy and earnings.
In short, the weight of fundamental factors point towards a
weaker Euro.
Pictet AM’s Strategy unit is currently underweight
the single currency in our grid. In our regional equity grid, we
retain a conviction that a weaker euro will go hand-in-hand with
weaker European equities for now as the direct currency impact
dominates in the short term.
Over the medium term, and only
once a sufficiently weak level has been established, a weaker
Euro will translate into higher earnings growth, creating a
buying opportunity further down the line. Our fixed income
colleagues are also short the Euro in their portfolios – they
believe that further euro weakness will stem from additional
sluggish economic data that will lead the market to price in a
higher probability of QE in the first half of next year.
[1] Source : Bloomberg, Datastream, EPFR
[2] Source : Bloomberg, données au 20.08.2014 et au 31.12.2013
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