Central bankers and equity investors can find common ground on one topic.
At a time when inflation is not a problem and bond yields suggest a degree of disinflationary pressure, no one wants a sharply strong currency let alone a tightening of financial conditions.
This clearly shows up when you look at the tussle between US and eurozone equity market performance. Until the latest verbal stoush referencing nuclear weapons between the US and North Korea on Tuesday, Wall Street and by extension the FTSE All World index have been hitting the record books hard.
In contrast, eurozone equities have been trading sideways since they peaked in early May. In that time, the value of the euro versus the dollar has taken flight from about $1.09 to a recent peak of $1.19.
As global equities swoon while havens such as gold, the swiss franc, yen and top tier government bonds attract buyers, investors still face a key question once the latest geopolitical tension abates.
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Tweaking share portfolios for the coming months comes down to just how much further investors think the euro can rally from here.
A stronger euro — and it has been broad, not just against the dollar — has hit classic European equity export sectors such as healthcare, staples and capital goods and oil-linked companies. Data this week revealed a drop in German exports for June that was nearly the largest decline seen in two years.
Meanwhile, the weaker dollar has bolstered the earnings performance of US blue-chips during the reporting season. That has helped Wall Street lately narrow its 2017 performance gap with eurozone markets in dollar terms, although when viewed through the prism of the euro, the S&P remains negative for the year.
While fund flows and many analysts favour European shares over Wall Street, the strength of the euro has become an issue. Until May, both the single currency and regional share prices were rallying in tandem as the recovery in the economy was stronger than expected at the start of the year.
As analysts at Société Générale note, that correlation has changed since May and represented a headwind for the broader European market.
Additional euro strength cannot be ruled out if the economy extends its upswing and the US lags behind. A successful passing of reforms in France under President Emmanuel Macron and further progress in dealing with the banking sector’s welter of bad debts would send a strong message to global investors that the eurozone recovery has legs and that their portfolios need to adjust after years of being underweight the region.
Playing a growing role in further boosting the euro will be the attitude of investors. Stronger net inflows into the eurozone and less hedging of the currency by foreign-based traders — who previously sold the euro when buying single currency assets — shapes as a powerful foreign exchange tailwind.
One can counter that the speed of the euro’s rise this year has been too rapid and has already outpaced valuation metrics. If we look at the still-wide divergence in bond yields between the US and Europe, some traders think $1.12 represents fair value for the world’s most actively transacted exchange rate. Currency positioning has also become stretched, hence the euro’s recent pullback.
Yet to weigh in, of course, is the European Central Bank — though Mario Draghi, its president, will address the annual gathering of policymakers this month in Jackson Hole, Wyoming. Discussion of euro strength was barely mentioned at the ECB’s most recent policy meeting in July, a development that prompted a rally in the currency.
This time the currency market awaits a degree of jawboning from Mr Draghi, which given the divergence in financial conditions between Europe and the US could well carry weight.
A weaker dollar has helped loosen financial conditions, thus offsetting the Federal Reserve’s three interest rate tightenings since December. Tighter financial conditions that moderate inflation at this juncture of a eurozone recovery is hardly desirable.
Alan Ruskin at Deutsche Bank says the risk of more tightening from the Fed and an ECB stressing the need for easy money well into 2018 beckons.
“Eventually you will get some counterbalance from financial conditions having shifted between the US and the eurozone,’’ says Mr Ruskin.
The importance of central banks in fostering the long-running bull market for equities means that when investors scan the horizon for a catalyst that could spur a market shock, they tend to focus on the withdrawal of monetary stimulus.
In those circumstances a more active Fed and by extension a stronger dollar remains a more likely outcome.
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