Fundamentals point to a weaker euro

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