Pascal Blackburne & Luc Synaeghel 2017-08-10

Numerous are the concerns that we have written about in recent letters – all the while striving to make the most of the ongoing sweet spot for the global economy and financial markets. Rich equity valuations, eventual wage-driven inflationary pressures, high correlations due to ETF and quantitative hedge fund proliferation, (geo)political uncertainties, build-up of Chinese non-performing debt: these matters (and more) have long featured on our worry list.

Currencies, however, were one area where we felt relatively secure. Their stability during the last couple of years has been such that it actually made us wonder whether some form of unofficial agreement between central banks had been found. In particular, since early 2015, the euro has traded within a 1.05-1.15 range versus the US dollar. Being long the euro at the low end of this range and hedging some exposure at the higher end was a straightforward and effective strategy.

eurusdSource: Bloomberg

Not anymore: the last days of July saw the single currency tear through the 1.15 resistance. And the move was clearly one of euro appreciation – rather than dollar weakening – insofar as it occurred against virtually all other currencies.

Explanations must thus first and foremost be sought in Europe, where we see three developments boosting the single currency: dwindling political concerns, economic growth truly gaining traction and slowly changing European Central Bank (ECB) wording.

In the US meanwhile, it is becoming increasingly apparent that the Trump administration is not delivering on its promises. Fiscal stimulus looks unlikely to happen anytime soon. Hopes for a major overhaul of the tax code have been dashed: all that consumers and companies might get are modest tax cuts – assuming Republican budget vigilantes do not rule the day. As for infrastructure spending, plans have yet to be discussed, let alone implemented. And then there is the Federal Reserve (Fed). With US growth proving slower than expected and inflationary pressures still absent, the need for further rapid rate hikes is not obvious.

So rather than diverging throughout 2017 as most observers expected, Fed and ECB monetary policies now appear on the brink of convergence. Despite having been proponents of such a scenario, we must admit that the timing and speed of the euro breakout took us by surprise.

Where the euro goes from here is very much open, complicating portfolio construction. Near term, a retest of the 1.15 level seems likely. Should monetary convergence materialise and the euro then head for its purchasing parity level of approximately 1.30, broad European equity indices would no doubt suffer – at a time when bonds are yielding next to nothing (and face the prospect of rising rates). That would leave few attractive spaces in which to invest, remembering that US equities are more expensive and boast less favourable earnings dynamics than their European peers. A thorough review of the euro-sensitivity of portfolio holdings is thus necessary at this point, and the need to find uncorrelated niche investment opportunities ever greater.

Monetary policy convergence...

At the onset of the year, the consensus view was that the Fed would adopt a hawkish stance throughout 2017. The perceived risk for the US was one of overheating, with promised Trump policy measures adding fuel to an already fully-employed economy. Conversely, Europe was seen as a sorry case, riddled with potential political pitfalls – implying that economic growth would likely remain slow and the ECB would be in no position to taper its asset purchases.

As the European electoral agenda cleared and economic growth proceeded to surpass that of the US, most investors were caught wrong-footed in terms of currency exposure. Short-covering thus probably contributed to the speed at which the euro recently broke out of its 1.05-1.15 range.

Our view on durable divergence between Fed and ECB monetary policies has been rather more dubious. In several letters this year we pointed out that a reversal of ECB easy money is inevitable and likely to occur sooner than generally expected. But while we were not surprised to see (indeed were positioned for) euro appreciation towards the higher end of its range, we must admit to having been taken by surprise by its subsequent breakout.

Going forward, monetary policy convergence (i.e. a structurally stronger euro) remains our base case. But we cannot rule out a converse scenario in which wage inflation risk causes the Fed to panic-hike rates. Or one in which the ECB has sudden qualms about the economic recovery and decides to extend quantitative easing. Limiting portfolio sensitivity to the direction of the euro thus seems warranted at this point, although not simple to achieve.

We would also caution that if such a rapid and surprising move can take place in currency markets – over which central banks probably (like to believe that they) have some control – then it could well occur in other financial markets, again catching investors off-guard.

… would lessen the appeal of european equities

Euro appreciation has clearly impeded the performance of European equity markets – beyond the post-Macron election relief rally. Since early May, the Eurostoxx 50 index has given back some 4%, while US stocks (as measured by the S&P 500 index) gained a further 7%. Mind you, that performance gap exactly matches the currency move – meaning that unhedged exposure to US equities would not have delivered positive returns in euro-based portfolios.

Source: Bloomberg

Exiting the “comfort zone” of range-bound currencies, in the event that the euro breakout is confirmed over the next few weeks, complicates our case for European equities.

Relative valuation remains a tailwind, as does the prospective leverage on earnings from higher topline growth – following a near-decade of depressed economic conditions that have made European companies leaner, meaner and fewer.

But continued euro strengthening would come as a headwind, especially hurting exporting and multinational companies. As such, not only may it warrant lower overall exposure to European equities, but it would also call into question our strategy of managing that exposure mainly at the index level. Focusing on certain segments of the European stock market, indeed on specific (non-euro dependent) companies, might instead make more sense. There lies our August homework.