Euro Strength?
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.
Sources:
Bloomberg, US Treasury, BEA, Lightman, October 2019
Legal
Disclaimer
This communication and its content are owned by Lightman Investment Management Limited (“Lightman”, “we”, “us”). Lightman Investment Management Limited (FRN: 827120) is authorised and regulated by the Financial Conduct Authority (“FCA”) as a UK MiFID portfolio manager eligible to deal with professional clients and eligible counterparties in the UK. Lightman is registered with Companies House in England and Wales under the registration number 11647387, having its registered office at c/o Buzzacott LLP, 130 Wood Street, London, United Kingdom, EC2V 6DL.
Target audience
This communication is intended for ‘Eligible Counterparties’ and ‘Professional’ clients only, as described under the UK Financial Services and Markets Act 2000 (“FSMA”) (and any amendments to it). It is not intended for ‘Retail’ clients and Lightman does not have permission to provide investment services to retail clients. Generally, marketing communications are only intended for ‘Eligible Counterparties’ and ‘Professional’ clients in the UK, unless they are being used for purposes other than marketing, such as regulations and compliance etc. The Firm may produce marketing or communication documents for selected investor types in non UK jurisdictions. Such documents would clearly state the target audience and target jurisdiction.
Collective Investment Scheme(s)
The collective investment scheme(s) – WS Lightman Investment Funds (PRN: 838695) (“UK OEIC”, “UK umbrella”), and WS Lightman European Fund (PRN: 838696) (“UK sub-fund”, “UK product”) are regulated collective scheme(s), authorised and regulated by the FCA. In accordance with Section 238 of FSMA, such schemes can be marketed to the UK general public. Lightman, however, does not intend to receive subscription or redemption orders from retail clients and accordingly such retail clients should either contact their investment adviser or the Management Company Waystone Management (UK) Limited (“Waystone UK”) in relation to any fund documents.
The collective investment scheme(s) - Elevation Fund SICAV (Code: O00012482) (“Luxembourg SICAV”, “Luxembourg umbrella”), and Lightman European Equities Fund (Code: O00012482_00000002) (“Luxembourg sub-fund”, “Lux product”) are regulated undertakings for collective investments in transferrable securities (UCITS), authorised and regulated by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. In accordance with regulatory approvals obtained under the requirements of the Law of 17 December 2010 relating to undertakings for collective investment, the schemes can be marketed to the public in Luxembourg, Norway, Spain, and Republic of Ireland. Lightman, however, does not intend to receive subscription or redemption orders from any client types for the Lux product and accordingly such client should either contact a domestic distributor, domestic investment advisor or the Management Company Link Fund Solutions (Luxembourg) S.A. (“Link Luxembourg”) in relation to any fund documents.
Luxembourg umbrella and Luxembourg sub-fund are also approved for marketing to professional clients and eligible counterparties in the UK under the UK National Private Placement Regime (NPPR). UK registration numbers for the funds are as follows: Elevation Fund SICAV (PRN: 957838) and Lightman European Equities Fund (PRN: 957839). Please write to us at compliance@lightmanfunds.com for proof of UK registration of the funds.
Luxembourg sub-fund is also approved for marketing to qualified investors in Switzerland, within the meaning of Art. 10 para. 3 and 3ter CISA. In Switzerland, the representative is Acolin Fund Services AG, Leutschenbachstrasse 50, 8050 Zurich, Switzerland, whilst the paying agent is NPB Neue Privat Bank AG, Limmatquai 1 / am Bellevue, 8024 Zurich, Switzerland.
Accuracy and correctness of information
Lightman takes all reasonable steps to ensure the accuracy and completeness of its communications; we however request all recipients to contact us directly for the latest information and documents as issued documents may not be fully updated. We cannot accept any liability arising from loss or damage from the use of this communication.
Wherever our communications refer to a third party such as Waystone, Link, Northern Trust etc., we cannot accept any responsibility for the availability of their services or the accuracy and correctness of their content. We urge users to contact the third party for any query related to their services.
Important information for non-UK persons (Including US persons)
This communication is not intended for any person outside of the UK, Switzerland, or the European Economic Area (EEA). Lightman or any of the funds referenced in this communication are not approved for marketing outside of the UK, Switzerland, or the EEA. All such persons must consult their domestic lawyers in relation to services or products offered by Lightman.
Risk warning to all investors
The value of investments in any financial assets may fall as well as rise. Investors may not get back the amount they originally invested. Past performance is not an indicator of future performance. Potential investors should not use this communication as the basis of an investment decision. Decisions to invest in any fund should be taken only on the basis of information available in the latest fund documents. Potential investors should carefully consider the risks described in those documents and, if required, consult a financial adviser before deciding to invest.
Offer, advice, or recommendation
No information in this communication is intended to act as an offer, investment advice or recommendation to buy or sell a product or to engage in investment services or activities. You must consult your investment adviser or a lawyer before engaging in any investment service or product.
GDPR
Lightman may process personal information of persons using this communication. Please read our privacy policy.
Copyright
This communication cannot be distributed or reproduced without our consent.
