Euro is showing signs of “fatigue” after its summer rally
The positive talks among European leaders over the summer raised the certainty over the creation of a EUR 750bn recovery fund to help the Euro area tackle the crisis caused by the pandemic and therefore avoid a massive increase in political risk. In addition, EU leaders also agreed on a seven-year budget of EUR 1.074tr, the Multiannual Financial Framework (MFF), bringing the total financial package to EUR 1.82tr. This raised investors’ hope on a faster-than-expected recovery following years of restrictive fiscal policy for Euro nations. It is important to notice that while the US was running a loose fiscal policy following Trump’s tax cuts and jobs act (2017) at a time when the unemployment rate was sitting at a 50-year low, the Euro area was running a restrictive policy with deficits ratios below 1% (of GDP) in 2018 and 2019.
Therefore, the massive “stimulus” agreed by Finance Ministers over the summer generated a strong rally on the euro, which soared from 1.10 in May to 1.20 on September 1st relative to the US dollar as investors were betting that a loose fiscal policy will lift up growth expectation in the euro area. However, the US dollar has received strong support in the past few weeks amid rising uncertainty over US elections; figure 1 (left frame) shows that the US dollar has been inversely correlated to the moves in the equity market – cheaper currency higher equities – in the past year and therefore we have been warning of a sudden reversal in the USD trend if volatility starts to rise.
We still remain slightly bullish on the euro against currencies such as the British pound or the Swiss franc; however, we will need to see stronger fundamentals in the Euro area in order to see more positive momentum on EURUSD.
Leading indicators are sending mixed signals
At this stage, our main leading indicators for the Euro area are currently showing mixed signals. For instance, we saw that the ZEW survey, which measures the level of optimism that analysts have about the expected economic development over the next six months, has recently surged to its highest level in 20 years and is pricing in a sharp recovery in the economic activity in the next few months. Figure 2 (left frame) shows that the ZEW survey has strongly led Euro industrial production by six months in the past 30 years. In addition, the IFO Business Climate, which has historically led industrial production by four months and measures the business sentiment, has also recovered strongly in the past few months (figure 1, right frame). The IFO is still significantly below its 2017 levels but is sending positive signal on the economic activity in the Euro area.
On the other hand, another key market indicator that measures the real-time state of the 19-nation bloc is the 2Y10Y yield curve; figure 3 (left frame) shows that after falling by 1% in the past year, the yield curve has remained flat in the past few months oscillating around 20bps and is not pricing in any signs of pickup in the activity.
Hence, when we compute an aggregate leading indicator for the Euro area, which includes a series of financial and economic variables, we are still standing at low levels relative to prior the pandemic; figure 3 (right frame) shows the dynamics of our 6M leading economic indicator in the past 25 years.
Outlook on European equities
We will need to see further momentum in economic fundamentals in the coming months to generate a positive trade idea on risky assets in the Euro area; we do not think that the rise in ECB assets will be enough to stimulate equities in the near term. Despite the massive increase in liquidity in the past six months, we can already see that markets are running out of stimulus and are very vulnerable to the uncertainty over US elections and Brexit. Figure 4 (left frame) shows that a rapid rise in ECB assets have generally resulted in a short three- to six-month rally in stocks in the past cycle, but we will need to have a clearer picture of the economic outlook in order to generate a positive view on stocks.
European banks, which could also be used as a good real-time proxy of the current economic activity, are still sitting at historically low levels amid growing concerns that the current health crisis will be suddenly followed by another financial crisis amid a massive rise in non-performing loans in the coming quarters.
Banks profitability has plunged due to the NIRP policy run by the ECB and the flattening of the yield curve in the past cycle. It is interesting to see that between 1995 and 2008, a flatter yield curve in the Euro area was associated with strong banks’ valuations (figure 4, right frame); however, we believe that we will need to see more positive momentum in economic fundamentals in order to start building a long-term bullish view on European risky assets.
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Disclosure: I am/we are long USDCHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.