Currencies: European renaissance
The political risks to the eurozone project are fading after elections in France, Austria and the Netherlands put centrists into power. A pro-euro, pro-globalization reform agenda could make the single European currency more appealing in the longer term.
Political risks are fading in Europe. After the win of Emmanuel Macron in France’s presidential election, one big threat hanging over the euro (EUR) exchange rate is now removed. Macron’s rival Marine Le Pen of the National Front had threatened to take France out of the eurozone. Earlier elections in the Netherlands and Austria did not end with populist victories either, while we believe the upcoming German election in September is likely to see the prolongation of Chancellor Angela Merkel’s time in office. Political headwinds for the euro are not completely gone as elections in Italy are expected in the spring of 2018, with the euro-skeptic Five Star Movement currently polling strongly. However, pro-euro and pro-globalization parties and politicians are on the rise in the countries of the single currency area, contrasting with the rise of populist movements looking to restrict free trade and migration in the U.S. and the UK.
In this edition of our quarterly outlook report, we look in detail at the prospects of the euro through the lens of our cycle, valuation and sentiment framework for market analysis:
- Business cycle: Negative interest rates and quantitative easing (QE) continue to weigh on the EUR, although we believe the European Central Bank’s next move will probably be to extend, but reduce its bond purchases in 2018. On the fiscal and structural policy front, President Macron may be joined by a reelected Chancellor Merkel to push for a reform of the eurozone institutions. Given euro-friendly political developments, our cycle view on the euro is modestly positive.
- Valuation: The European single currency is supported by attractive valuations, and the euro trade-weighted exchange rate is low compared to history. The euro is also cheap vis-à-vis the U.S. dollar (USD) from a purchasing power parity perspective, as shown in the chart on the next page.
- Sentiment: For the euro, it is positive. The currency has enjoyed a solid recovery since the beginning of the year, particularly after the French elections, without the rally becoming overheated.
- Conclusion: We are becoming more constructive on the euro. Already attractively valued and buoyed by fading political risks, more pieces of the jigsaw puzzle could fall into place in the second half of the year to create a sustained rally. Other European currencies that usually correlate closely with the euro, such as the Swiss franc and the Swedish krona, could also benefit.
EUR/USD: purchasing power parity (PPP)
Source: Thomson Reuters Datastream, as of June 12, 2017.
Other major currencies
- U.S. dollar (USD)
Long USD was a winning consensus position after the 2016 U.S. presidential election, but the greenback has reversed course since the beginning of the year. Optimism around U.S. federal tax reform (including the border tax adjustment, and corporate and personal tax cuts) proved premature and faster Fed rate hikes did not come through in early 2017. While interest rate differentials between the U.S. and the rest of the G10 countries are still supportive of the U.S. dollar, the greenback is also still expensively valued. All in all, we believe that the greenback is unlikely to revisit or exceed its previous highs in the second half of 2017.
- Japanese yen (JPY)
From a monetary policy perspective, the JPY is subject to similar forces as the EUR. The Bank of Japan is very stimulative, having promised to keep Japanese government bond yields at zero. While this is a drag on the yen, the latter enjoys the tailwind of appealing valuation. We are also wary of the potential for a downward correction in risk markets, which could drive demand for safe-haven currencies such as JPY.
- UK pound sterling (GBP)
After the UK general election in early June delivered a hung parliament, the ruling Conservatives managed to form a minority government propped up by the Democratic Unionist Party (DUP) in Northern Ireland. In our main scenario, a diminished Conservative seat share may actually deliver a “softer” Brexit, which would be a positive for the pound and keep it within the 1.20 to 1.30 range to the U.S. dollar. Sterling also enjoys favorable valuation vis-à-vis the U.S. currency, which could eventually push it beyond 1.30. Due to the slim margin of safety for the government and the possibility of inconclusive new elections, there is an outside risk that Britain leaves the EU without a deal. This prospect could push the pound below 1.20, but it is a less likely scenario.