In Morgan Stanley’s “Sunday Start” note, the bank’s chief European economist, Elga Bartsch, looks at the recently surging EUR, where net spec positioning remains near the most bullish level in the past 6 years…
… notes that according to the bank’s currency expects, the “bull case of 1.28 for EURUSD looks increasingly likely”, but wonder “at what point a bit of breathlessness could turn into outright altitude sickness.“
Here is MS’ latest take on “what’s next in global macro” with a focus on the common currency.
Climbing Mountains or Walking Hills
You don’t have to climb one of the mountain peaks in the Alps to feel a bit breathless this summer. Watching the euro climb further might already suffice if you are an investor. And we might not be near the peak yet. According to our currency experts, their bull case of 1.28 for EURUSD looks increasingly likely, even with Friday’s relatively solid US employment report. Investors will therefore be wondering at what point a bit of breathlessness could turn into outright altitude sickness. For now, the ECB seems unconcerned about the strength of the euro, largely because it is reflecting stronger economic fundamentals and better prospects for political reforms. While it is clear that the euro area economy has shifted into higher gear, it remains to be seen whether reforms will able to make a quantum leap.
This past week, the euro area economy put in three back-to-back quarters of above 2%Q SAAR GDP growth. In response, we raised our euro area GDP growth forecast to 2.1%Y for 2017 and 1.8%Y for 2018, 20bp higher for each year. An average growth rate of 2.25%Q SAAR since last autumn might not seem much for some of our readers, but on the ‘Old Continent’ this pace sits a full percentage point above potential growth. As a result unemployment keeps falling faster than many forecasters, including us and the ECB, expected. At 9.1% of the labor force, unemployment remains above the pre-crisis level of around 7%. But it is not very far above most estimates of the natural unemployment rate. While inflation pressures remain subdued, core inflation inched further above 1%Y in July. At 1.2%Y, it now stands half a percentage point above its March low.
However, additional euro strength will make it increasingly difficult for the ECB to be sure that inflation will head back to its target of below, but close to, 2%Y. Back in June, the ECB staff projections were based on an exchange rate assumption of 1.09 versus USD. On our estimates, a sustained 10% appreciation in trade-weighted terms reduces GDP growth and headline inflation by about 0.7 percentage points. Hence, in the light of the current FX dynamics, the ECB might have to revise its projections lower in September. A downward revision to the already below-target inflation projections might make for a difficult backdrop to announce tapering at the same meeting. Hence, we now expect the ECB to wait until October before committing to such a step. However, our base case remains that the ECB will slow down its asset purchases starting in January.
Importantly, a stronger euro would create additional headwinds for European equities: Having underperformed the US by 6% since mid-May, European equities are not yet oversold enough. None of the market timing indicators our European equity strategy team runs regularly have moved into buy territory yet. Hence, we are happy to hold onto our equity market preference for the US and Japan over Euro. In addition, a fiirther 10% rise in the euro from here would kick 5-8% off EMU earnings. Already in the current earnings season, we have seen the net balance of European companies beating their earnings estimates tracking at a modeest 8% compared to the 29% net beat in 1Q. Given that the euro has just put in the strongest three-month gain in over six years, a further weakening in European earnings momentum might lie ahead. Thus far, Morgan Stanley analysts on average assume 1.13 in their 2018 earnings forecasts. This might be too conservative if the euro keeps pushing higher. The exact impact on eamings also depends on hedging. Unfortunately, hedging information is rarely fully disclosed. However, where it is specifically mentioned. Euro Stoxx 50 companies are hedged at least 12 months out.
Historically, underperformance of European equities versus the US caused inflows – a key driver of the euro strength year-to-date – to slow about three months later: Hence, it is possible that the euro rally could lose momentum in the autumn. Also, the ECB could to lean against the euro strength by stressing that the period it intends to let elapse between the end of asset purchases and the first depo rate hike is longer than the three months the market is pricing in. In addition, the new-found hope investors have regarding European reforms could be disappointed this autumn. The new French government will have to deliver on a range of difficult domestic reforms in the coming rnonths. Prospects for broader European reforms will depend on Angela Merkel’s choice of her coalition partner after the September election: the pro-European, anti-austerity Social Democrats or the pro-market, more eurosceptic Free Democrats. Thus far, the Merkel-Macron ‘plan for Europe’s future’ has remained somewhat vague.
Time will tell whether long euro positions are going to climb a mountain to come down a hill or walk up a hill to climb down a mountain: Much will depend on the extent to which European politicians are able to deliver on the reforms needed to strengthen economic and monetary union as set out in the Five Presidents’ report in the remainder of this year. If there are not far-reaching reforms, with respect to joint macroeconomic stabilisation tools, it will likely take another crisis to force the necessary quantum leap for EMU. This would likely imply a very different trajectory for the euro exchange rate. But whether your path leads you up a steep mountain or a gentle hill this weekend, enjoy the great outdoors.