Thursday, July 27th, 2017

Euro-Schizophrenia

Our models have a split attitude towards Eurozone equities. Our dollar-based global equity model has all the individual countries at or close to the top of the leader-board for all the usual reasons: above-trend and accelerating GDP growth, strong currency, reduction in political risk, safer banking system. This is in obvious contrast with other developed markets like Japan, the UK and USA which have weak currencies and political gridlock.

However, our euro-based asset allocation model has reduced exposure to Eurozone equities by 9 percentage points in the last 5 weeks. This is part of a general move out of equities into fixed income. This sounds strange since our fixed income portfolio is currently producing negative returns. However, when we compare the change in the running returns over the last two months the reason becomes clear. At the end of May, our global equity portfolio, which is heavily overweight Europe and underweight the US had a running return of 20%, compared with a 0% running return from our fixed income portfolio (with all constituents close to neutral weight). As of last week, the numbers are -5% for fixed income, but only 3% for equities. The gap between the run rates has closed from 20% to 8% in less than two months, and the composition of the equity or fixed income portfolios has no more than a marginal effect. Our two big exposures relative to benchmark are the consensus overweight on the eurozone and the underweight on the US.

The elephant in the room is of course the strength of the euro, which has risen from 1.059 against the dollar at the beginning of April to 1.166 as of last week. The good news is that it now looks overbought in the short term against the dollar and the yen. The bad news is that is still below the middle of its three-year range against the dollar (approx. 1.20) and is trending higher against all major currencies. We have no problem with the idea of a short-term pull-back, but all the reasons which make eurozone equities so attractive to international investors also mean that that euro is likely to appreciate over the medium term.

Aside from the usual sector and country rotation, we see three principal effects if the euro trends higher over the rest of this year. First, euro-based investors would gradually shift out of international equities, because the returns in euro terms would not be as attractive as they were. Second, Eurozone companies would start to downgrade earnings growth expectations for 2018, mainly because of translation effects. Third, these two factors lead would to a significant shift away from equity towards fixed income. The strength of the euro leads to tighter monetary conditions in Europe, allowing the ECB to postpone the day when it has to contemplate a sustained rise in interest rates or start to shrinking its balance sheet.

Of course, there are many reasons why euro strength may not continue. It’s possible that the result of the German and Italian elections may not be so market-friendly as the French and Dutch elections. But that would hardly be good for Eurozone equities either. We still think they will be the largest single position in our asset allocation model for some time to come, but they will be a normal overweight in a portfolio which is modestly overweight equities. As we argued shortly after M. Macron’s election, we are already past peak Euro-phoria.

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