In recent months the euro has risen sharply against most currencies. The currency's appreciation is ...
In recent months the euro has risen sharply against most currencies. The currency's appreciation is likely to continue, certainly against the US dollar.
Sentiment remains firmly against the dollar, partly due to world events but also due to the low money market yield offered, and an unwinding of the currency's overvaluation relative to its fair value. In contrast sentiment is still behind the euro. The currency has been historically undervalued and, relatively speaking, offers a reasonable money market yield.
Continued and prolonged euro appreciation will have a negative effect on European competitiveness. The eurozone is particularly dependent on exports, especially to the US. This dependence on exports is particularly acute given the current underwhelming level of consumer spending in the continental European economy. Therefore, the single currency's appreciation bodes ill for the outlook for the profits of European companies. There are some positive aspects of the euro's strength. A strong European currency will have the effect of driving down the cost of imports. This has two benefits.
Firstly, it partially offsets the damaging effect of higher natural resource prices at a time when such prices are particularly high.
The other benefit is that a strong exchange rate, by acting as a disinflationary force, leaves the European Central Bank (ECB) with more room to reduce interest rates.
The recent appreciation of the euro will make it easier for the ECB to justify cuts in interest rates and stimulate Europe's reticent consumers into spending some of their savings. Money markets are currently expecting the ECB to cut interest rates over the next six months.
The current level of oil prices is also having a damaging effect on the European economy. For example, France, which is already very efficient in its use of oil (French consumer preference is for smaller cars and the vast majority of French electricity comes from nuclear power), does not have much room for efficiency gains. This means the French economy will suffer in a high oil price environment.
This is in sharp contrast to the US, which could gradually respond to price increases with massive efficiency gains by changing the buying habits of drivers and switching from oil-fired to natural gas-powered electricity generation.
The duration of the problems in Venezuela and the Middle East are very difficult to estimate. By implication, so is the cost to the European economy.
Another problem is that European equity analysts are downgrading their profit forecasts at a quicker pace than their counterparts in North America and Japan.
On the other hand, from a valuation perspective, it would be very hard to argue that European markets are not attractively priced.
However, as long as the European consumer remains subdued, the euro remains strong, and analysts continue to be gloomier than their North American and Japanese colleagues there will be better returns in other equity markets.
Stronger euro will make imports cheaper.
Room for ECB to reduce interest rates.
European equities look attractively priced.
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