Euro-dollar spread a boon for multinationals

We are at a point in the global economic cycle at which the US economy is slowly but firmly entering a normal cycle and the first leg of the euro-zone recovery has helped the periphery to position for a domestic recovery. The divergence between the United States and euro-zone monetary policies has allowed for a currency decoupling and effectively set the stage for an increase in the US dollar in the short and medium term against the euro.

In the euro zone, the need for a lower external value of the euro has become manifest over the past six to nine months. It can be seen in the decline of the rate of inflation in the euro area relative to that in other developed markets. This has put downward pressure on corporate earnings in the euro zone in relation to the United States. This is why equities analysts point out there has been no significant improvement in the expected sales growth of companies in the euro zone since the middle of last year, despite the recovery of real GDP growth.

There is a degree of divergence between dollar and euro short-term money market rates. The euro has remained strong since the beginning of the year as short-term money market rates in the euro zone rose sharply this year. We believe a main reason why they stayed high is that this period coincided with accelerated long-term refinancing operation repayments by the banks. As these new European Central Bank (ECB) measures were previously announced, they are now falling below those of the US.

This is why we believe that the key aims of the ECB chief Mario Draghi’s actions in June were to incentivise lending in the longer term and also to convince the market of the necessity for a lower currency. The main condition for the adjustment of the euro/dollar exchange rate is that the US economy should continue to grow marginally above the trend. Assuming the European economy continues its improving trend, real yields of all maturities of US-dollar debt should tend to rise relative to those of euro debt over the next 12 months, albeit gradually.

We believe the direct beneficiaries of this market theme would be companies with a cost base in euros and sales in dollars. European dollar earners have also experienced attractive valuations recently, mostly because other developed economies have fared better than the European one since the beginning of the year.

Flows between the euro and the dollar are also a good indicator of market positioning, and they have already started turning more negative. The flow data for May painted a mixed message. US equity outflows are running at record highs, and more importantly US-based investors are rotating away from Europe, where net equity flows turned marginally negative. Some sell-side high frequency proxies have confirmed the pause in inflows since May, but recently showed the largest daily equity outflow in the history of this series (which we believe to be a potential explanation behind the recent breakout below 1.35 for the euro/dollar rate).

We believe the divergence in monetary policies has created the conditions for multinational companies to arbitrate the cost structure between developed markets’ currencies. The ECB is implicitly in favour of a weaker euro. We believe European multinational companies are well-positioned for this environment.

Cesar Perez is the chief investment strategist for Europe, the Middle East and Africa (EMEA) at JP Morgan Private Bank

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