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Five years ago Mario Draghi delivered his famous “whatever it takes” speech in London. Since then the euro has been on a rollercoaster ride, but today sentiment towards the European economy and the common currency is the best it has been since before the global financial crisis.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Psychology of Investing.
Year to date the euro has appreciated approximately 13% against the US dollar. The good news is the strength of the euro can be traced back to better-than-expected economic data on the continent. Unemployment is falling, consumer and business confidence is rising, and overall the economy looks the most robust since before the euro debt crisis in 2011. Europe’s unemployment rate fell to 9.1% in July, its lowest level in eight years. Potential political headwinds have also disappeared following the Dutch and French elections where far right candidates failed to win overall majorities. And even though the far right in Germany entered Parliament for the first time in almost 60 years, Angela Merkel remains as Chancellor in Germany.
Momentum swings in favour of the euro over the last 10 months can be broadly explained by two events. Firstly, President Donald Trump’s election in November 2016. The euro depreciated by almost 4% versus the dollar in the two weeks following the presidential election on the back of Trump’s pro-growth spending plans. However, there was a reversal in momentum as investors lost confidence in the Trump administration’s ability to carry out these plans. This coincided with Emmanuel Macron’s victory in the French presidential election in May; the euro was valued at $1.12 prior to his election. Since the French election the euro has surged to $1.20, and pressure remains on the US dollar as speculators have amassed the ‘largest netshort position on the dollar in more than four years.’
Euro remains undervalued
Despite its recent appreciation, the euro is still approximately 12% undervalued versus the dollar at 1.18, based on the Organisation for Economic Co-Operation and Development (OECD) measure of purchasing power parity (PPP) fair value is 1.34 (See Figure 1). However, through a wider lens the euro’s recent strength should be seen in the context of where it was just a few years ago. Since 2014 the euro has tumbled from 1.40 all the way down to 1.05, so the recent movements are just somewhat a reversal of this, moving back towards fair value.
Figure 1: EUR/USD PPP
The impact on European investor’s returns has been significant. In dollar terms, global equities are up over 14% year to date, but when converted into euros, returns are little more than 3% (See Figure 2). Given the recent weakness in the dollar, investors could be tempted to dump their US dollar assets. This would be a rash move in our opinion. All one has to do is to think back to the questions about the future of the euro that persisted during the euro debt crisis.
Almost the entire economics community believes there are still many structural problems with the Eurozone and if the union will survive without further fiscal integration, which some nations may decide is too high a price to pay for Eurozone membership.
Secondly, to invest in some of the key trends taking place in the world today, investors often need to invest in US companies. This is particularly true in areas such as technology and biotechnology where US companies are world leaders. We believe the question is not whether one should hold any dollar assets, but how much. In our portfolio construction process we guide investors to remain diversified and not be over exposed to specific currency movements.
Figure 2: Euro strength has dampened asset class returns
WARNING: Past performance is not a reliable guide to future performance. The value of investments and of any income derived from them may go down as well as up. You may not get back all of your original investment. Returns on investments may increase or decrease as a result of currency fluctuations.
WARNING: Forecasts are not a reliable indicator of future performance.