EURUSD: the next big thing in the next months ahead

1. EDITORIAL

Major indices of US equity ended last week very close to record highs with the VIX very close to a record low, anchored by the absence of volatility in debt markets. The credit signals remain positive, Europe included.

We do not expect to see the S&P500 trading back below the 2450-2460 break-out area. However, the summer story has a sub-plot. USD weakness has extended the phase of consolidation in European and Japanese equity. In particular, EURUSD has reached a critical frontier zone.

The area of $1.16-1.18 represents the upper limit of the range within which this parity has traded since early 2015.

Our interpretation is that we are witnessing the tension that characterises the end of a currency movement, not its beginning. Trans-Atlantic yield differentials do not signal further Euro appreciation at this time. The investment consensus is already bullish and long the Euro.

Accordingly, investors expect that European equity should join US equity in the “late show” rally in August. The reappraisal of the Euro has been associated with a gradual transition of market leadership in Europe since Q1 from globally-exposed to domestically-oriented stocks. There are two significant exceptions to this general rule at this time: the UK market and commodity-sensitive stocks.

The positive momentum of global activity and trade, the resilience of demand from China and a weaker USD is producing a commodity “second wind”. The investment industry is reassessing its suspicious view of China.

The conventional wisdom that “valuations are too high and volatility is too low” has encouraged the accumulation of short positions in the unfashionable, “broken” segments of the equity space.

We think that conditions favour a summer squeeze of such short positions. Many of Europe’s least loved and under-owned stocks and equity segments may perform surprisingly well through this quarter.

In particular, we are witnessing a further demonstration of the leadership of USD denominated growth assets (see figure 1).

Figure 1: USD denominated Equity Growth

We have said it many times before but we will say it again: the simplest, most effective way of enjoying excess returns in a bull market is to identify the leadership assets and to remain invested in them.

The summer sub-plot is provided by the absence of USD recovery. USD weakness is especially damaging for European equity at this point because Euro-USD has reached a critical frontier zone. The area of $1.16-1.18 represents the upper limit of the range within which this parity has traded since early 2015 (see figure 2). A move above this zone would make a difference to relative trans-Atlantic pricing and profitability.

Figure 2: EURUSD FX

The critical nature of the battle here was emphasised by the unsubtle attempt by Mario Draghi to talk down the Euro on the 20th July. The evident failure of his attempt triggered a mini-panic in the more excitable part of the investment community. Evidently, USD weakness has extended the phase of consolidation-correction in European and Japanese equity. As a consequence, many investors in these markets are becoming frustrated and anxious. It is not a consolation to them that their markets are not under-performing when measured in a common currency because the currency form of prosperity is not going into their pocket.

In particular, Euro-USD has risen by 10% since the end of Q1 as the investment consensus bought into the argument of an economic “take-off” in the euro zone. Through this period EURJPY and EURCHF have risen by 10% and 3.4% respectively.

Investors who want performance in local currency terms should consider the large cap indices of UK equity. It was predictable that the EU would inflict economic damage upon the entire region by pursuing an unnecessarily adversarial and antagonistic approach to the Brexit negotiation. The consequence is that the GBP has been sliding towards the Euro1.10 threshold.
Commodity stabilisation plus currency depreciation means that the FTSE100 is out-performing in local currency terms within Europe even as it continues to under-perform from a common currency perspective.

The financial world recognises that the predominant influence upon the USD this summer may be the politics of Congressional deadlock and White House confusion. The “Impeach Trump” campaign in certain sections of the US media is relentless. This political influence appears to be unpredictable. There is speculation that the culture wars in America will degenerate into a debt ceiling crisis and Presidential impeachment this summer.

The banks observe that the trade-weighted value of the USD has fallen back almost to its lowest level of the last two years (figure 3). The trans-Atlantic yield differentials do not signal further Euro appreciation at this time. We consider that the investment consensus is already bullish and long the Euro.

Figure 3: EUR & USD effective exhchange rates

We suspect that the Euro will not weaken until the low conviction money capitulates, which probably implies a move to about the USD 1.17 threshold. Most of all, we consider that the environment this summer is not consistent with lower yields in USD debt markets.

Accordingly, our interpretation is that we are witnessing the controversy and tension that characterises the end of a currency movement, not its beginning.
Indeed, we suspect that we shall have a conclusion soon. We doubt that forex will travel through August without a significant profit-taking in EURUSD.

The latest, most emblematic indicators of the business climate for June in the major developed economies would seem to confirm the diagnosis that there is no weakening of the global cycle of output and trade as we enter the year’s second half.
In particular, the investment industry is reassessing China. It has begun to adopt more a positive attitude to China for two reasons. On the one hand, China is the epicentre of the revival of global trade flows that began with the resurgence of producer values early last year. The scale of this revival has been systematically under-estimated. On the other hand, it has begun to be noticed that the decline of inflation and the stabilisation of the external exchange rate should allow an improvement of monetary-financial conditions in China and despite the official insistence that policy will continue to discourage excess financial leveraging in its multiple Chinese forms.

2. DATA TO WATCH

US

• 04th August: Change in Non-Farm Payrolls & Unemployment Change
• 08th August: NFIB small business Optimism
• 09th August: MBA Mortgage Applications
• 10th August: Initial & Continuing Jobless Claims
• 10th August: PPI Final Demand MoM & YoY
• 10th August: Bloomberg Consumer Comfort
• 11th August: CPI MoM & YoY
• 15th August: Import Price Index
• 15th August: Empire Manufacturing
• 15th August: Retail Sales Advance MoM
• 15th August: NAHB Housing Market Index
• 17th August: Industrial Production
• 17th August: University of Michigan Sentiment

EU

• 04th August: Factory Orders MoM & YoY [GER]
• 04th August: Retail Sales MoM & YoY [ITA]
• 04th August: Markit Retail PMI [EZ, GER, FRA & ITA]
• 07th August: Industrial Production SA MoM & WDA YoY [GER]
• 07th August: Manufacturing Production MoM & YoY [UK]
• 09th August: Industrial Production SA MoM & WDA YoY [ITA]
• 10th August: Industrial Production SA MoM & WDA YoY [FRA & UK]
• 10th August: Manufacturing Production SA MoM & WDA YoY [UK]
• 11th August: CPI MoM & YoY [GER & FRA]
• 15th August: CPI MoM & YoY & PPI MoM & YoY [UK]
• 16th August: GDP WDA QoQ & WDA YoY [EZ & ITA]
• 17th August: CPI MoM & YoY [EZ]
• 18th August: PPI MoM & YoY [GER]

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