24 Feb Inflating European Expectations
The Wall Street Journal reported yesterday that for the first time in almost 4 years none of the Eurozone’s 19 member countries was in deflation during January. Aggregate Inflation across the region is now 1.8%, approaching the ECB’s target of 2.0%. The data is a notable marker that may be the signal for the ultra-accommodative ECB to reign in its QE program a little over two years since the Fed ended QE3 in the fall of 2015. Such a move would have a profound effect on European currency rates with the U.S. Fund flows follow real interest rates over the long-term. With real interest rates higher in the U.S. than almost any Developed economy it is a no brainer that money should flow into the dollar. As the fed began raising rates at the end of 2015 it is no surprise that European currencies correspondingly declined substantially over the course of last year. The Fed’s most recent hike has put further pressure on the value of GBP, EURO, CHF and Kroners.
Enter the natural beauty of self-correcting global economics. Between 2011 and 2015 global fx markets were mind numbingly boring. During, what on the surface, appeared as a turbulent period in global economic history Sterling and the Euro traded within a very narrow range with the USD. With virtually all central banks aligned behind hugely stimulate actions, transatlantic currencies traded largely in unison. In such circumstances with the US ahead of the curve in terms of post crisis economic recovery the competitive advantage lay in North America. The turn in Fed policy at the end of 2015 broke that trend and 2016 served as a corrective year in terms of currency equalization.
The downdraft in European currency valuations has had the twin effect of boosting Europe’s competitive position and pushing up inflation as import prices increased. European markets have quietly taken note. Despite European equity performance in dollar terms once again falling behind U.S. in 2016, in local terms European equities had a strong year with aggregate performance reaching high single digits. For U.S. based investors the benefits of increasing exposure to Europe are sweetened by the weak currencies and the opportunity to shop around for stock at attractive discounts. Wow, even a Big Mac in London is now 6% cheaper than the U.S., in London!
In the post crisis-era international markets have morphed into risk-on trades. Despite positive U.S. based market returns, investors have remained jittery in recent years preferring assurance over risk. As global economic growth increases and a reflation trade gets underway the irony of a successful Trump economy could very likely be that international markets begin to outperform as risk appetite re-emerges and investors seek higher returns at reasonable valuations–sounds like Europe to me.