We present ten reasons that will sustain a further euro appreciation (FXE) to 1.50 in the upcoming two to four years. The main one is that Germans are net global creditors and Americans net debtors. This is reflected in fiscal and monetary policy and in investors' behaviour.
The financial establishment still bets on a strong dollar
The opinions of the financial establishment are usually very volatile: in Summer 2011, they were very bullish on emerging markets and gold, since the beginning of 2013, they have become dollar bulls.
(click to enlarge)
In June, when EUR/USD was trading under 1.30, Pictet was saying "The dollar is ready for a steady rise"; we replied "Pictet Become Secular Dollar Bulls and Gold Bashers: Our Response". Our reasoning against the dollar bulls was that the slowing in China was only temporary and caused by European austerity.
Some months later, growth in China rebounded. According to the OECD it will grow by 8.2% in 2014.
In July we published a history comparison piece and maintained "Why There Won't Be A Strong Dollar, Even If the Financial Establishment Thinks So". Our main point was that the Fed will not hike rates any time soon. Therefore Americans will not repatriate their investments in foreign securities and many will remain short the US dollar.
We are not continuous euro bulls, in January even German growth prospects seemed affected. We were asking whether peripheral trade surpluses were sustainable given that they were achieved with just spending cuts. At the time we were betting against the euro, at levels of 1.34. Some time later it fell to 1.27.
But what are the reasons for our current and continuing euro bullishness?
Reason 1: Americans are net debtors, Germans net creditors
The German net international investment position has improved from zero in the year 2000 to 43% of GDP recently, while the American position continues to weaken.
Americans have become net global debtors. Europeans, in particular Germans, are net global creditors.
(click to enlarge)
Graph: U.S. household debt and net international investment position show that Americans are rather global debtors, European household debt is lower see IMF
Therefore, Americans and their Keynesian economists would like inflation to wipe out the (housing) debt, but Germans want to maintain their purchasing power. Germans hate inflation, and with the euro crisis and ECB money printing this fear has intensified. With the U.S. and Southern European housing crisis, Americans have become debtors and Germany the clear leader for European fiscal policy and the implicit European financier.
European and German leaders have successfully smashed the rational expectation in the European periphery that salaries must always rise - and gave a halt signal to inflation (see also labor costs graph below). This has reduced the excessively high peripheral government bond yields and should limit over the longer term the rapid rise of public debt.
When Germans want deflation or low inflation, and Americans want inflation, they shall obtain their wishes via their currencies. A strong euro will help to remove German inflation fears, a weak dollar and high inflation shall wipe out American debt.
Reason 2: Trade flows are paramount
Until 2007/2008, we lived in a period when capital flows were far more important than trade flows, the carry trade was in vogue. After the crisis there was a period of risk aversion and high volatility until 2012; and in the end currencies with trade surpluses, like the European CHF, SEK and NOK but also the Korean Wong and the Chinese Renmimbi, greatly appreciated. The JPY initially inched up thanks to trade surpluses, but the end of nuclear energy and the reliance on imported oil created a trade deficit. Risk appetite and Abenomics did the rest and destroyed Japanese purchasing power.
Since the end of the euro crisis that brought global austerity and low inflation, trade flows continue to be paramount. The next victims were emerging markets with trade deficits like the Indian Rupee, the Indonesian IDR and the Brazilian BRL. Brazil has a trade surplus, but has high financing costs in US$.
Some pundits suggested investing like before 2008, shorting the Swiss franc - the currency with the highest surplus - and investing the proceeds in US Dollars and in currencies with high carry (e.g. AUD), which was a fatal strategy. The hedge fund FX Concepts was one of the victims.
The euro zone has achieved a huge trade surplus but not yet appreciated a lot. The goods are produced in Europe and foreigners need to pay in euros, increasing the demand for the single currency. As the euro collapse fears have receded and no higher US interest rates are in sight, European companies often do not hedge their dollar exposure.
At 1.32 the German "unit-labour cost-based euro" was still 10% undervalued against the year 2000. Moreover, German high-quality exports are relatively FX rate insensitive. If the euro costs 1.30 or 1.50, there is no big difference for them, also because supply chains and production have partially been globalized.
Global growth has been and will be driven by China once again. Germany is China's strongest ally, they provide the capital goods and technology to counter Chinese wage increases and to remain competitive.
The European periphery sells, in particular, into the euro zone without currency risk, a recovering German demand is currently helping them. German exports to the U.S. are ten times higher than exports from Spain to the U.S., but German population less than two times higher than Spain's.
According to new research, the periphery has started to turn from local customers to exports. But structural reforms take time: We will need to wait another two to four years until both export surplus and consumption could rise together.
How to observe trade flows: During hours without fundamental news, especially during European or Asian trading, the euro very often appreciates; no matter if stocks go up or down. Good U.S. or bad European fundamental data is able to stop this tendency; but only for a limited time.
Reason 3: Equity valuations drive capital flows
In the absence of interest rate differentials, for capital flows the asset market model is paramount: American stocks seem to be overvalued against P/E ratios, while European ones might still be undervalued, given that the European business cycle follows the American one with a lag of two or three quarters.
American investors buy a lot more European securities than the opposite. This is visible in the net positive portfolio investment inflows below. Even during the euro crisis the value barely fell into negative territory, but seems to stabilize now at 1.5% of EU GDP. European direct investments are a net outflow, but they are directed more to Emerging Markets rather than to the U.S.
Balance of Payments September 2013 Eurozone (source ECB)
European investors have burned their fingers twice already with U.S. investments:
- The first time during the dot com bubble and the following dollar collapse from EUR/USD 0.80 in 2000 to 1.60 in 2007.
- The second time: the Fed's QE1 and QE2 drove foreigners out of U.S. investments.
In particular Germans, the owners of the biggest trade surplus, prefer to invest in local stocks (often with global exposure!) and do not trust the love for debt in America; this preference is reflected in the recent huge run-up of the DAX.
In times of zero interest rates, risk-averse funds prefer the currency with the highest real interest rates; and thanks to low inflation figures, this is the euro. Recently the Norwegian Krone has strongly depreciated: the reasons were the higher Norwegian inflation, a diminishing trade surplus and a dovish Norges Bank.
Reason 4: The Fed is a dovish, while the ECB is a hawkish central bank
The ECB has a pure inflation mandate, with the inflation rate "below but close to 2%", hence it is by definition a hawkish central bank. The Fed has a double mandate: high employment and an inflation target of 2 or even better 2.5%, hence it is by definition a dovish central bank. American economists are mostly Keynesians, Germans are ordoliberals and supply-siders.
The discussion about negative ECB deposit rates created an outcry at German banks. For the ECB there are no unconventional methods, like QE, available to create inflation. Still in 2012 Draghi said negative rates would destroy the credibility of the central bank, and it would be against European contracts. Thanks to dis- and deflation, peripheral yields have stabilized so that even a long term refinancing operation (LTRO) would not be feasible now.
Hence the ECB's race to the bottom is finished, while the Fed is still doing its massive QE3 programme, which are implicit negative rates.
Reason 5: The euro is the new Deutschmark, just as European leaders wanted
Former ECB chairman Jean-Claude Trichet calmed Germans on several occasions that the euro is as stable as the Deutschmark when they were concerned about inflation.
By 2013 austerity and conditionality has clearly triumphed over "whatever it takes". Since they cannot devalue the currency, the European periphery is forced to devalue internally: lower labor costs are required. Many of them have already started in wage deflation, Italy and France might follow. European leaders explicitly wanted a reduction of peripheral labor costs to increase competitiveness and become more productive. They are on a "good" way and they are increasing price stability and the euro's value.
Price stability, as if the euro were the Deutschmark.
Reason 6: Basel III will depress European credit growth for years
The Basel III rules require from banks a higher capital to (risk weighted) assets ratio. For years Germans deposited their increasing wealth and company profits at banks and blew up their liabilities. Rising home prices did the rest, both banks' liabilities and assets have strongly increased.
With the post-financial crisis anti-debt sentiment, European hawks are suggesting that most European banks do not have sufficient capital.
As usual, European investors are fearful, hence raising new capital has become difficult. Therefore assets must shrink; this implies lower credit growth. Lower European money supply, the equivalent of credit on the other side of the balance, implies that a higher supply of dollars needs to be converted into euros: the currency with lower supply appreciates.
Sure, without credit growth, new business is difficult, but have you ever tried to start a new business in socialist Europe, while the US is slowly copying the European model?
Reason 7: Tapering does not imply a stronger dollar against euro
Yes, there will be some good U.S. data, U.S. GDP growth will be somewhat higher than that of the euro zone. The Fed will reduce its asset purchases.
Yes, the Fed will taper, then the dollar will rise for a couple of hours or days, but that's it. A taper or a taper rumour is always a good moment to buy: buy stocks, gold or the euro but not the dollar.
Reason 8: The Fed's double mandate is a mission impossible
In the current "race to the bottom" for interest rates, the Fed's double mandate is a mission impossible. They are able to:
- EITHER achieve full employment - thanks to rising competitiveness of U.S. firms via low or no wage increases and consequently lower inflation than targeted,
- OR achieve the inflation target of 2.5% - but this implies higher American wages as opposed to falling European labour costs. Higher wages will destroy American jobs in the global competition for higher company profits without physical and virtual boundaries. Boundaries that still existed in times of the strong dollar (early 80s or late 90s)
Achieving both low unemployment and 2.5% inflation is hence a mission impossible.
Even Bernanke affirmed that "the target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end".
Recently, American companies have been creating (part-time) jobs, yes, but GDP growth is far behind.
More people in work, a slight recovery in manufacturing and the weaker oil price have helped to reduce the U.S. trade deficit, but more people in work are now destroying company margins, if Americans do not spend....
The 1.4% rise in personal expenditures (PCE) for Q3 is insufficient. The consequence is that European company margins will be rising more than American ones, which lifts again the euro, due to reason 2 above.
This time the Fed has created just a mini bubble
In line with Larry Summers "secular stagnation", we believe that the U.S. is currently in a bubble based on rising house prices and initially higher spending. As opposed to 2002-2007, this time the bubble will be far smaller: the majority of Americans still sits on debt, while a minority profited on higher stocks or price increase of rather expensive houses, often in metropolitan areas. With global competition and so many Americans out of the labor force or working part-time, wage increases are still far off.
Reason 9: Fed's mini bubble has reduced the need for European credit growth
Small or negative credit growth does not imply that GDP growth is negative. The European trade surplus is in the end the equivalent of company profits in global trade, in the trade with the U.S.
European companies are able to finance themselves with higher profits rather than with new loans. And the profits are deposited in European banks, strengthening the banks' balance sheets.
Reason 10: Oil prices should rebound again in two to four years
Global growth between 2008 and 2012 was largely created by Emerging Markets. China's economy is very much oriented to investment, while the Chinese regime and hard competition reduces wage hikes and consumer spending.
China delivers 40% of global growth (source Soberlook)
Brazil, Russia, India, Indonesia and South Africa (call them "BRIIS" excluding China) were some of the countries that have experienced high salary increases for years. Their rising purchasing power created the necessary demand that avoided a bigger "global Great Recession" despite the American Great Recession. On the other side, higher wages and a rising trade deficit have reduced the current accounts and the competitiveness of the BRIIS. Lower European and own demand lowered commodity prices which again depressed the commodity currencies among them - RUB, ZAR, BRL and partially IDR.
Global disinflation currently help them to fight excessive wage increases. Lower spending - et al. lower Indian gold imports - currently improves their current accounts. Workers must learn that the period of high salary increases is finished. With disinflation, their central banks will be able to cut rates so that companies will get more competitive again.
Admittedly, fighting inflation will take another two to four years, but with slowly rising global demand, oil and commodity prices should inch up again. Therefore, a taper will not put the BRIIS into constant danger. They have accumulated many currency reserves so that they depend far less on U.S. capital than they did before the year 2000. Thanks to their trade surpluses, China and Russia are nearly independent of U.S. investments.
Oil demand: This implies that growth of emerging markets and consequently demand for oil should continue to rise. Between 1996 and 2012, both India and China have doubled their oil consumption per person, a tendency that stopped in 2012 with less European demand for Chinese production. A global recovery should move oil consumption on trend again.
Oil supply: Despite the "shale revolution", there will be no oil glut like in the early 1980s or a technology bubble that could direct investment out of emerging markets, reduce oil prices and help the U.S.
Shale oil has very high production and transport costs between 55 and 75$. Its daily capacity of 2 mbd is just the equivalent of 22% of U.S. or 2% of global oil production. With shale oil production costs nearly equal market prices and depletion increasing future costs, we think that the U.S. has and will continue to import big parts of its oil. Hence. the American economy will continue a competitive disadvantage against Europe and other countries with shorter distances and/or better infrastructure.
Still, shale oil is for the U.S. an insurance that future oil and gasoline price increases will be limited. Europeans go the other way, they develop alternative energies and reduce their dependency on oil.
The counter argument
There is just one important counter argument. Will Americans really continue spending?
The tea party, churches, conservative and libertarian politicians have managed to gain more and more influence. A big part of the population might listen to their arguments and discontinue their over-spending habits. If the U.S. PCE remains clearly below the latest 1.4% increase per year, then oil prices will be hit and Americans could finally improve their trade deficit. In this case the dollar should appreciate.
To give a rule of thumb:
We think that the U.S. PCE will rise between 1% and a maximum of 2.5% for many years and this is definitely euro-bullish. A PCE value that persists over 2.5% could trigger Fed rate hikes, one under 1% would play for the greenback via lower oil prices.
P.S.: Remember that FX rates never appreciate in straight lines. Some parts of this essay might be satirical but the essence remains the same: we think that the euro will get stronger over time.