Eurozone Economic Recovery Can Ease Pressure On Fed

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Includes: SPY, USDU
by: Disruptive Investor

Summary

There are some early signs of recovery in the eurozone, but investors still need to wait for sustained economic recovery.

Recovery in the eurozone is likely to strengthen the euro to some extent and relative weakening of the dollar is positive for the US economy and desirable for policymakers.

Even if Greece defaults, it is unlikely to impact asset markets meaningfully. I am still bullish on US equities as compared to European equities.

As the Greek drama continues, there are early signs of recovery in the eurozone. This article discusses some key economic recovery indicators in the eurozone. This is a critical point to discuss not just from a eurozone investment perspective, but also from a policy decision perspective for US policymakers.

Before discussing the early indicators of economic recovery in the eurozone, I would first like to explain why US policymakers would watch eurozone economic developments closely. In the recent past, I have discussed the point that a strong dollar is one of the key concerns for the fed as a strong dollar impacts the Fed's outlook on growth as well as inflation expectation. Ideally, the fed would like to have a relatively weaker dollar before policymakers initiate the first rate cut.

However, if the eurozone economy remains weak and the US economy remains resilient, the impact would be a strong dollar (NYSEARCA:USDU). Further, the eurozone has expanded its QE while the US QE is limited in the form of artificially low interest rates. Therefore, the QE impact would also translate into a strong dollar.

The point I want to make is that US policymakers might not be able to raise interest rates even when economic activity suggests an increase in fed fund rates. The risk is that near-zero interest rates even when economic activity is robust can translate into risks for the financial system. As this article from the Federal Reserve Bank of St. Louis suggests, there are both benefits and risks associated with low interest rates.

On the other hand, if eurozone economy recovery gradually, the euro is likely to gain is strength and a relatively weak dollar would be positive for corporate growth as well as inflation expectations. I can say with some conviction that the eurozone QE will be prolonged, but as recovery gathers pace, the QE can potentially be narrowed, resulting in a stronger euro.

Coming to some of the early indicators of economic recovery in the eurozone, the first chart below gives the eurozone retail PMI along with q-o-q change in consumer spending.

It is clear from the chart that the retail PMI has expanded significantly in the recent past and was at 51.4 for May 2015. This is the strongest reading in 49-months and is indicative of the point that the QE is having some positive impact on economic growth. While it is important to wait for more sustainable growth, the eurozone economy is unlikely to enter into recession.

Another indicator of recovery in eurozone economic activity is the sharp pick-up in retail inflation in the recent past even as producer price inflation for consumer good remains muted.

One of the key worries for policymakers is deflation and the stimulus seems to be working on the retail inflation front. While I am talking about retail inflation, eurozone annual inflation increased by 0.3% in May 2015, the first positive reading after five months of decline or stagnation. Therefore, there are clear signs that the economy is recovering.

I would also like to mention that Germany is the key growth driver in the eurozone and a lot depends on the country's economic healthy. It is encouraging to see strong job creation in Germany in the recent past even as job creation remains sluggish in France and Italy.

The impact of these data is already evident on the euro-dollar exchange rates. The euro bottomed out at 1.088 against the dollar on May 28, 2015. As of June 17, 2015, the exchange rate was at 1.125. I would again like to mention that investors need to watch for more sustainable growth than few strong months. However, the QE seems to be working and I believe that this is good news for US policymakers.

I can say with some conviction that US policymakers would wait for the dollar to weaken significantly before any decision on rate hike. In line with this view, I am positive on US equities (NYSEARCA:SPY). While the eurozone seems to be on a recovery path, I would avoid exposure to equities in the region because of the Greek crisis. In an earlier article, I had explained that any potential Greek default is likely to have a minimal impact on financial markets. However, markets are driven by sentiments and there can be short-term jitters if there is a Greek exit from the eurozone.

In conclusion, eurozone economic data remains critical for US policymakers and there are some positives related to economic data. However it is still too early to talk about a sustained economic recovery and how the eurozone acts politically might decide the future more than further stimulus or sustained stimulus.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.