The recent inversion of the traditional 2Y10Y yield curve in the US has raised investors’ attention on the global economic outlook within the next 12 months to come. Unlike 6 months ago, the probability of a recession is not negligible anymore and many participants are questioning which asset will perform well in the current environment.
Even though the 2Y10Y yield curve is not inverted in all the developed economies, our GDP-weighed G7 yield curve is now standing a few basis points away from zero (figure 1, left frame). With the elevated political and economic uncertainty pricing in higher price volatility (figure 1, right frame), it is clear that investors should not run aggressive risky strategy for the moment, and should preserve their capital by holding traditional safe havens such as gold, bonds and some major currencies such as the US dollar, the Swiss franc and Japanese yen.
Weakening fundamentals and falling inflation expectations
We saw recently that the economic outlook in the UK was very gloomy amid elevated uncertainty weighing on business investment and consumer spending. Another area which struggles to find its bottom is Europe, where business sentiment and consumer confidence have collapsed in the past 12 months, with all leading indicators pricing in weaker economic activity in most of the countries. For instance, figure 2 (left frame) shows that the IFO survey is currently at its lowest level since November 2009 and pricing further deterioration in the industrial activity.
The ZEW index, which covers a number of areas, sectors and regions and aggregate sentiments of roughly 350 economists on the futures outlook of Germany and the Euro area, has also been trending lower in the past few months and tend to lead industrial production as well (figure 2, right frame). It is interesting to see that some of the sentiment indicators are trading at lower levels than in the middle of the sovereign debt crisis in 2012.
In addition to the slowdown in the economic activity, inflation expectations have also been trending lower in the Euro area. Figure 3 shows that the 5Y5Y inflation swap, a market measure of LT inflation projections that became popular after Draghi’s speech at Jackson Hole in August 2014, is currently trading at 1.2%, which is far below the 2-percent ECB target. Considering that Euro policymakers need also to deal with the uncertainty associated with the Brexit outcome, we may see more weakness in the 5Y5Y in the coming months.
Source: Eikon Reuters
Europe cannot deal with a stronger currency
It is clear that with deteriorating fundamentals and falling inflation expectations, the last thing Euro policymakers want is a stronger euro. We mentioned in several occasions that the single current is significantly undervalued according to a variety of FX fair value metrics. For instance, Eurostat-OECD PPP prices is at a fair value of 1.37, implying that the current exchange rate is almost 20% undervalued (figure 4, left frame). We can also notice that the real effective exchange rate (OTC:REER) has started to diverge from its long-term average once again, implying that the single currency is 6 percent undervalued relative to a broader range of currencies (figure 4, right frame).
We know that the euro has been vulnerable lately as it has not reacted to any macro news, ranging from the Fed’s pivot earlier this year to the improvement of the situation in Italy. The drop in Italian yields has not generated any momentum on EURUSD (we saw that the rise in the 10Y yield was one of the major drivers of the EURUSD in the first half of 2018).
As a consequence, market participants have been pricing also a rate cut in the Euro area; figure 5 (left frame) shows that the Dec20-Dec19 implied yield curve dropped from 30bps in October 2018 to -15bps in August. In addition, economists have also speculated in the past few months that the ECB was going to embark on a fresh round of bond purchases this autumn, estimating that there was at least EUR 400bn that the ECB can buy without breaking the CSPP eligibility rules (source: Goldman Sachs, figure 5, right frame).
Lower rates, weaker banks...
Even though the ECB is already running a ZIRP policy and has expanded its balance to over 40% of the Eurozone GDP (EUR 4.7 trillion), policymakers do not have other options than just follow the Fed’s path in the coming months in order to stimulate the economy and protect the currency from appreciating. However, lower rates will continue to weigh on the banking sector, which has been suffering significantly in the past cycle.
We can notice that the Eurostoxx Banks index (SX7E) is trading close to a 30-year critical support (figure 6, left frame). The little pickup we saw in excess liquidity, which tends to lead financial stocks by 9 months (figure 6, right frame), is mainly coming from a collapse in industrial production rather than a sudden rise in real money growth and therefore will limit the performance of financial stocks in the medium term. Can the ECB come up with some extraordinary measures for banks?
With the Eurostoxx index oscillating around 3,200 in the past 5 years, the equities have been a dead market in Europe and it does not seem that the situation is about to change in the coming months…
Disclosure: I am/we are long GBP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.