Will the euro shine again in 2018?

Market comment 10.01.2018 by Christophe Bernard
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To paraphrase an expression (wrongly) attributed to Mark Twain: reports of the euro’s death have been greatly exaggerated. Not too long ago, pundits have doubted the currency’s long-term survival. Moreover, Europe’s legal tender had become a favorite scapegoat of economically challenged European nations. However, five years after the culmination of the European debt crisis, the euro has regained its poise and credibility. Yet after a surprising winning streak last year, its near-term potential seems limited. Among our favorites for 2018 are emerging-market currencies.

Reviewing foreign-exchange developments in 2017, the most striking outcome has been the strength of the European currency. It gained ground versus all major peers, particularly the U.S. dollar (+14 percent). Performance was driven by the following three factors:

1. At the start of 2017, the euro was significantly undervalued compared with the U.S. dollar in terms of purchasing power parity. If nothing else, this pointed at upside potential (see chart 1).

Chart 1: Euro’s prospects versus U.S. dollar looked dim at the end of 2016
Exchange rate

Euro’s prospects versus U.S. dollar looked dim at the end of 2016

Source: Thomson Reuters Datastream, Vontobel


2. The European Monetary Union’s economic performance clearly exceeded consensus expectations given a real GDP growth rate of (most likely) 2.4 percent versus 1.6 percent forecast at the end of 2016. This compares well with the U.S. economy, which has (most likely) grown by 2.3 percent in 2017.

3. The election of the pro-European centrist politician Emmanuel Macron as French president proved to be a key catalyst for euro strength by reducing perceived political risk. At the same time, the Trump administration failed to deliver growth-enhancing reforms in a timely fashion, disappointing expectations that had run high after the November 2016 election.

We expect the euro to continue its upward path in the medium term towards levels of 1.25-1.30 versus the U.S. dollar thanks to the euro zone’s current-account surplus. However, the near-term prospects are less buoyant. Sticking to a neutral stance, we do not advise clients to chase the euro at present. This view is based on the following:

1. Our proprietary short-term models point to overvaluation versus the U.S. dollar. We currently see fair value in the 1.10-to-1.15 range.

2. The Greenback is oversold and expectations concerning U.S. economic growth are subdued, leaving potential for positive surprises. Moreover, market participants have yet to price in the three rate hikes that the U.S. Federal Reserve predicts for this year.

3. Political risks ahead of the forthcoming parliamentary elections in Italy are likely to resurface. Additional headwinds could arise from the still inconclusive German coalition talks and the political impasse in Catalonia.
 

For a euro alternative, look north and south

An alternative may be close at hand. The Swedish krona is “cheap” versus the euro. In addition, it should benefit from strong economic momentum and inflation readings near the Swedish central bank’s target level of 2 percent. Moreover, we believe that the Riksbank will start tightening monetary policy before the European Central Bank does. The krona is our favored currency for 2018.

The overvaluation of the Swiss franc versus the euro is slowly but surely diminishing with our price target of 1.20 now firmly in sight (see Investors’ Outlook from September 2017) and we intend to hedge euro exposure in Swiss franc portfolios at such levels. Even though the weakness of the Swiss currency could take the EUR/CHF exchange rate beyond 1.20, we shall not underestimate the fundamental attractiveness of the franc: The currency’s long-term strength stems from a large structural current-account surplus alongside the country’s enviable balanced budget. In addition, the Swiss franc would provide useful diversification should global growth disappoint.
 

Yen may sag, pound sterling is a dark horse

Although the Japanese yen exhibits an attractive valuation, the Bank of Japan’s commitment to flood markets with liquidity should fuel weakness in the period ahead. Meanwhile, pound sterling remains a dark horse. It is the cheapest currency among the majors, but the uncertainty related to Brexit negotiations is likely to persist, capping its potential.

Within our central scenario (“Goldilocks again”, see Investors’ Outlook from December 2017), emerging-market currencies should perform well in 2018, supported by real yield levels vastly above those of their developed-market peers (see chart 2). At the same time, valuations are not excessive and vulnerability has decreased, especially compared to the period of the so-called taper tantrum in May and June 2013. At that time, emerging-market currencies slumped on investors’ fears that the Fed would tighten monetary policy abruptly.

To conclude, the euro is unlikely to be the winner again in 2018 as it needs to digest recent gains. However, its medium-term prospects remain intact. We expect the Swedish krona to gain against the euro in 2018 but overall, we prefer emerging-market currencies. These should benefit from a supportive global environment, reasonable valuations and superior yields, both in nominal and real terms.

Chart 2: Emerging-market currencies clearly beat developed-market peers in terms of real yield
In percent, deflated by consumer-price inflation

Emerging-market currencies clearly beat developed-market peers in terms of real yield

Red bar: real policy rate emerging markets
Blue line: average real policy rate emerging markets
Black bar: real policy rate developed markets
Yellow line: average real policy rate developed markets

Source: Thomson Reuters Datastream, Vontobel

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About the author Chief Strategist Vontobel

Christophe Bernard

Christophe Bernard joined Vontobel 2012 as Chief Strategist. He is also Chairman of the company’s investment committee.

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