Why absolute euro-dollar parity is ‘bad news’ for stocks

By Eleftherias Kourtalis

And where investors in Europe thought the outlook for stocks couldn’t get gloomier given the ongoing energy and inflation shocks and recession fears, the euro has hit absolute parity with the dollar for the first time in two decades, creating new challenges for stock markets and further clouding the investment outlook.

Since the beginning of the year it has fallen by 12% due to fears surrounding the energy crisis as well as disagreements within the ECB Governing Council regarding the amount of interest rate increases and the form of the new anti-fragmentation tool, while the release of new US inflation data (at 9.1% in June) that boosted expectations for a more hawkish Fed added to the headwinds swirling around the common currency.

While a weaker euro is a positive development for export-oriented companies – domestic products are offered more cheaply in foreign markets, thus boosting the turnover of companies that produce them – the single currency’s plunge adds headwinds for European investors stocks already facing slowing economic growth, soaring inflation and an energy crisis that threatens to deepen if Russian gas flows are not restored after Nord Stream 1 maintenance works are completed in a few days. And at the moment when the pan-European Stoxx Europe 600 index completed, at the end of June, its worst decline in the first half of the year since 2008, and analysts have already warned of further declines to come. Underscoring the gloomy investment climate, ZEW’s monthly index of investor expectations for the German economy fell in June to the lowest level since the start of the eurozone’s sovereign debt crisis in 2011.

Banking stocks are likely to take a major hit, a Bloomberg report says, as the single currency is a barometer for the state of the Eurozone economy, while a weaker euro amid recession fears could reduce the chances of much-needed higher interest rates. banks to boost their profit margins. The euro’s continued decline has already hit shares of companies with exposure to the Eurozone more than those with higher dollar exposure. A Goldman Sachs basket of European stocks with heavy dollar exposure has fallen about 9% this year, significantly outperforming its basket of euro-exposed stocks, which is down nearly 17%.

Against this backdrop, Goldman Sachs maintains its defensive stance on equities over a three-month horizon, with overweight positions in cash and commodities, neutral positions in equities and government bonds and underweight positions in corporate bonds. Until the growth/inflation mix improves, markets are likely to remain volatile as investors turn from inflation concerns to recession fears, he says. Geographically, it favors Asian stocks and remains underweight for US and European stocks, while continuing to have a general preference for sectors and commodity/infrastructure stocks with high dividend yields and stable profitability, as well as those with high and stable profit margins.

The “headache”, however, from the exchange rate plunge is not only for European stocks but also for US stocks. A key reason for the devaluation of the euro/dollar exchange rate is – in addition to the fears surrounding the Eurozone economy and the evolution of the energy crisis – and the strength of the American currency. While this is a good development for Americans traveling abroad, Morgan Stanley warned that many US companies will suffer as their international operations become less profitable, forcing many of them to revise down their earnings forecasts and they see their stocks go down.

Such rallies, he says, usually coincide with heavy market pressure or a recession – or both, underscoring that a stronger dollar can limit demand internationally for US companies – 30% of whose sales are overseas – , while trying to cope with high inflation and reduced consumer spending. Estimates for corporate results have not yet been downgraded despite growing concerns about an impending recession, but are now subdued. Morgan Stanley expects companies to start cutting expectations in the coming quarters. And regardless of whether the economy goes into recession or not, the US bank predicts that such revisions to the results could push the S&P to 3,400 points – about 14% below current levels.

For its part, Credit Suisse notes that the outlook for corporate earnings growth in the US has worsened with a strong dollar, high geopolitical uncertainty, weakening global growth and a sharp slowdown in US money supply growth. It now expects revenue growth to slow from +15% on average in 2021 to around +7% this year and -2% in 2023 even if no major recession follows. Coupled with deteriorating margins, this also suggests shrinking profitability in the future.

Where will the euro go?

As analysts comment, the euro is trading as if a crisis in Europe is just around the corner. Currency markets are “discounting a serious European recession,” in the euro-dollar trade, notes BMO Capital Markets. “This scenario is closely linked to energy supply constraints as well as the possibility of winter (or even summer) energy rationing.”

Deutsche Bank estimates that an eventual fall in the EUR/USD rate to 0.95-0.97 would match the all-time extremes seen in exchange rates since the end of Bretton Woods in 1971.

UBS, Nomura and JP Morgan estimate that it is very likely that we will soon see the euro trading at 0.90 against the dollar if the recession scenario materializes in the Eurozone due to the interruption of natural gas flows. “If Russia cuts gas supplies to Europe, the fall in GDP levels will reach 4% and the euro will fall sharply to 0.90 against the dollar,” UBS points out. “If Nord Stream 1 is not restored, 0.90 EUR/USD is a significant possibility during the winter,” Nomura notes. “We cut our estimate for the euro to 0.95 against the dollar this year from 1,000 previously, a level that equates to a 2% additional drop in eurozone growth against the US. However, if the gas cut materializes, the rate will test this year 0.90,” points out JP Morgan.

What does a weaker euro mean for the ECB?

A weak euro and the added inflation this development brings adds to the challenges of the ECB, which is already being tested by markets ahead of its first rate hike in 11 years as well as the announcement of its new anti-fragmentation tool. As the German magazine Der Spiegel characteristically notes, the European Central Bank is at a critical crossroads: If it takes decisive measures against inflation and the weak euro and raises the key interest rate significantly, it could plunge the Eurozone into a deeper recession. If he focuses on economic growth again, he will permanently lose price control.

Making matters worse for the central bank, which is mandated to tame inflation, is that the euro has not only weakened against the dollar but also against other currencies such as the Swiss franc and the Japanese yen.

“A weaker euro supports the view of a more aggressive rate hike,” notes ING. “The argument behind that would be that if we go for a 50 basis point hike next week instead of 25, that could immediately stop the fall in the euro because it would surprise the financial markets.”

However, some analysts argue that an economic downturn will bind the ECB, preventing it from any aggressive tightening of monetary policy. This in turn would ensure that interest rates in the Eurozone remain much lower than in the US. This expectation is already playing a role in the fall of the euro. “Interest rate differentials between Europe and the US continue to widen as the prospects for economic growth, and hence for tighter monetary policy, in the US and Europe diverge. In short, the Eurozone appears headed for recession, while the economy of the US continues to hold up better,” notes Capital Economics.

At the same time, the euro must also address lingering concerns about the ECB’s ability and willingness to contain the periphery’s spreads. “While concerns have eased somewhat since last month’s emergency Governing Council meeting, we are concerned that policymakers will fail to deliver a credible tool at the meeting later this month. This would put further pressure on the euro,” Capital said. Economics.

For its part, Goldman Sachs notes that the sharp weakening of the euro since the June session, by 6.5% against the dollar and around 3% on a trade-weighted basis, is an argument in favor of a more aggressive increase in ECB interest rates. If this recent devaluation is sustained it could boost inflation by an additional 0.1-0.2% in each of the next two years. Goldman therefore expects the ECB to say it is “closely watching” the exchange rate and will take into account euro weakness to the extent it affects the outlook for inflation.

“One possibility would be to intervene in the markets only verbally, at a first stage,” argues DZ Bank. However, experience shows that in such a case speculators are active, whose bets can drop the euro’s exchange rate within a few days.

As ECB Governing Council member Francois Villeroy de Gallo noted, the ECB is monitoring the euro-dollar exchange rate as recent lows could further push up inflation already at record levels. “It’s good news for activity, as it supports exporters, but unfortunately it increases inflation a bit,” he said, while adding that “the exchange rate is not something we set, but we monitor it because it matters for inflation.” However, the French central banker said recent moves in currency markets do not necessarily mean the euro is weak. “Looking at what has happened since the beginning of the year, we notice that it is not so much that the euro is weak, but the dollar is strong, mainly because it is traditionally a safe haven,” he stressed.