The euro is no longer a sure bet if investors connect the dots in Europe
Nicholas Spiro says weaker growth, the lack of integration and the end of quantitative easing spell a less secure future for the euro zone and its currency
For currency traders, the euro is the closest thing there is to a one-way bet.
According to the latest data from the Commodities Futures Trading Commission, hedge funds and other speculative investors have built up the heaviest “long” positions – the purchase of a security in the expectation that its value will rise – on the euro on record, convinced that the euro zone economy will continue to perform well and, crucially, that the European Central Bank (ECB) will soon begin to tighten monetary policy, buoying the euro, which has already risen 16 per cent against the dollar over the past year.
Yet over the past few months, the cracks in Europe’s growth story have become more apparent.
The latest sign that Europe’s single currency area is more vulnerable than assumed was the publication on Tuesday of the results of a closely watched survey of economic sentiment in Germany produced by the country’s ZEW think tank. The indicator dipped into negative territory, having plummeted since February mainly due to concerns about the escalation in trade tensions between China and the US.
Germany’s export-driven economy is acutely sensitive to an increase in trade protectionism. The automotive sector, which dominates the country’s outbound foreign direct investment, stands to lose heavily from the imposition of punitive tariffs, with BMW and Mercedes’ parent firm Daimler exporting the largest number of cars to China from the US each year, according to the Financial Times.
The slowdown in Europe’s economic powerhouse is part of a broader softening of growth across the euro zone. The recent batch of Purchasing Managers’ Index surveys produced by IHS Markit, a data provider, show that output in the bloc’s manufacturing and services sectors has slowed to its weakest level since early 2017.
Make no mistake, the region that as recently as the end of last year was leading the global economic expansion has lost significant momentum.
This would not be so worrying – growth in the euro zone is still relatively robust but is no longer beating expectations – if it were not for the second, more important, vulnerability that has come into focus over the past few weeks: the inability of Germany and France, Europe’s two leading economies, to agree on vital economic and financial reforms to deepen the integration of the euro zone in order to avert another major crisis akin to the one that nearly tore the bloc apart in 2012.
A fragile monetary union that still lacks the political and fiscal integration needed to put Europe’s single currency on a secure footing, the euro zone is divided between a German-led group of member states wary of being on the hook for the profligacy of other countries and a French-led one reluctant to implement the tough fiscal and banking reforms demanded by Berlin in exchange for financial aid.
On Tuesday, German Chancellor Angela Merkel, who is under intense pressure from her own conservative party to reject anything which could saddle taxpayers with more liabilities, rejected proposals by French President Emmanuel Macron, who favours bold reforms to bolster the euro zone, to speed up the creation of a European Monetary Fund.
Germany is suffering from “bailout fatigue” and is in no mood to bear more of the financial burden for shoring up the bloc. The message to Macron when he visits Berlin will be a polite but firm nein.
The tensions between France and Germany come just when the ECB is preparing to unwind its ultra-loose monetary policies which have played an instrumental role in averting a break-up of the euro zone and have driven the fierce rally in the bloc’s government and corporate bond markets over the past several years.
It is this third vulnerability – the significant risks posed by the termination of quantitative easing (QE) – which not only threatens the stability of the euro zone but is one of the most important, if not the most important, sources of uncertainty in markets right now.
The ECB has been acting as the backstop for riskier countries and banks – mainly in southern Europe – in the absence of fiscal integration. The end of QE will expose the flaws in the governance of the bloc, adding to the pressure on debt markets as the monetary punchbowl is drained. Italy, the weakest link in the euro zone due to the country’s dangerously high level of public debt and large stock of bad loans, is particularly at risk, especially following the victory of populist parties in last month’s parliamentary election.
If investors start to connect these dots – weaker growth, the lack of integration and the end of QE – the investment case for Europe will become a lot weaker.
The euro is by no means a one-way bet.
Nicholas Spiro is a partner at Lauressa Advisory