US supplants Europe as main source of political risk – a remarkable shift in perception from six months ago
Euro surges nearly 5.5 per cent since April 13 to its highest level against the greenback since early October
At the beginning of this year, few investors would have placed bets on the euro being the best-performing currency in advanced economies in the first five months of 2017.
Yet this is what has happened, with the fortunes of Europe’s single currency improving dramatically since mid-April. In one of the most stunning developments in global markets this year, the euro has surged nearly 5.5 per cent since April 13 to its highest level against the US dollar since early October.
Several factors account for the euro’s newfound vim.
Firstly, the euro zone has been enjoying brisk economic recovery. On Tuesday, the publication of the latest purchasing managers’ index survey showed the bloc’s manufacturing and services sectors continued to expand at their fastest rates in six years this month.
IHS Markit, the producer of the euro-zone PMIs, notes that growth is “impressively strong” and is “consistent with the [European Central Bank] taking a hawkish stance”.
Indeed, it is the prospect of a withdrawal of monetary stimulus in Europe, as growth and inflation rebound, which has led to a surge in inflows into European equity funds.
A monthly survey of global fund managers by Bank of America Merrill Lynch revealed the third-highest allocation to euro-zone stocks on record. These inflows of capital are helping drive the euro higher.
Yet it is the third reason for the euro’s ascent which, for the time being, is the most important: diminishing political risk following the election of the centrist and pro-European Emmanuel Macron as France’s president earlier this month.
This is happening just when the US is in the grip of a major political – and potentially constitutional – crisis as allegations against Donald Trump over his presidential campaign’s links to Russia threaten to severely undermine his presidency.
All of a sudden, Europe is perceived by international investors to pose less of a threat than the US, at least from the standpoint of political risk.
This is a remarkable shift in market perceptions from six months ago when Trump’s election as president, coupled with Republican control of the legislative branch of the US government, breathed new life into global equity markets and pushed the dollar to its highest level since 2003.
The contrast between, on the one hand, the prospect of a hefty fiscal stimulus programme and a burst of financial deregulation in the US and, on the other, an escalation in political risk and subdued growth and inflation in the euro zone fuelled a sharp divergence in the performance of US and European assets.
In the three months or so following Trump’s victory, investors poured money into US equity funds and remained cautious towards Europe mainly because of perceived political risks.
European stock funds suffered a torrid 2016, with a massive US$100 billion pulled from the asset class, and only started enjoying net inflows again in early February, according to EPFR Global, a data provider.
Now the tables are turning.
The dollar index, a gauge of the greenback’s performance against a basket of other currencies, has fallen 3.7 per cent since early April, with the bulk of the decline occurring since the Russia scandal – which is being compared to Watergate and has already led some politicians and academics to call for Trump’s impeachment – escalated earlier this month.
For markets, the issue is not so much the scandal itself but rather the impact it will have on the ability of the Trump administration to win congressional approval for its pro-business policies, in particular comprehensive tax reform.
In the euro zone, on the other hand, the politics of economic reform seems to be improving. The defeat of far-right candidate Marine Le Pen in France’s presidential election has averted the threat of an imminent break-up of the bloc and, crucially, increased the scope for a much-needed overhaul of the economic and political governance of the euro zone.
Still, market perceptions of Europe and the US are heavily influenced by initial expectations.
Just as investors were too optimistic about Trump’s policy agenda, they were overly concerned about the possibility of Le Pen becoming France’s president.
An important, if not the most important, factor behind the performance of US and European assets over the past few months is the readjustment in market expectations.
These assumptions, however, can always change again, particularly if political risks in the euro zone, notably in Italy, resurface and Trump makes headway in passing a tax reform plan.
Yet for the time being, Europe is clearly benefiting from the political woes of the US.
Nicholas Spiro is a partner at Lauressa Advisory