The picture continues to improve

The picture continues to improve

Even the most Eurosceptics are coming to realize that a turning point is approaching. After several years of extraordinarily easy money, the European Central Bank (ECB) should announce a gradual tapering of its asset purchases at its October meeting. Strong 2.3% 2nd quarter GDP (Gross Domestic Product) growth, broadly positive leading indicators and abating political risk indeed make this an opportune moment for the ECB to shift away from crisis management. In turn, financial markets are adjusting their expectations: futures now suggest that interest rate normalisation may start around the end of 2018.

Currency markets have been the most reactive, with the euro up 12.5% year-to-date against the US dollar. Contrary to some to concerns, we do not consider euro strength as a threat for the region’s economic expansion.

For a start, although net exports were an important driver in the early stages of the recovery, domestic demand has accounted for almost all of Eurozone growth over the past couple of years. This does not mean that a sharp euro upmove cannot hamper growth via a drag on exports, but it does suggest that the slowdown should be modest and certainly not of the recession-generating variety.

We also expect the ECB to react differently to currency appreciation resulting from economic outperformance than during prior episodes of euro strength – President Draghi has himself stated that demand-driven currency appreciation is qualitatively different to exogenous shocks and expected to have less of an impact on inflation.

Finally, focusing solely on the eurodollar is misleading. Its large rise this year results from both euro strength and dollar weakness (with the latter down against most major currencies). Measured against 19 major trade partners, the euro is up only 5.5% year-to-date. This is the more important figure from an economic perspective.

More concerning for growth would be a broad-based tightening of financial conditions. For now, while the euro has appreciated, interest rates remain low and strong appetite for risk is keeping credit spreads tight and equity valuations robust. An abrupt change in ECB stance could of course threaten this equilibrium but, given the current inflation outlook, a gradual policy shift still seems most likely. As such, our constructive outlook on the Eurozone remains squarely in place.

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