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#Investments — 14.09.2017

The Strong Euro Is Causing A Dilemma For European Companies

Guillaume Duchesne

The ECB and European companies face a strong euro which has appreciated by nearly 7% against the dollar in three months.

The euro is trading today at almost 1.20 dollars, up nearly 7% in the space of three months! This is bad news for the European Central Bank which fears the risk of lower inflation, but it is equally bad news for European companies. The eurozone has a very open economy, accounting for a 25% slice of global exports (vs. 13% for China). Consequently, a large number of companies are heavily dependent on exports outside the eurozone. A rapid appreciation of the euro usually makes products less competitive abroad. 

Sharp currency movements on the euro have triggered a debate about the likely effects on business activity in the euro area. Most statistical tests show a large elasticity of European growth to the euro’s movements, but this can vary from one country (and one sector) to the next. These differences are mainly linked to the variable currency effects on import prices (and logically consumer prices) and on export volumes.

The immediate impact of the exchange rate

A stronger euro makes foreign products less expensive for economic players in the eurozone. This has the effect of pushing up company profits and consumer purchasing power, and is usually (statistically) immediate. So the current appreciation of the euro may be driving the momentum of domestic demand, which has been solid in Europe thus far.

The effects on exports in the longer term

It takes longer to see the effects feed through to exports. Although the euro is strengthening, it may still be deemed undervalued. This is the case today. Based on the unit wage cost, economists estimate that if the euro’s trade-weighted rate (*) were to appreciate by a further 5%, the European currency would enter into territory in which European products would lose their competitiveness relative to their main trading partners.

That said, an important variable must be analysed to measure currency effects accurately: the capacity of companies to offer differentiated products. Even if a stronger euro makes exports of European businesses dearer, their clients are still prepared to pay a higher price for very specific goods. Elasticity of demand to the exchange rate is indeed low for high value-added products, particularly in the manufacturing sector where they are difficult to substitute.

How vulnerable eurozone countries are to currency movements depends on the sectorial structure of their exports. As such, Germany, Belgium and the Netherlands appear less sensitive to currency movements. 

Another factor that must be taken into account is the degree of integration in the global value chain. With an increasing need to source from suppliers based outside the euro area, companies have fragmented their production, thereby reducing their exposure to currency movements. Indeed, a stronger euro implies a reduction in prices for intermediary products. Germany’s economy is often said to be well integrated into global value chains. However, despite its large openness to international trade, currency movements weigh less on Germany than on eurozone countries which are less open.

In conclusion, understanding the correlation between the euro’s movements and economic growth/company profits is not an easy task. In today’s context of volatile exchange rates, we recommend avoiding investments in a particular eurozone market, and capturing the sector trends that we have already identified:

  • Solid domestic demand in the euro area: we favour financials, telecoms and smaller activities like commercial services & supplies, and infrastructure;
  • Rebound in commodities: we focus on the energy sector which is cheap and which will benefit from a stabilisation in oil prices;
  • Selectivity within global stocks. At present, we like the pharmaceutical industry but will wait before returning to global cyclicals.

At this stage, a sector strategy seems more relevant than intra-European regional choices, in our view.

 

(Read our previous publication: Bad Geopolitical Context And A Good Economy... What Is The Impact For The Stock Markets?).

 

 (*) The trade-weighted exchange rate measures the purchasing power of a currency against a basket of currencies of the eurozone’s main partners.