Summer lull - delayed

21 July 2017

As the summer holiday season is getting into full swing, one would expect capital markets to be calm. The opposite was the case, as particularly European stock markets continued to grapple with the perspective of their central bank threatening to take away the (easy money) punch bowl, just when their regional economy is shyly starting to '˜party' a little.

We wrote about the dynamics of market tantrums last week and it appears we are not far off with our expectation that the prospect of monetary policy change will keep markets in motion for a while. This week, the late stock market sell off on Friday came as a bit of a surprise, because European Central Bank's (ECB) president Mario Draghi had sought to reassure markets that the Eurozone's central bank would not tolerate significantly tighter financial conditions as could result from market (over-) reactions to the prospect of future monetary tightening.

Instead, markets took it as confirmation that the ECB's direction of travel had changed. This, together with increasingly disappointing political prospects in the US for any Trump driven fiscal stimulus or deregulation relief, led to a rally in the €-Euro while the US$ sold off. Such €-Euro strength in itself should lower the need for the ECB to reduce monetary liquidity in a hurry, because it lowers prices for imported goods and undermines export competitiveness, which combined reduce any feeble inflationary pressures further and prevent overheating of economic activity. This is precisely what we observed when the US$ rallied 3 years ago, on the back of the US Fed's own QE taper program.

An overly strong €-Euro would also reduce the value of European companies' overseas revenue streams, which would explain the sudden fall in share prices, when actually normalisation in central bank policy should be seen as a positive sign of a strengthening economic outlook.

Just as was the case with the US$ strength, we do not foresee the €-Euro strength to become a significant headwind for Europe's recent economic revival. Instead we observe earnings announcements which show continued faster growth of corporate earnings than in the US, where earnings are still expected to be running at a very respectable growth rate of 10% year on year.

So, in summary, we have found our expectations of vulnerable equity markets confirmed, even if we continue to see this more of an issue for the much higher trading US equity market than Europe's far lower valued stocks.

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