Pessimism toward the euro has increased as survey data have worsened significantly over the past several weeks. It may be a bit counterintuitive, but the weakness in U.S. data has a negative effect on the euro as well. Europe needs growth to heal, and a more pessimistic outlook for European growth and a slower U.S. economy, combined with modest growth in Asia, do not provide enough demand to offset austerity measures Europe has already implemented, not to mention new measures being proposed.
The outcome from the Greek elections is also troublesome for the eurozone debt crisis as the first review of the second bailout package is set to take place in June. A dragged-out process to establish a credible Greek government will likely keep risks involving Greece in the foreground during the coming months. Fears of a Greek renegotiation of its EU/IMF financing program or even talk of a euro area exit may weigh on sentiment toward the wider euro area. The explicit cost of letting Greece leave the eurozone would be much higher than keeping it in the zone; however, without a government, there is no authority with whom the troika of Greece’s creditors can engage, increasing the likelihood of an accidental, uncontrolled exit.
A point of stability for the euro has been the European Central Bank’s (ECB) two Long Term Refinancing Operations (LTRO), which have ensured that banks are able to achieve financing. The risk premium for the currency had been reduced as financial disaster was averted; however, the unintended consequence of the LTROs has been increased interdependence of domestic banks to purchase sovereign debt as foreigners disinvest holdings. This is leading to lower ability for credit extension to the domestic (and foreign) markets, causing weaker economic data, continued pressure on sovereign bond markets, and falling prices of bank stocks, many of which have returned to fresh lows. This will put interest-rate cuts on the table eventually, and push the size of the ECB balance sheet beyond that of the Fed. These factors should also keep pressure on the single currency.
The concerns weighing on the euro have similarly affected the European equity markets, sparking a sell-off that has lasted since the end of March when the Spanish government started to backslide on its fiscal reform commitments. Since then, the French elections, a Greek political debacle, and the inability of European policymakers to establish a coherent and credible plan for addressing the region’s economic woes have put further downward pressure on equities. Additional headwinds for market performance have come from recent lackluster U.S. economic data combined with several worrisome factors in China. Significant uncertainty surrounds China’s growth trajectory as it struggles to cope with an export slowdown. China also faces a deflating housing price bubble, potential bad debts, and a transition in political leadership. That said, in our opinion European equity valuations are now looking significantly more attractive. We believe there are opportunities to buy into globally leading franchises at prices offering material upside to fair value on a medium-term view, assuming the euro survives as the currency for most of the region.