The recent strengthening of the euro against the US dollar raises the question of whether this is a temporary or permanent movement. KBC’s economists and investment strategists take the view that a number of fundamental factors will support further euro appreciation in the longer term. All the same, the recent exchange-rate movement seems like an overreaction, and so we expect the euro to ease in the short term.

Dollar seems largely to have peaked...

Several fundamentals will provide the euro with longer-term support against the US dollar. The most important of these is the anticipated shift in European monetary policy. The radual tapering of quantitative easing in 2018 by the ECB will herald in future interest-rate hikes. The ECB expects inflation to rise very gradually, making possible the normalisation of interest-rate policy. Inflation will not only lead to higher short-term rates, but also to an increase in long rates. The rate spread with the United States will narrow as a consequence. Rising European interest rates will support the EUR-USD exchange rate, since euro investment s will become relatively more attractive. A second supportive factor is the strong performance of the European economy. European growth figures are systematically improving. European exports are also doing exceptionally well, giving rise to a larger European trade surplus, in contrast with America’s trade deficit. Export growth will increase international demand for euros. The European cycle is still improving, whereas the US economy is gradually showing signs of overheating. The latter is apparent in increasing labour costs, for instance, a sharp downturn in the savings ratio, and a decline in producer confidence.
 
The difference in inflation will also play a major long-term role. Higher inflation leads to a weaker domestic currency. The easing of the US dollar is due in part to the fact that inflation is higher in America than in the euro area. We expect inflation to remain structurally lower in Europe than in the United States in the longer term too, which will further boost the euro over that period.
 

... but the market has gone a little too far in recent months

The recovery of the European economy, as well as the anticipated shift in ECB monetary policy, have already boosted the euro substantially in the past few months. This means that the appreciation of the euro has substantially priced in a favourable economic and monetary development in the future. In the short term, this response is probably exaggerated. Further recovery in Europe will require far-reaching economic reforms, especially in terms of European labour markets and public finances. Time will tell to what extent the high expectations will be met. There is a great deal of optimism right now regarding President Macron’s planned reforms in France. Italy’s problems also appear less acute at the moment. The fundamental problems could, however, still throw a spanner in the works.
 
The signals for the future are positive at present, but doubts could flare up again in the short term regarding the stability of Europe’s recovery. Meanwhile, the uncertain outcome of the Brexit negotiations continues to hang over the European economy like a sword of Damocles.  We therefore expect a temporary retreat in the euro’s advance.
 
In addition to economic factors, political uncertainty is playing a major role in exchange-rate volatility. The current hapless approach of the Trump administration is doing little to inspire confidence in efficient US government policy. This is adversely impacting the dollar. At the same time, the euro area is benefiting from renewed political stability after several turbulent months. Both situations could shift rapidly, however. The international environment also has a part to play. Major international conflicts typically result in a flight to the US dollar, leading the euro to weaken once more. The fact that we currently face
several escalating international conflict situations (relating to North Korea, in particular) could therefore cause the US dollar to firm again in the short term.
 
 

Investment strategy* backs dollar recovery

Profitable investment opportunities in the fixed-income component of our investment strategy are extremely scarce. Those wishing to avoid too much exposure to the consequences of possible interest-rate hikes will have to make do in euros with returns close to, or even below, zero. Higher US rates present a return opportunity – which we will take advantage of in the bond portfolio – especially if it is linked with something of a recovery in the dollar exchange rate. Relative to the euro, we consider a return to 1.10 in the months ahead as the most likely scenario. We will, of course, keep a close eye on the movement of the dollar and will make the necessary adjustments when this price target is reached. The ‘away from the low-interest euro’ theme is, incidentally, pursued more broadly than simply via the US dollar. We are also including other higher-yielding currencies via a diversified portfolio.
 
Otherwise, we are avoiding bond exposure as much as possible by investing substantially below the standard level and above all by opting for equities. In the latter category, we are investing sharply above the benchmark level with clear choices for themes like high dividend stocks and family businesses and emphases in German and Asian equities and in the pharmaceutical sector.
 
(*) The investment strategy described in this document relates to all investment funds (undertakings for collective investment) managed by KBC Asset Management NV, which make explicit reference in their investment policy, as laid out in the prospectus, to KBC Asset Management’s investment strategy. The stated strategy is not, therefore, altered in the case of other investment funds, the investment policy of which does not refer directly to KBC Asset Management’s investment strategy. It is possible that these investment funds are managed in a way that differs from the investment strategy. You should always read the prospectus and the Key Investor Information Document for the relevant investment fund.
 


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