The euro has reached parity with the US dollar.
The war in Ukraine, the ensuing surge in energy prices, and the accumulated delay by the European Central Bank (ECB) in confronting the Federal Reserve (Fed) in raising interest rates to contain inflation caused a sharp decline in the value of the euro against the US dollar in months The first eight of 2022. A rapid recovery of the European currency may be elusive, but its depreciation could create short-term opportunities for investors in value stocks.
Energy price hike
At the beginning of the year, the euro recorded a gradual decline in its value against the US dollar, but the Russian invasion of Ukraine caused a more pronounced weakness. The reason is mainly due to the sharp increase in inflationary pressures and the lack of energy and military security in the region. In the wake of the invasion, energy prices soared across Europe due to fears of disruption to natural gas exports from Russia, fears that subsequently materialized. In fact, the Russians recently closed the important Nord Stream 1 gas pipeline, first for maintenance and then even the lifting of sanctions. The move comes at a time when countries like Germany are stockpiling natural gas to make sure they have enough to make it through the winter. Over time, Germany and other European countries that depend on Russian gas are expected to move to other energy sources, such as renewables and liquefied natural gas (LNG). However, in the short term, we may see a persistent supply shortage and a steady rise in prices.
The disruptions to energy supplies also come at a time when the continent has already been affected by other inflationary pressures due to disruptions in supply chains.
In addition, lower river levels in Europe over the course of the summer made river transportation more difficult and expensive. Like the United States, Europe is experiencing unprecedented levels of inflation. According to data from Eurostat, the region’s consumer price index registered an 8.9% year-on-year increase in July, compared to 8.6% in June and 2.2% over the previous year. On both sides of the Atlantic, higher costs affect the purchasing power of consumers, negatively impacting the domestic oriented consumer goods business. Our research revealed that inflation significantly affects the relative levels of currencies. If higher energy prices and other inflationary pressures in Europe prove to be more stable than in the US, we could see further erosion in the value of the Euro in the coming months.
Increasing the interest rate differential
In the wake of these inflationary pressures, the European Central Bank and the Federal Reserve raised interest rates at different rates. This difference is exacerbating the weakness of the Euro. In general, the higher the interest rates, the more valuable the country’s currency, as higher rates tend to attract more foreign investment.
By contrast, the European Central Bank will raise key interest rates by 125 basis points in 2022, with further increases expected in the remainder of this year. As in the United States, the central bank is committed to containing inflation by balancing the pursuit of price stability with slowing economic growth. The war and its aftermath have put the European economy under unprecedented pressure, which we believe will not abate anytime soon and could plunge the region into recession.
Stagnation in stock growth
The depreciation of the euro had mixed effects on European economic activity. American travelers flocked to Europe, which has had positive repercussions on the growth of the Old Continent’s nations, especially those in southern Europe, which have been hit hard by the COVID-19 pandemic.
The purchasing power of American tourists has increased significantly since last year, boosting local economic activity. However, a lower euro is causing imports, especially dollar-denominated ones, such as goods, to rise for European consumers. In addition, due to the weak European economy, companies will find it more difficult to pass on cost increases to consumers and end users. The depreciation of the euro, inflationary pressures, fears of a recession in Europe and pressures on consumers have a different effect on each company. Therefore, we believe that the selection of active stocks will be vital.
Investors will need to understand to what extent a particular company benefits from natural hedging and whether there is a cost-revenue mismatch that can lead to an increase or decrease in profits. In recent years, European stock markets in general have shown a significant valuation discount compared to their US counterparts, due to their greater exposure to value-oriented sectors such as finance, energy and materials. This year, some market areas made a strong comeback with the revival of the value style. A weak euro creates challenges and opportunities for European companies. In the coming months, it will be essential to know where to look and what to look for.
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