Timely commentary from Wells Fargo Investment Institute on international topics in the news.
What to Expect from the Euro in 2018
- The euro strengthened notably versus the U.S. dollar in 2017 as global economic growth, particularly in Europe, gained pace.
- Our outlook for the euro versus the dollar is broadly neutral in 2018, reflecting offsetting positive and negative factors.
What it may mean for investors
- Overall, we expect the euro to trade in a broad range versus the U.S. dollar throughout 2018, but we believe that U.S. investors should be mindful of investment implications related to currency volatility.
When considering the potential currency contribution to foreign investment returns, a weaker dollar tends to improve returns for U.S.-based investors, while a stronger greenback is a headwind to returns. To this point, in broad terms, an important exchange rate for many U.S.-based investors is that of the euro to the U.S. dollar, given its outsized contribution to the U.S. Dollar Index (DXY), and this index’s utilization as a currency benchmark for various international investments.
Our current year-end 2018 forecast of $1.16-$1.24 suggests little change in the euro-dollar exchange rate, with the potential for wide swings around this range due to several fundamental crosscurrents. In today’s report, we briefly highlight those factors that might influence market participants to push the U.S. dollar (from the euro perspective) higher or lower during the course of this year, and we summarize our neutral conviction on the currency pair.
Factors that could lead to a weaker dollar (stronger euro)
- Trade-related demand—Business and consumer confidence in the U.S. and around the world gained pace last year, leading to reaccelerating international trade. This trend was most notable in euro-area export volumes, prompting higher cross-border utilization of the currency to settle trades in goods and services. We expect this trend to persist in the coming year as the eurozone economy continues to strengthen.
- Investment-related demand—Tangible signs of improving eurozone economic conditions and rising corporate earnings last year arguably spurred higher foreign investment flows into the currency bloc’s risk assets, most notably equities. While foreign appetite for European (ex-U.K.) risk assets ebbed at the end of 2017, we believe that further economic or earnings surprises in the eurozone could renew investor interest in this region of the world (Chart 1).
Factors that could lead to a stronger dollar (weaker euro)
- Widening rate differentials—In mid-2017, the euro strengthened as market participants priced in the potential for a more hawkish rate policy from the European Central Bank (ECB), following evidence of stronger economic growth in the eurozone. Nevertheless, inflationary pressures remain subdued in the currency bloc. We believe that market participants solely positioned for a tighter rate differential between the Federal Reserve (Fed) and the ECB could become disillusioned with the euro in 2018—as the Fed raises rates, while ECB Governing Council meetings come and go without indication of tighter policies as meaningful inflation in the eurozone fails to materialize.
- Geopolitical risks—Upcoming Italian general elections also could pose a downside risk to the euro should populist sentiment gain momentum in March. While we believe that the risk of financial-market impact from a renewed Euroskeptic political movement in Italy is limited, a win for the once anti-euro Five Star Movement nevertheless could introduce heightened levels of political uncertainty (and volatility) in European markets. Such a development could drive foreign investors out of eurozone risk assets, selling euro and buying into perceived safe-haven investments such as U.S. Treasury securities (in U.S. dollars) or Japanese government bonds (in yen).
Where we stand
Overall, we expect the euro to trade in a broad range versus the U.S. dollar throughout 2018, yet we believe that U.S. investors should be mindful of investment implications related to currency volatility. While dollar weakness generally has been viewed as a negative development by some observers, U.S. investors positioned internationally are likely to benefit as foreign currencies (such as the euro) strengthen. As a foreign currency appreciates, investors are able to buy more U.S. dollars when they bring gains (or losses) home. For example, the MSCI European Monetary Union (EMU) Index rallied in 2017 by approximately 7% when measured in euro terms (Chart 2). When converted into U.S. dollars, however, the gain was nearly 21%, given the positive currency effects. In our view, U.S.-based investors planning to buy or sell euro-denominated assets should do so while considering both current market volatility and expected currency targets.
In general, we expect that a broadly neutral euro-dollar outlook (with the potential for a more positive fundamentals-related euro bias as the year progresses) is a favorable backdrop for foreign investments in developed markets. This is another reason why we believe that U.S. investors should maintain broad exposure to international investments. However, the many crosscurrents for the euro suggest that large swings are possible again in 2018—as in 2017. Since the euro is, by far, the largest constituent of the U.S. Dollar Index—at 58%— any move toward a more positive balance of drivers for the euro likely would be reflected in weaker levels in the industry-benchmark U.S. Dollar Index.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets.
MSCI EMU (European Monetary Union) Index captures large and mid-cap representation across the 10 Developed Markets countries in the EMU.
U.S. Dollar Index (USDX) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies.
An index is unmanaged and not available for direct investment.
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