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Markets may be too optimistic about eurozone QE tapering
Yet again, last week, the macro-economy and international financial flows were in the limelight, rather than businesses, which are the midst of earnings reporting.
 
In terms of the macro-economy, the €uro/USD parity flirted with an exchange rate of USD1.25/€1. This came as a surprise as it was not generally believed by strategists that it would be reached until the end of the year after the ECB had stated its plans for gradually “tapering” the QE programme. As so often, the market clearly interpreted Mario Draghi’s words very optimistically. In fact, they are so optimistic that they consider that the eurozone has virtually sorted out its problems.
 
We recall that markets are good at preparing for crises, so much so that they may see one when it does not exist.
 
So, whether they are in a state of euphoria, or because they are tired of seeing the zone bogged down in the last 10 years, they may believe that we are leaving the QE programme earlier than in fact is the case.
 
Although markets are supposed to reflect their national economy, they also act as economic agents in the ST. If the markets believe that the eurozone will return to solid growth owing to the QE and that the ECB will easily be able to adopt a more restrictive policy, they can curtail the process via the exchange rate. This makes the ECB head’s task more difficult. He can easily extend the bond purchases. But France has a serious trade deficit and the eurozone accounts for 60% of exports, so it is not so easy here. But maybe they will act on current drivers in the eurozone, such as Germany: it is clearly  not in Germany’s interests to have a strong euro because it could lose orders in emerging countries or the USA.
 
We summarise our update on the €uro/USD parity in four points:
 
  1. Whatever the ECB chief says, the ECB should pay attention to the euro/dollar parity and adjust its policy on the basis of the exchange rate.  Although the central bankers and heads of governments meeting at Davos usually talk about free exchange and advocate “currency peace”, they are really playing poker.  Short of ammunition, they try to ensure that their respective nations remain competitive so value their currency at the lowest level acceptable. At least Donald Trump is frank and goes to the point: America comes first, so last week, he stated that he wanted to impose a few additional customs barriers.
 
  1. Consensus opinion at the beginning of the year was that the euro would continue to appreciate (it has been rising since first half 2017). This is only logical. Consensus opinion merely stems from forwards prices, which are based on current prices and trends. That is how, in 2015, players forecast that oil would fall to $20/barrel or interest rates down to -0.30%. And today they forecast peaks of volatility of 11-12 in 2018. So, in herd mentality, trading flows automatically follow this direction (even if it leads to excess).  Although markets are “rational”, they do not often think through their reasoning.
 
  1. Players and observers have theorised about interest rate stagnation and deflation for decades but after only a few months of recovery and deflation, they now go for growth and inflation. This is enough to warrant Draghi’s stepping up QE tapering to avoid market overheating! Firstly, economic recovery and inflation have only just begun so could move forwards fast, particularly if the euro appreciates too much. Secondly, the US began to taper the QE after 5 years, in 2013. Given the length of time taken to taper, this gives us some idea of the time it will take for the ECB to do so. Tapering entails raising interest rates and reducing assets. The markets appear to have made a start, forecasting the situation in 6-10 years’ time. But there is still room for error and there are numerous sources of disappointments.
 
  1. Since the spread is slightly higher in the US, the interest rate differential between the two currencies is about 2.5% for sovereigns and nearly 3% for corporates. This gap has created a carry cushion which is considerable in relative terms. In the medium term, it could absorb a significant decline in the USD. So, for a 5-year investment, if the USD depreciated by more than 15% an unhedged bond would provide the same yield as a euro bond, that is, USD at 1.47.
 
In conclusion, we consider that it could be the moment to invest in an unhedged block of USD floating rate bonds maturing after 2023. Some months back, LT interest rates moved upwards and the Fed’s ST interest rate hikes (3-4) are expected to continue the trend towards curve flattening (ST rates up, LT rates stagnating). If there are fears of a recession, its actions could even trigger an inversion. An FRN indexed to the Libor will follow the increases, whereas long-dated bonds are not expected to suffer too much from interest rate hikes. But beware of sectors such as retail or technology, and of certain issuers (higher leverage, M&A risk).
 
In relation to corporates, we note that last week Carrefour rolled out its strategic plan which aims at managing the emergence of giants in on-line retail. But minor French giants will not be able to cope with the likes of Amazon and other such GAFA by acquiring small online groups at lowish prices (cf Showroomprivé), patching up their fortunes or drafting pages on hypermarket designs imagined in the 1960s.
 
In conclusion, France’s “major” retailers have two options:
 
1/ They can link up with a web giant, making sure that they do not lose out in so doing and that the “target” performs efficiently. US group Walmart, which is much larger and more flexible than Carrefour, announced this week a link-up with Rakuten, a retail pioneer in on-line retail in Japan. We wonder how the duo will fare against Amazon. We wonder too whether Carrefour will make much headway with Showroomprivé and patching up a few holes in its defences. Auchan will probably do better with Alibaba (partnership agreement in November 2017), so the tandem will work if one does not munch up the other.
 
2/ They can change their business-models totally which would mean making massive investments and taking risks: (i) transform hypermarkets into robotised warehouses, (ii)
maintain a few hi-tech shopping malls based on the Amazon concept (24/24, sensors, no pay-out desks, automatic payments), (iii) recruit thousands of IT engineers, (iv) make joint-investments in delivery drones or other such modern systems, (v) establish withdrawal and deposit points and all this in city centres. Such actions, or total absorption, might ensure their survival for the next decade, or might not … if not, long, slow death.


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