Our analysts Paul Walsh, James Lord and Marina Zavolock discuss
the dollar’s decline, the strength of the euro, and the mixed
impact on European equities.
Read more insights from Morgan Stanley.
----- Transcript -----
Paul Walsh: Welcome to Thoughts on the
Markets. I'm Paul Walsh, Morgan Stanley's Head of European
Product. And today we're discussing the weakness we've seen
year-to-date in the U.S. dollar and what this means for the
European stock market.
It's Tuesday, July the 15th at 3:00 PM in London.
I'm delighted to be joined by my colleagues, Marina Zavolock,
Morgan Stanley's Chief European Equity Strategist, and James
Lord, Morgan Stanley's Chief Global FX Strategist.
James, I'm going to start with you because I think we've got a
really differentiated view here on the U.S. dollar. And I think
when we started the year, the bearish view that we had as a house
on the U.S. dollar, I don't think many would've agreed with,
frankly. And yet here we are today, and we've seen the U.S.
dollar weakness proliferating so far this year – but
actually it's more than that.
When I listen to your view and the team's view, it sounds like
we've got a much more structurally bearish outlook on the U.S.
dollar from here, which has got some tenure. So, I don't want to
steal your thunder, but why don't you tell us, kind of frame the
debate, for us around the U.S. dollar and what you're thinking.
James Lord: So, at the beginning of the
year, you're right. The consensus was that, you know, the
election of Donald Trump was going to deliver another period of
what people have called U.S. exceptionalism.
Paul Walsh: Yeah.
James Lord: And with that it would've been
outperformance of U.S. equities, outperformance of U.S. growth,
continued capital inflows into the United States and
outperformance of the U.S. dollar.
At the time we had a slightly different view. I mean, with
the help of the economics team, we took the other side of that
debate largely on the assumption that actually U.S. growth was
quite likely to slow through 2025, and probably into 2026 as well
– on the back of restrictions on immigration, lack of fiscal
stimulus. And, increasingly as trade tariffs were going to be
implemented…
Paul Walsh: Yeah. Tariffs, of course…
James Lord: That was going to be something
that weighed on growth.
So that was how we set out the beginning of the year. And as the
year has progressed, the story has evolved. Like some of the
other things that have happened, around just the extent to which
tariff uncertainty has escalated. The section 899 debate.
Paul Walsh: Yeah.
James Lord: Some of the softness in the
data and just the huge amounts of uncertainty that surrounds U.S.
policymaking in general has accelerated the decline in the U.S.
dollar. So, we do think that this has got further to go. I mean,
the targets that we set at the beginning of the year, we kind of
already met them. But when we published our midyear outlook, we
extended the target.
So, we may even have to go towards the bull case target of
euro-dollar of 130.
Paul Walsh: Mm-hmm.
James Lord: But as the U.S. data slows and
the Fed debate really kicks off where at Morgan Stanley U.S.
Economics research is expecting the Fed to ultimately cut to 2.5
percent...
Paul Walsh: Yeah.
Lord: That’s really going to really weigh
on the dollar as well. And this comes on the back of a 15-year
bull market for the dollar.
Paul Walsh: That's right.
James Lord: From
2010 all the way through to the end of last year, the dollar has
been on a tear.
Paul Walsh: On a structural bull run.
James Lord: Absolutely. And was at the
upper end of that long-term historical range. And the U.S. has
got 4 percent GDP current account deficit in a slowing growth
environment. It's going to be tough for the dollar to keep going
up. And so, we think we're sort of not in the early stages, maybe
sort of halfway through this dollar decline. But it's a huge
change compared to what we've been used to. So, it's going to
have big implications for macro, for companies, for all sorts of
people.
Paul Walsh: Yeah. And I think that last
point you make is absolutely critical in terms of the
implications for corporates in particular, Marina, because that's
what we spend every hour of every working day thinking about. And
yes, currency's been on the radar, I get that. But I think this
structural dynamic that James alludes to perhaps is not really
conventional wisdom still, when I think about the sector analysts
and how clients are thinking about the outlook for the U.S.
dollar.
But the good news is that you've obviously done detailed work in
collaboration with the floor to understand the complexities of
how this bearish dollar view is percolating across the different
stocks and sectors. So, I wondered if you could walk us through
what your observations are and what your conclusions are having
done the work.
Marina Zavolock: First of all, I just want
to acknowledge that what you just said there. My background is
emerging markets and coming into covering Europe about a year and
a half ago, I've been surprised, especially amid the really big,
you know, shift that we're seeing that James was highlighting –
how FX has been kind of this secondary consideration. In the
process of doing this work, I realized that analysts all
look at FX in different way. Investors all look at FX in
different way. And in …
Paul Walsh: So do corporates.
Marina Zavolock: Yeah, corporates all look
at FX in different way. We've looked a lot at that. Having that
EM background where we used to think about FX as much as we
thought about equities, it was as fundamental to the story...
Paul Walsh: And to be clear, that's because
of the volatility…
Marina Zavolock: Exactly, which we're now
seeing now coming into, you know, global markets effectively with
the dollar moves that we've had. What we've done is created or
attempted to create a framework for assessing FX exposure by
stock, the level of FX mismatches, the types of FX mismatches and
the various types of hedging policies that you have for those –
particularly you have hedging for transactional FX mismatches.
Paul Walsh: Mm-hmm.
Marina Zavolock: And we've looked at this
from stock level, sector level, aggregating the stock level data
and country level. And basically, overall, some of the key
conclusions are that the list of stocks that benefit from Euro
strength that we've identified, which is actually a small pocket
of the European index. That group of stocks that actually
benefits from euro strength has been strongly outperforming the
European index, especially year-to-date.
Paul Walsh: Mm-hmm.
Marina Zavolock: And just every day it's
kind of keeps breaking on a relative basis to new highs. Given
the backdrop of James' view there, we expect that to continue. On
the other hand, you have even more exposure within the European
index of companies that are being hit basically with earnings,
downgrades in local currency terms. That into this earning season
in particular, we expect that to continue to be a risk for local
currency earnings.
Paul Walsh: Mm-hmm.
Marina Zavolock: The stocks that are most
negatively impacted, they tend to have a lot of dollar exposure
or EM exposure where you have pockets of currency weakness as
well. So overall what we found through our analysis is that more
than half of the European index is negatively exposed to this
euro and other local currency strength. The sectors that are
positively exposed is a minority of the index. So about 30
percent is either materially or positively exposed to the euro
and other local currency strength. And sectors within that in
particular that stand out positively exposed utilities, real
estate banks. And the companies in this bucket, which we spend a
lot of time identifying, they are strongly outperforming the
index.
They're breaking to new highs almost on a daily basis relative to
the index. And I think that's going to continue into earning
season because that's going to be one of the standouts
positively, amid probably a lot of downgrades for companies who
have translational exposure to the U.S. or EM.
Paul Walsh: And so, let's take that one
step further, Marina, because obviously hedging is an important
part of the process for companies. And as we've heard from James,
of a 15-year bull run for dollar strength. And so most companies
would've been hedging, you know, dollar strength to be fair where
they've got mismatches. But what are your observations having
looked at the hedging side of the equation?
Marina Zavolock: Yeah, so let me start with
FX mismatches. So, we find that about half of the European index
is exposed to some level of FX mismatches.
Paul Walsh: Mm-hmm.
Marina Zavolock: So, you have
intra-European currency mismatches. You have companies sourcing
goods in Asia or China and shipping them to Europe. So, it's
actually a favorable FX mismatch. And then as far as hedging, the
type of hedging that tends to happen for companies is related to
transactional mismatches. So, these are cost revenue, balance
sheet mismatches; cashflow distribution type mismatches. So,
they're more the types of mismatches that could create risk
rather than translational mismatches, which are – they're just
going to happen.
Paul Walsh: Yeah.
Marina Zavolock: And one of the most
interesting aspects of our report is that we found that companies
that have advanced hedging, FX hedging programs, they first of
all, they tend to outperform, when you compare them to companies
with limited or no hedging, despite having transactional
mismatches. And secondly, they tend to have lower share price
volatility as well, particularly versus the companies with no
hedging, which have the most share price volatility.
So, the analysis, generally, in Europe of this most, the most
probably diversified region globally, is that FX hedging actually
does generate alpha and contributes to relative performance.
Paul Walsh: Let's connect the two a little
bit here now, James, because obviously as companies start to
recalibrate for a world where dollar weakness might proliferate
for longer, those hedging strategies are going to have to change.
So just any kind of insights you can give us from that
perspective. And maybe implications across currency markets as a
result of how those behavioral changes might play out, I think
would be very interesting for our listeners.
James Lord: Yeah, I think one thing that
companies can do is change some of the tactics around how they
implement the hedges. So, this can revolve around both the timing
and also the full extent of the hedge ratios that they have. I
mean, some companies who are – in our conversations with
them when they're talking about their hedging policy, they may
have a range. Maybe they don't hedge a 100 percent of the risk
that they're trying to hedge. They might have to do something
between 80 and a hundred percent. So, you can, you can adjust
your hedge ratios…
Paul Walsh: Adjust the balances a bit.
James Lord: Yeah. And you can delay the
timing of them as well.
The other side of it is just deciding like exactly what kind of
instrument to use to hedge as well. I mean, you can hedge just
using pure spot markets. You can use forward markets and
currencies. You can implement different types of options,
strategies.
And I think this was some of the information that we were trying
to glean from the survey was this question that Marina was asking
about. Do you have a limited or advanced hedging program?
Typically, we would find that corporates that have advanced
programs might be using more options-based strategies, for
example. And you know, one of the pieces of analysis in the
report that my colleague Dave Adams did was really looking at the
effectiveness of different strategies depending on the market
environment that we're in.
So, are we in a sort of risk-averse market environment, high vol
environment? Different types of strategies work for different
types of market environments. So, I would encourage all
corporates that are thinking about implementing some kind of
hedging strategy to have a look at that document because it
provides a lot of information about the different ways you can
implement your hedges. And some are much more cost effective than
others.
Paul Walsh: Marina, last thought from you?
Marina Zavolock: I just want to say overall
for Europe there is this kind of story about Europe has no
growth, which we've heard for many years, and it's sort of true.
It is true in local currency terms. So European earnings growth
now on consensus estimates for this year is approaching one
percent; it’s close to 1 percent. On the back of the moves we've
already seen in FX, we're probably going to go negative by the
time this earning season is over in local currency terms. But
based on our analysis, that is primarily impacted by translation.
So, it is just because Europe has a lot of exposure to the U.S.,
it has some EM exposure. So, I would just really emphasize here
that for investors; so, investors, many of which don't hedge FX,
when you're comparing Europe growth to the U.S., it's probably
better to look in dollar terms or at least in constant currency
terms. And in dollar terms, European earnings growth at this
point are 7.6 percent in dollar terms. That's giving Europe the
benefit for the euro exposure that it has in other local
currencies.
So, I think these things, as FX starts to be front of mind for
investors more and more, these things will become more common
focus points. But right now, a lot of investors just compare
local currency earnings growth.
Paul Walsh: So, this is not a
straightforward topic, and we obviously think this is a very
important theme moving through the balance of this year. But
clearly, you're going to see some immediate impact moving through
the next quarter of earnings.
Marina and James, thanks as always for helping us make some sense
of it all.
James Lord: Thanks, Paul.
Marina Zavolock: Thank you.
Paul Walsh: And to our listeners out there,
thank you as always for tuning in.
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