Rebound in dollar shall not deter European equity advance

Paul Jackson and his team at Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) do not expect weakening of the U.S. dollar (USD) versus the Euro (EUR). The EUR has gained about 2% versus the USD in the past month and 4.4% year to date as of October 25, 2013 (EUR/USD at 1.3807).

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE), along with consensus, still believes that the U.S. dollar will strengthen versus the Euro (EUR/USD will weaken to a long-term fair value of 1.20) as the yield differential between the United States and Europe widens. This trend has not materialized yet as the Federal Reserve is still injecting money into the U.S. economy. Other market participants believe that the advance in the USD may hamper gains in European equities.

Paul Jackson, on the other hand, believes that European stocks can rally at the same time as the USD strengthens. As long as the latter gains because of U.S. economic strength instead of fears of financial crisis, European stocks could rise as firms generate revenues from exports to the United States. The chart below shows the pre-crisis relationship between EUR/USD and MSCI Europe, which is negative. As the EUR/USD weakened, the MSCI Europe gained. The relationship turned positive during the crisis as the USD gained as market participants flocked to U.S. Treasury instruments to protect themselves from negative fluctuations. Risk assets such as credit and equities were sold as market participants became uneasy fostering a positive correlation between the MSCI EMU and the USD.

Societe Generale

Source: Societe Generale

Stronger USD may dampen peripheral country gains: Societe Generale

The MSCI Europe gained 8% in local currency during the third quarter of 2013 despite market participants’ concerns about Federal Reserve tapering, initial signs of emerging market strain, and political uncertainty in the U.S. and Italy regarding fiscal budgets and governance. In turn, the MSCI Europe rose 15% year to date as of September 30, 2013 and has gained 16.21% year to date as of October 25, 2013. Peripheral countries such as Spain and Finland have outperformed MSCI Europe during the third quarter of 2013. Finland was boosted by the 70% gain in Nokia Corporation (NYSE:NOK) (BIT:NOK1V) (HEL:NOK1V) while Spain’s gains were more broad-based.

Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) analysts recognize that a weaker USD has contributed to their bullish stance on European equities and their preference for peripheral countries. In Societe Generale’s view, any short-term correction can present a buying opportunity as valuations suggest annualized returns of 12% over the next 5 years.

Regarding countries and their correlation with the USD, Societe Generale analysts note that Austria has the highest positive correlation with EUR/USD (negatively correlated to the USD) while the Netherlands has the lowest correlation with EUR/USD (positively correlated to the USD). Correlations have varied over time, and the gap between correlations from Austria and Netherlands has been the widest in 20 years.

Paul Jackson and his team also opine that U.S. dollar weakness was a tailwind to peripheral countries’ outperformance and that such countries may correct if the USD strengthens. The correction may be limited as it is possible that companies in peripheral countries are less exposed to the USD relative to firms in countries like the Netherlands or France. Therefore, the latter countries that have more greenback exposure may perform better in light of a stronger greenback bridging the gap between their gains and the recent gains of peripheral markets.

Source: Societe Generale

Source: Societe Generale

Country selection is important again: Societe Generale

Correlations across countries have dropped over the last three years suggesting that investors can benefit from country valuation differences. History shows that correlations will likely rise again as investors favor countries that are undervalued and that are growing faster than the MSCI Europe. The cheapest markets compared to historical long term averages are Italy, Austria, and Finland. Societe Generale SA (OTCMKTS:SCGLY) (EPA:GLE) is overweight on the two former markets but neutral on the latter given Finland’s recent outperformance that may call for a correction. Spain also presents good value and Paul Jackson favors this market. France represents the better value among larger Eurozone markets. In contrast, Paul Jackson is underweight on the most expensive markets that include Germany and Belgium. Outside the Eurozone, Societe Generale analysts have a negative outlook for Denmark and the UK.

Source: Societe Generale