- Today's Markit manufacturing PMIs signal good times to continue for the euro
- Euro remains correlated to the strength of Germany's manufacturing sector for a few good reasons
- Despite ongoing strength, Eurozone banking sector remains heavily reliant on USD borrowing
Based on the US dollar index, USD fell by 10% against a basket of currencies in 2017, its worst performance since 2003. Against the euro, the currency fared even worse and fell by more than 12%. Given the mean-reverting nature of currencies, one would assume that the dollar would at least enjoy a relief rally at the outset of 2018. Following today’s Markit Eurozone manufacturing PMI numbers, it looks like the dollar rebound has yet to arrive. Despite the big run up in EUR/USD, the pair can continue strengthening.
Germany’s significant manufacturing sector underpins the euro
While manufacturing has declined globally (measured as a proportion of overall GDP), the sector plays a significant role in the German economy and also dominates the country’s exports. As the largest economy and exporter in the Eurozone, the health of Germany’s manufacturing industry is a key driver of the common currency. When compared to G20 economies, only South Korea has a greater weighting of manufacturing as a proportion of overall GDP. Countries that operate significant trade deficits, such as the United Kingdom and the United States, tend to be dominated by professional services. This is shown below:
Germany is a world leader in manufacturing
As can be seen above, the only large economies with a higher proportion of manufacturing are China and South Korea. Even Japan, long known for its industrial economy, has a relatively smaller manufacturing sector as a proportion of its overall economy.
Beyond its significant scale, German manufacturing is primarily export-oriented. This underpins the euro via significant export surpluses. The trade surplus in goods, by country, is shown below for reference:
Manufacturing drives Germany’s trade surplus
As can be seen above, Germany has the world’s second highest goods trade surplus (+$300b in 2016) after China (+$494b in 2016). While commodity exporters such as Russia, Brazil and Saudi Arabia also appear on this list, the size of their trade surplus is much smaller relative to Germany. On the other end of the scale, countries including the United States, United Kingdom and India operate significant goods deficits.
“Euroboom” can continue driving EUR/USD higher
Following today’s strong Eurozone (60.6) and German (63.3) Markit manufacturing PMIs, there are few reasons to be bearish on the euro. As highlighted above, the euro depends on Germany’s manufacturing sector, and the latest data suggests that it is firing on all cylinders. Beyond optimism for GDP growth in 2018, markets will also start pricing in the end of the ECB’s asset buying program. While ECB President Draghi has been fairly coy regarding this subject, justifying the current monetary stimulus program will be difficult in light of strong growth data. As Eurozone monetary policy looks set to converge with the US, positive momentum can keep driving EUR/USD higher. Our trending indicators for EUR/USD remain bullish in both the short-term and the medium-term. One caveat is that the pair is looking slightly oversold on a daily chart, so a better entry price may be available for those willing to wait.
Longer-term outlook: not just sunshine and roses
Over the longer term, Germany’s manufacturing-led surplus cannot indefinitely keep the euro on a strengthening path. Looking at recent history, the euro has suffered significant declines when the health of its banking system has been called into question. This has occurred when GDP growth has been on a decelerating path. In particularly, this happened during the global financial crisis in 2008 and the Eurozone debt crisis in 2011-2012. In the latter case, the resolution of the crisis was ultimately engineered by the ECB in 2014, which resorted to negative rates and a significant asset buying program.
Looking to the future, we have seen many warning signs that have historically led to sharp sell-offs in the euro recently. Specifically, the cost of borrowing US dollars for euro-based banks and corporations rose sharply in December 2017. As European banks are increasingly reliant on US dollar funding, a dollar shortage can escalate into a full-blown banking crisis (as was the case in 2008). Despite growing problems in US dollar lending markets, we believe that this issue is unlikely to develop into a crisis in the near-term. As GDP growth continues to accelerate in most major economies, the ‘good times’ look set to continue.