The investment appeal of the European currency rose significantly on Tuesday, as government data indicated faster-than-expected economic recovery in Q1, stirring up speculation that downside risks receded.

Q1 output in the Eurozone rose by 0.4%, after rising by 0.2% in the Q4, 2018, surpassing the consensus of 0.3%. The data mended market beliefs that the EU economy can reach an annual growth rate of 1.2%, although prior to the release, there were scenarios for even lower growth forecasts.

Germany and Italy, beleaguered by world trade and fiscal instability issues, posted better than expected growth figures, almost falling out of the expansion trajectory in the second half of last year. National accounts data showed that consumption had regained its title of the ‘main driver of growth’ after vague prospects last year. Self-sustained economic growth, i.e. focused on growing domestic demand, is the key welcomed result of the ECB. This should allow the regulator to rely on the acceleration of consumer inflation to resume debates about normalization of monetary policy.

Considering that the euro was mired by alarming statements from ECB officials, whether it’s speculation about tiered rates on deposits or even a return to QE if necessary (the statement from ECB vice-president), it’s reasonable to assume that the markets will be all more inclined to price this information out of the currency since the data has improved markedly. The beginning of this trend has already been set from the start of this week.

Taking consumption as the main driver of growth, we should expect that the strengthening of this component of GDP was preceded by the growth of income, as well as a shift in the structure of spending (decline in the share of consumer staple goods and growth of discretionary). Here, for example, the dynamics of an ETF that replicates the dynamics of EU firms from MSCI consumer discretionary sector (which obviously depend heavily on consumer confidence in future income):

With rising income, the consumer should increase spending on discretionary purchases faster than on staples (since discretionary are under-consumed where incomes are low) in what can be considered one of the most reliable early signs of improving consumer optimism. As can be seen from the chart above, the market considered it reasonable to expect the growth of companies engaged in the production of these goods.

If we compare with the dynamics of ETF on consumer staples, we can see that their drawdown in 2018 was less sharp, which, roughly speaking, reflects the lower elasticity of consumption of consumer staples to the expectations of future incomes. Additionally, the dynamics of the index looks more stable in general:

In other words, in the event of weakening consumer demand, it can be expected that sales of basic consumer goods will be more stable than discretionary.

The main weakness in EU economic growth emanates from a deterioration of export sales, as recent corporate sentiment gauges by IFO and ZEW continue to speak about. The euro is starting to look even more attractive if the following two facts are taken into account – EU trade with China is growing as opposed to pressure in the US and the Chinese economy found support by the end of the first quarter, as can be seen from retail sales data and relatively stable manufacturing PMI. Even more encouraging is stronger rebound (albeit due to seasonality) in passenger car sales in China in March compared with 2017 and 2018:

Recall that the European Union mainly exports cars to China.

Foreign exchange markets are actively responding to GDP data, as it reflects the change in real aggregate demand and the change in price levels. The first component (change in demand) helps us to build expectations about future inflation (especially if a favorable trend occurs in less volatile components of demand, such as discretionary consumer purchases), which in turn determines the policy of the Central Bank. A change in the difference in growth rates between countries leads to changes of capital flows, which is in perpetual search for a better rate of return with less risk.

Please note that this material is provided for informational purposes only and should not be considered as investment advice. Trading in the financial markets is very risky.

 

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