Euro Rally Weighs on Inflation, Sapping Appetite for Stocks

The U.K.’s rollout of a Covid-19 vaccine is among the factors prompting bets on a global economic recovery.

The U.K.’s rollout of a Covid-19 vaccine is among the factors prompting bets on a global economic recovery.

Photo: victoria jones/Agence France-Presse/Getty Images

The dollar’s weakness is complicating matters for both policy makers and investors in Europe.

Bets that Covid-19 vaccines will propel the global economic recovery next year have prompted investors to buy assets outside the U.S., pushing the dollar lower in recent weeks. That has left the euro up more than 8% against the greenback this year, and near its highest level since April 2018. It traded Wednesday at about $1.2135 apiece.

The rally in the common currency threatens to impede European policy makers’ efforts to stoke inflation in the region. A stronger euro makes exports from the region less competitive overseas, potentially curbing economic growth. It would also make imports less expensive for the eurozone, and damp inflation.

Such concerns are eroding investors’ appetite for eurozone stocks. The Euro Stoxx 50, a benchmark for the region, has dropped more than 5% since the end of last year. That compares with the S&P 500 index’s almost 15% gain.

The region’s pace of economic growth “is okay, but not enough to put any upward pressure on inflation,” said Chris Iggo, chief investment officer for core investments at AXA Investment Managers. “It’s not a time for big asset-allocation decisions in Europe.”

A slowdown in the eurozone’s economic growth has raised concerns about a double-dip recession. The faltering rebound, combined with a weak recovery in the labor market, is likely to weigh on inflation, Mr. Iggo said.

Some investors think the dollar will continue to drop in coming months. That means the euro could strengthen further, adding to the challenges facing policy makers.

The European Central Bank aims to get inflation close to 2% over the medium term. But that may be a long time coming: The central bank is currently projecting inflation will rise to 1% in 2021, and 1.3% in 2022.

Many investors are skeptical about the ECB’s ability to meet that 2% goal. The German 10-year break-even rate, a measure of how much inflation investors expect annually in Europe’s largest economy over the next decade, ticked down to 0.94% on Wednesday, from 0.99% at the end of last year.

“We want inflation to be rising,” said Hani Redha, a multiasset portfolio manager at PineBridge Investments. “The best environment for risk assets is when inflation is low, but rising.”

Mr. Redha is among those who are optimistic that the ECB will succeed in bolstering inflation in coming years. He bought stocks of smaller companies in France and Spain, and is betting they will benefit from the global economic recovery and rally further in coming years if inflation ticks higher.

A stronger euro isn’t the only barrier to inflation. Unemployment in the eurozone rose during the pandemic. Without a tight labor market in which people can demand higher wages for jobs, prices will be unlikely to move meaningfully higher, analysts and economists say. Consumers have also curtailed spending because of the economic uncertainty. And oil prices, a key component of consumer prices, have dropped roughly 25% this year.

The common currency’s rally has caught the attention of policy makers.

Measures expected from the European Central Bank, headquartered in Frankfurt, could boost inflation and weaken the euro, according to analysts.

Measures expected from the European Central Bank, headquartered in Frankfurt, could boost inflation and weaken the euro, according to analysts.

Photo: Zuma Press

In September, ECB President

Christine Lagarde
said the central bank doesn’t target levels in exchange rates, but the euro is an “important determinant” of price stability. The central bank didn’t take any actions to limit the euro’s climb at that time.

Many investors now expect that the ECB, at a policy meeting Thursday, will both increase its bond-buying program and extend it until the end of 2021. Many are also counting on the central bank extending a program offering cheap loans to banks.

If those measures reduce the cost of financing and bolster the pace of economic recovery, that could boost inflation and weaken the euro, analysts said.

But there is little else the ECB can do.

Because interest rates in the eurozone are already subzero, investors say the central bank has less room to cut them, which would help weaken the euro.

“The ECB cannot afford a stronger euro, but there is not much they can do,” said Athanasios Vamvakidis, head of foreign-exchange strategy at Bank of America Global Research. “They are the furthest away from their inflation target they’ve even been, and they have few means to address it. If they address it, the euro will follow.”

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com