A look at the euro

At its last policy meeting, the European Central Bank (ECB) kept rates unchanged at 4.25 per cent as expected and maintained its stance of 'no bias', but it was still a fairly eventful press conference. In the opening statement, the ECB toughened up its call on the need to avoid second round effects and made an explicit call for wage indexation schemes to be 'abolished'. The downward revisions to the 2008 and 2009 growth projections were in line with expectations, but the inflation projection for 2009 was revised up further.

The Eurozone may already be in a technical recession, but if the ECB is serious about its inflation target, it will do what it takes to contain inflation expectations. And as Governor Trichet highlighted, breakeven inflation rates may have fallen with the oil price, but the five-year forward inflation breakeven has remained unsatisfactory.

What is particularly worrying from a Eurozone asset perspective is that while the Eurozone five-year breakeven "remains unsatisfactory", the same cannot be said of the US. In the US, this has fallen aggressively. While the cyclical downturn is deemed to be squeezing inflation out of the US system, this is not the case for the Eurozone.

It is notable also that in the latest Survey of Professional Forecasters, over 55 per cent of respondents did not expect the ECB to meet its inflation target in five years' time. With this all in mind, the market must be questioning its previous build up of Eurozone assets.

Portfolio flows into the Eurozone have surged since 2006 when the USD turned decisively lower. Eurozone growth was outstripping that in the US with lower inflation. From 2006 to the end of 2007, the Dax soared while the S&P made measly gains. This drove the world (in net terms), to purchase €650 billion worth of Eurozone equities and bonds since 2006. The euro, from an external accounts point of view, was being supported by portfolio inflows. We also note a clear dramatic increase in buying of Eurozone bonds in the three months to last June.

So why was the world buying Eurozone debt in the three months to June so aggressively? We have to cast our minds back only a few months when the market thought inflation was the main danger and the ECB was about to raise rates to stem inflation - oil prices at the time were headed for $150 and some were forecasting $200. The Federal Reserve Bank, on the other hand, was paralysed and could not raise rates due to the weakness in the financial system and was perceived to have let the inflation genie out of the bottle. With this macro view in its mind, the market gravitated further towards Eurozone-fixed income products.

With the oil price and commodities having fallen in recent weeks, inflation is no longer the primary concern of the markets. It would seem the Fed's stance has been vindicated and, in addition, the US is showing little signs of wage growth. Slower growth in the US is bringing inflation down. However, in the Eurozone we have seen the ECB raising its inflation numbers despite slower growth. Global investors must be reconsidering their long Eurozone fixed income positions. If investors decide their large position in Eurozone debt needs to be reduced, then we are only witnessing the beginning of a much larger fall in the EUR.

However, the fixed income argument is still open to debate. The ECB may have to drive the economy down very aggressively to squeeze out inflation and one may argue that the fixed income markets in the Eurozone may still perform well. However, the Eurozone equities argument is far more compelling.

The more interesting feature of the portfolio flows is the equity side of the equation. Since 2006, foreign investors bought a whopping €541 billion worth of Eurozone equities. The problem with this long equity position is now that Eurozone growth is slowing and inflation is rising. Indeed, rather than the DAX and CAC out-performing the S&P they are now under-performing it. So far this year, the DAX and CAC are down around 25 per cent compared with a 15 per cent fall in the S&P. Eurozone corporate profits could now suffer due to high rates, high wage growth and weaker growth.

It is unsurprising that the market is already trying to unwind some of this long eurozone equity position. If the market really believes that the economic situation in the Eurozone is deteriorating and abandons its long Eurozone equity position, then this could prove euro negative as global investors cut down on their portfolio holdings in the euro.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.