The economic and stock market consequences of a weak euro against the dollar - 27 january 2025
Donald Trump's threats on trade have led the euro to almost reach its 2022 undervaluation record against the dollar in terms of deviation from purchasing power parity. This situation will not translate into strong macroeconomic competitiveness for the euro, but it does offer strong support for the profits of major European multinationals.
Up and down, the euro's exchange rate against the dollar is adjusting to Donald Trump's small talk on trade. This exchange rate flexibility is good news, as it acts as a shock absorber. Compared with its purchasing power parity (estimated at USD 1.4 by the OECD), the euro is currently undervalued by 27% against the dollar (graph 1), which seems particularly favorable to the euro zone in terms of price competitiveness.
This undervaluation is obviously welcome at a time when the euro zone is economically weakened. The exchange rate reflects the economic gap between the two zones, and consequently an interest rate differential that markets expect to deepen in 2025. The ECB is expected to continue cutting rates, while expectations are less clear for the Fed. The euro's near-record deviation from its purchasing power parity needs to be put into perspective, however, as it is partly the logical consequence of the relative terms-of-trade shock occurring in 2021 & 2022 (graph 2), at the time of the post-Covid reopening and the disruption of supplies of cheap energy to Europe (Russian gas). This shock has since been partially corrected, but it continues to weigh, which argues in favor of maintaining a weak euro.
Finally, the euro-dollar exchange rate is only one component of the eurozone's price competitiveness, as the United States accounts for only 15% of the eurozone's foreign trade in goods (18% of exports and 11% of imports). The eurozone's real effective exchange rate, which takes into account both the weight of the various trading partners and inflation differentials, provides a better indication of the currency's relative value. The real effective exchange rate is barely 5% below its historical average (graph 3), reflecting a high degree of overall stability. The euro's strong undervaluation against the dollar, Chinese yuan and Polish zloty is offset by a marked overvaluation against the Japanese yen, Scandinavian currencies and, to a lesser extent, the British pound.
The eurozone is therefore not benefiting from any strong macroeconomic impetus linked to its exchange rate. From the point of view of Europe's major listed companies, however, it's a different story. While Eurozone exports to the USA account for just 3% of GDP, US sales by Eurozone multinationals represent a much larger percentage of their turnover. For EuroStoxx 50 companies, this percentage averages 20%. For them, and therefore for the European equity market, the euro's marked undervaluation against the dollar in terms of purchasing power parity provides a substantial advantage by boosting their euro-denominated earnings.