EUR/USD Parity elevating pressures on US companies

Date of publishing: 12.09.2022

Executive Summary

EUR/USD is trading at parity for the first time in 20 years

Several economic indicators show significant headwinds for the European economy

Facing a possible recession and having the EUR/USD at parity exposes US corporations, which derive a significant share of their revenue from Europe to serious risk

Many US corporations make more than 40% of their revenue in Europe

Introduction

For the first time since 2002 the EUR/USD currency pair is trading at parity. Back then this movement was fuelled by rising inflation as well as rate hikes, but the 30-year treasuries seemed to keep their strength, which accelerated dollar denominated investments into the treasuries.^[1]

Current Situation in the West

Something similar could have been heard in the news over recent months. Record high inflation in the USA and Europe is one of the major problems our societies face at the moment, at least it appears so. The different reactions by the respective central banks lead to constant changes in the Foreign Exchange markets. The hawkish stance by the Fed strengthened the Dollar compared to the Euro, as the Fed already started hiking its key interest rate earlier this year^[2] and it took the ECB more than a quarter^[3] to follow the Fed’s lead. Another reason is the importance of the USD as a reserve currency and in times of distress many investors flee towards the USD, strengthening the currency further, and on the other hand gives the Fed the chance to react more stringent to the US inflation.

One of the reasons for the reluctance of the ECB to hike its key interest rate significantly is the high indebtedness by some of the European states, in 2012 they were already labelled as “P-I–(I)-G-S”^[4].

With every basis point the ECB hikes the rate, it increases the pressure on the respective countries, which arguably hinders the ECB to take appropriate action against the elevated inflation, the Union currently experiences .

Why the Parity matters

What might seem harmless, can be detrimental for the overall economy. On the one hand it gets cheaper for Americans to buy Euro denominated products, but on the other hand products exported by US companies will become more expensive for European consumers and companies. This could lead to a decline of demand in an already weakened economy, adding further pressures on companies which have a higher exposure to the Euro.

European Recession Risks

Factors that are currently moving markets most significantly besides the already mentioned high inflationary pressures, are Russia’s invasion of Ukraine, China’s influence on most supply chains and rising tensions around Taiwan, but that is not all.

Whilst the financials of eurozone companies seem to remain stable, increasing interest rates will most likely put an end to that. Cost of capital is already rising which will particularly hit highly leveraged and small cap firms.

What makes the current situation especially treacherous is the combination of a possible recession and war. In most recessions so far, demand went down and consequently resolved inflation, whereas in this scenario inflation and commodity prices will most likely continue to rise. This is a development that has not been seen in recent decades and central banks therefore must decide which mandate they want to fulfil in order to tackle stagflationary risks.

One of the charts signalling a dramatic rise in costs for the whole European economy are the natural gas futures for Europe.

Starting with the invasion of Ukraine and the fear of being cut off from Europe’s most important gas supplier the volatility and price of European gas futures increased significantly, not only affecting regular European households but having a detrimental impact on the European industry, which was and still is heavily relying on Russian gas in one way or the other.

The development of the overall inflation also significantly fuelled by rising energy costs has led to an astonishing decline in the consumer confidence in the biggest economy of Europe, Germany.

As can be seen the index currently notates at an all-time low. Not even the housing bubble or the euro crisis have been as detrimental for the consumer confidence as the current inflationary pressures, with sky rocketing electricity prices, supply chain bottlenecks and many other unknowns under which most economies are currently suffering.

Last but not least, an important index to have a look at is the Producer Price Index (PPI) as it shows the average change over time in the selling prices received by domestic producers for their products. The PPI for the Eurozone shows a staggering increase since the end of 2021, exceeding any of the last 12 years. This figure clearly shows us an unusual change in prices in the business-to-business market, which once again puts further pressure on the European economy.

It is safe to say that a situation as we have it at the moment bears high risks of a recession, although the classic warning signs have not yet emerged – unemployment is still decreasing, and corporate profit margins remain stable. But if we look to the US, which – with two consecutive quarters of negative GDP growth – now more or less officially entered a recession, their numbers did not forecast that either.

Companies that fit out criterion

To have a better overview we have searched for companies^[10]^[11] with high exposure to the European market, by looking at the Revenue generated in the Euro-Zone.

As can be seen the selected companies have made at least 38% of their revenue in Europe and with CNH Industrial we have a company which generates almost 50% of its revenue in the Euro-Zone.

It is Important to mention though, that there are also other companies with high percentage wise exposure to the Euro, though not all companies are impacted the same by the EUR/USD parity other the other mentioned factors. For this reason, we excluded companies which could be regarded as safe havens, operating in the medical space and producers of consumer goods like food, beverages and tobacco.

Looking at the historic performance of the respective companies compared with the S&P500 we can see that back during the time when we’ve already seen a EUR/USD parity as well as a recession, the respective companies performed considerably worse (-4.5%) than the S&P500 itself.

Trade Structure

In order to trade the above presented thesis, we’ve decided to structure Bear-Call Spreads for all equities except for Autodesk which we trade via a Bear-Put Spread. Both strategies are bearish with limited risk.

Bear-Put Spread

The Bear-Put Spread consists of a long put and a lower striking short put with the same expiration date. When entering the trade, a premium (debit) needs to be paid, which together with the paid commission, represents the maximum loss. To reach the maximum gain the underlying needs to trade below the strike price of the short put. The maximum gain is the difference between the strike prices minus the debit taken. This strategy profits from an increase in implied volatility. A risk to consider is theta or time decay which diminishes the value of the option.

Setup of the Bear-Put Spread:

*The underlying CNHI is trading at low volume, so this setup for the spread seemed best in our opinion. A naked long put would also be a viable strategy for CNHI.

The reason why we want to trade ADSK via a Bear-Put Spread instead of a Bear-Call Spread lies in the difference between the implied volatility and the historical volatility. As mentioned above, this strategy profits from an increase in IV. Currently, the IV is below the HV which might suggest an increase in IV and therefore benefit our strategy.

Bear-Call Spread

For the Bear-Call Spread a call needs to be sold and a higher striking call needs to be bought with both expiring at the same date. The Bear-Call Spread is a Credit Strategy, meaning when entering the trade, a premium is received. The premium received minus commission paid represents the maximum gain. In order to obtain the maximum profit, the underlying must trade below the strike of the short call. The difference between the two option strike prices minus the premium received represents the maximum loss. This structure profits from time decay and a decrease in implied volatility.

Setup of the Bear-Call Spreads:

*The underlying CNHI is trading at low volume, so this setup for the spread seemed best in our opinion. A naked long put would also be a viable strategy for CNHI.

Summary

No one is able to say if or if not, Europe will experience a recession. There are arguments for both sides of the coin, but there are serious headwinds facing Europe and all the companies which are doing business within the Union. It might be possible that companies from the US generating a significant share of their revenues in the Euro-Zone encounter an elevated risk, because their products will become even more expensive for Europeans due to the significant decrease of the foreign exchange rate between the Euro and the US Dollar.

Disclaimer The information set forth herein has been obtained or derived from sources generally available to the public and believed by the authors to be reliable, but the authors do not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with WUTIS – Trading and Investment Society e.V.