Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Europe Stocks Outperform as Dollar Weakens on Rate Divergence
Transcript
- Lucas: So it's mid-May 2026, and if you've been watching the headlines, you'd think European markets should be under pressure. The dollar index hit 119.3 last week — that's up almost five percent year-to-date. The Fed is talking about another hike in July. And yet, look at the numbers: the Vanguard FTSE Europe ETF, ticker V-G-K, is up nearly one percent over the past five days. The iShares MSCI Eurozone ETF, E-Z-U, up about eight-tenths of a percent. European stocks are actually holding up better than US equities this month. Luna: That does feel counterintuitive. A stronger dollar typically means capital flows out of non us assets, right? What's propping up Europe? Lucas: A couple of things. First, the weaker euro. One euro is buying about one point one six dollars now, down from around one point one seven a week ago. For a German industrial exporter — say a Siemens or a Volkswagen — a weaker euro means their products become cheaper in dollar terms, which boosts revenues when you convert back. That's a real tailwind for earnings. Luna: So it's not that European stocks are immune to the dollar — they're actually benefiting from it. That's a neat inversion. Lucas: Exactly. And the second factor is that the ECB has actually steadied expectations. After last year's rate-cutting cycle, the market now sees rates holding relatively stable through the summer. That's removed one layer of uncertainty. Compare that to the US, where the Fed is back in hawkish mode — you've got bond vigilantes pushing yields up, and traders now see the next move as a hike, not a cut. Luna: Right, that narrative shift was really driven by the April inflation data. And Kevin Warsh being sworn in as Fed chair on Friday — that adds another layer of hawkish expectation. Lucas: Warsh is seen as more inflation-hawkish than Powell, so the market is pricing in a higher terminal rate. That's strengthening the dollar. But for European equities, especially the export-heavy indices like Germany's Dax, the weaker currency is a buffer. The Germany ETF, ticker e w g, is actually up one and a half percent over the past five days — best performer among the major European country ETFs. Luna: Let's talk about the Italy situation. The Italy ETF, e w i, is down about four-tenths of a percent over the same period. That's the outlier. What's going on there? Lucas: Italy is a different story. It's more sensitive to political risk and bond spreads. The spread between Italian and German ten-year yields has widened a bit recently — partly because of the global rate environment, partly because of some domestic fiscal concerns. Italy has a higher debt to gdp ratio, so when global rates rise, its borrowing costs rise more. That spooks equity investors. Luna: So the strong dollar is actually a tale of two Europe s: the export champions benefit, but the high-debt periphery gets squeezed. Lucas: That's a really good way to frame it. And look at the broader macro picture. Eurozone nominal GDP is now over thirty-one point eight trillion dollars — up from about thirty-one point four trillion at the start of the year. Real GDP growth annualized at two percent, up from just half a percent in the prior quarter. The economy is actually accelerating. That gives the ECB room to hold steady, which helps the export story. Luna: It also means European earnings estimates might actually be upgraded, while US estimates are being trimmed on rate fears. Lucas: Exactly. And that's the divergence that investors are starting to trade. You see it in the relative performance of the ETFs. Spain, e w p, up one and a half percent. France, e w q, up one percent. The UK, E-W-U, up nine-tenths. Broad-based strength except for Italy. Luna: I want to ask about the energy angle. The headlines about Putin-Xi talks on a gas pipeline and Iran rattling energy markets — does that feed into the European story? Lucas: It does, but maybe not in the way you'd think. Europe has been diversifying away from Russian gas for two years now. So the geopolitical noise around a stalled pipeline actually has less direct impact than it would have in 2022. What matters more is the indirect effect on global energy prices. If Iran tensions push oil higher, that's a tax on European consumers, but it also boosts the energy sector within European indices — the UK has big oil majors, for instance. So it's mixed. Luna: Let's zoom out. You mentioned the dollar index at 119.3. How much further can it run? If the Fed actually hikes in July, could we see 120 or higher? Lucas: It's possible. The trade-weighted dollar index has been on a tear. But a lot of that strength is already priced in. And if European growth continues to surprise on the upside, you could see the euro stabilize or even rebound a bit. One point one six is not an extreme level historically. It could go to one point one four, but I think the bigger move is already behind us. Luna: So for a us based investor looking at European equities right now, the currency risk is actually the return driver? If the euro weakens further, your dollar returns get a boost. Lucas: Right. Unhedged European exposure is effectively a bet on both the equities and the currency. And right now, the equity side is working because of the export boost. The currency side could work if the euro stabilizes. So it's not a bad risk-reward. Luna: Before we go further, I want to mention something quickly. If today's episode has been useful to you and you'd like to keep it ad-free, listeners can support the show at buy me a coffee dot com slash fexingo. That's what keeps these conversations independent and accessible to everyone. Lucas: Yeah, it really does. Even a small contribution helps us keep the lights on and the content free for everyone. So if you find value here, that's the place. Luna: Alright, back to the markets. Lucas, you mentioned the ECB holding steady. But what about the risk that the Fed's hawkishness forces the ECB to follow suit? That would change the calculus. Lucas: That's the key risk. If the euro weakens too much — say below one point one zero — it could import inflation through higher import prices. The ECB might then feel compelled to signal a rate hike, which would hit the periphery hardest. But we're not there yet. The ECB's primary focus is still on domestic inflation, which is coming down. Core inflation is trending toward two percent. Luna: So the window for European outperformance is open as long as the ECB stays patient and the export engine keeps humming. Lucas: Exactly. And that's the trade right now. The data supports it. The GDP numbers, the earnings momentum, the currency tailwind. It's not a runaway bull market, but it's a defensible rotation trade. Luna: Last thing — what specific indicators are you watching over the next few weeks to see if this trade holds? Lucas: Three things. One, the euro-dollar exchange rate — if it breaks below one point one four, that's a signal of more dollar strength and potential ECB concern. Two, the Italy-Germany spread — if it widens past two hundred basis points, that suggests stress in the periphery. Three, the next set of PMI data for the Eurozone, due in early June. If that comes in above fifty-five, it confirms the growth acceleration. Luna: And if Warsh's first speech as Fed chair surprises on the dovish side? That could reverse the dollar trade entirely. Lucas: That would be a real pivot point. But given his reputation, I think the market expects hawkish continuity. If he surprises, European markets could rally even more on a weaker dollar. So either way, Europe is well-positioned in the near term. Luna: It's a fascinating moment. A strong dollar, a hawkish Fed, and yet European stocks are quietly climbing. Something worth keeping an eye on. Lucas: Absolutely. And we'll be watching those three indicators closely.