French stocks have taken a battering recently as numerous fundamental factors weigh on the outlook for the French economy, specifically the CAC 40 equity index. The latest decision handed down from the European Central Bank combined with the worsening global outlook presents several obstacles for the equity benchmark even though 1-year returns are still well above that of comparable global indices. The upward trending Euro will also work to stymie any upward momentum and rebound in the CAC 40 as stocks become more expensive due to the appreciation of the common currency, possibly leading to a longer than anticipated near-term selloff in the index even though longer-term prospects remain largely positive.

ECB Disappointment Leads to CAC Losses

Amid widespread speculation that the European Central Bank would opt to expand the current rate of monthly asset purchases, the French CAC 40 rallied into the latest interest rate decision and announcement regarding quantitative easing. However, the failure by the ECB to expand the pace of monthly purchases by the expected €15-20 billion from the current €60 billion was met with substantial losses across the board for European stocks and regional benchmarks. Generally speaking, there is a very strong correlation between the expansion of a central bank’s balance sheet and upward momentum in equity instruments.

When a central bank, such as the ECB, opts to loosen monetary policy and buy assets in an effort to drive down longer-term borrowing costs, the monetization process oftentimes limits the available pool of outstanding assets for investors while decreasing potential yield. This invariably leads investors on the hunt for higher yielding assets in order to attain higher returns. However, in the case of central banking and the post-crisis experience, this type of central bank strategy oftentimes channels investment straight towards the higher risk and higher reward characteristics of stocks and broader equity indices.

Balance Sheet Growth Remains Positive for Stocks

Evidence of the impact of Central Banking is evident when looking at the momentum higher in European stocks since the announcement of asset purchases. When compared to the US S&P 500 which dipped into negative territory year-to-date during yesterday’s session, the CAC 40 has risen by 9.57% year-to-date and 13.31% on a one-year basis. Nevertheless, while the ECB balance sheet is still expanding at a substantial monthly rate, the disappointing results from the latest meeting of the Governing Council heavily weighed on regional benchmarks including the German DAX 30 and more notably the French CAC 40.

The ECB announcement saw the Euro immediately surge versus peers, making European stocks more expensive than other global peers, adding to the downside onslaught. Since the announcement, the CAC 40 has fallen by nearly 4.50% and the continued appreciation in the Euro might add to the downside pressure. Although part of the weakness can be attributed to global conditions after weak trade data from China set off a global panic that extended to the American session, the Euro remains a major factor in the decline of the CAC. However, a reversal in the Euro might well be possible in the coming week as anticipation of liftoff from the Federal Reserve becomes increasingly likely.

US Liftoff to Benefit European Stocks

After the latest US payroll data confirmed the relative strength of the US economy, expectations are high that the Federal Reserve will opt to enter a tightening cycle, with the FOMC decision in the coming week expected to see rates rise by 25 basis points to 0.50%. If this is the beginning of a rate hike cycle, it could mean a substantial turnaround in the US dollar over the coming weeks which would push the Euro lower and add to CAC 40 tailwinds. After falling through a major technical support level at 4800, this might be enough to propel the CAC 40 back to the upside.

While action from the Federal Reserve might not necessarily spur momentum leading the CAC 40 back to multi-year highs seen back in April, should the Euro fail to depreciate further after the latest monetary policy decision, it may raise the specter of further action from the ECB in the next meeting. Generally speaking though, with a wide berth of analysts forecasting EURUSD at parity in the coming months due to the divergence of monetary policy, there is a strong probability that near-term losses in the CAC 40 will soon reverse on the back of policy adjustments.

Conclusion

Generally speaking the French economy has struggled to shake off the sovereign debt crisis as evidenced by high unemployment and structural deficiencies in the economy that are preventing greater global competitiveness. While recent policy decisions have certainly weighed on the CAC 40, this can be viewed in the context of a technical pullback based on the outlook for monetary policy from the ECB and Federal Reserve. Should the ECB expand asset purchases and the Federal Reserve opt to raise interest rates, it could spell further losses in the EURUSD pair which make the CAC 40 more attractive on a relative basis. These actions could similarly raise the prospect of a retest of multi-year highs in benchmark equity index. However, it need be noted that a rebound from recent losses in the CAC 40 is largely dependent on the actions of policymakers and less so the rise and fall of corporate fortunes.