* Euro at risk from slowing flows into euro zone stocks
* Euro zone stocks no longer appear cheap
* Risk of deflation, slowing growth may hurt portfolio flows
By Anirban Nag and Toni Vorobyova
LONDON, Nov 12 Strong inflows from foreign portfolio investors into euro zone stocks - a major support for the euro this year - are showing signs of running out of steam, leaving the currency vulnerable to near-term losses.
U.S. investors alone have doubled holdings of European equities this year to some $56.5 billion, according to Lipper data, helping push the euro to two-year highs against the dollar.
But that tide seems to be turning, with flows into Exchange-Traded Funds, traditionally the most nimble, slowing sharply this month. link.reuters.com/kyg64v
Concerns about sub-par euro zone growth, a perception that European stocks are no longer cheap, and a lacklustre earnings season are putting off equity investors. That will leave the euro at the mercy of a rate-cutting European Central Bank, just as the Federal Reserve contemplates scaling back stimulus - a step that should lift U.S. bond yields and the dollar's appeal.
"Given the importance of equity inflows for euro outperformance, we suspect that evidence that these flows are abating could add to the headwinds for the single currency," said Valentin Marinov, G10 currency strategist at Citi.
Euro zone equities are priced in euros, as are the main pan-European indexes, meaning foreign players must buy the currency to invest in the region. Portfolio investors bought 135 billion euros in the 12 months to August, ECB data shows.
However, data from UBS shows foreign investors sold $1 billion in stocks in the euro zone last week, on top of more than $2 billion a week earlier, when a shock drop in inflation raised the risk of deflation in the bloc.
That prompted the ECB to cut rates, with President Mario Draghi forecasting a prolonged period of low inflation.
The euro has shed 2.7 percent against the dollar in the past two weeks, to $1.3450 on Wednesday, but is still close to a two-year high on a trade-weighted basis.
It is also stronger than implied by the rate gap between two-year U.S. and euro zone bond yields, which ING says should see the euro at $1.32. Similar models at Nomura suggest $1.31.
That in turn suggests that thanks to trade and investment flows, the euro is 2-3 percent stronger than would be expected based on rate differentials alone.
U.S. investment in European equity ETFs
Equity valuations - U.S. vs euro zone forward P/E gap
European and U.S. valuations by index
VALUATION GAP BRIDGED
Falling prices are not good news for companies as they affect pricing power. If companies cannot price goods and services to protect margins and generate profits, they push back their investment plans, which can hurt growth prospects and hit overall demand in the economy.
Those concerns, coupled with equities prices that are no longer cheap following a long rally, are reducing investor appetite for the region and thus inflows supporting the euro. The EuroSTOXX 50 index of euro zone blue chips has gained nearly 50 percent since June 2012.
"The valuation gap between the United States and Europe that drove those inflows has been bridged. U.S. and European stocks now have similar valuations and to us the relative growth prospects for the United States seem better than the euro zone," Morgan Stanley's head of European FX strategy Ian Stannard said.
The rally in euro zone equities has slashed their valuation discount versus the United States to its lowest since 2002, based on respective 12-month expectations for earnings in the S&P 500 and Euro STOXX 600.
That coincides with the euro zone blue-chip index trading at its most expensive in five years, with a price/earnings ratio of around 11.2 times. In contrast, U.S. valuations have plateaued around three-year highs.
Analysts at JPMorgan are among those turning more cautious on European equities in the near term, recommending investors take some risk off the table.
While strong equities have been good for the euro, a strong currency has hit many companies' profits. An elevated exchange rate has been cited as a key factor behind the weak third-quarter earnings season, in which some 70 percent of euro zone firms missed expectations, StarMine data shows.
"The problem is that without any real (economic) progress, is the value in those assets going to be realised?" said Stewart Richardson, chief investment officer at wealth managers RMG.
"So we wonder whether the flow of money coming into Europe is going to stall out, with underlying economic currents clearly not being that strong. We think the (euro's) up-trend is over, and we are going into a downtrend." (Graphics by Toni Vorobyova; Editing by Nigel Stephenson and Catherine Evans)
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