The
Euro: Humpty Dumpty or Egg Over Easy
by John Kaupisch
The Investec Ernst Cambist
Now
that the Euro has scrambled below parity, now that it's not even
worth eight (bacon) bits, what's to be done? How much more verbiage
will we ingest from the too many cooks of Europe's finest finance
ministries while the dollar value of the Euro slowly boils away?
Is the Euro finally all that it was cracked up to be or will
it suffer the unfortunate fate of Humpty Dumpty, who fell and
then fell apart? As you know, we tend not to be market timers
(unlike Peter Lynch, we don't even own an egg timer). This being
the first day of leap month, however, we feel compelled to step
out to the precipice. We say that the Euro has taken its plunge.
Like the groundhog, it could emerge soon from its winter and
poke a head well above the flat field of parity. The Euro framework
(or shell, if you prefer) remains intact, although yesterday's
news in regards to Austria could prove an intriguing test. In
short order, we believe we're near the bottom for what everyone
calls wistfully "the beleaguered currency." In our
view, the potential upside for the Euro easily outweighs its
current downside. A Euro below 95 at year's end would surprise
us; a Euro well above 1.10 would not.
The slide in the Euro recently
came about again predominantly because of outstanding U.S. economic
news and not due to fundamental weakness within the Euro-11 economies.
Price movement through parity (and later .98) triggered technical
cues, which exacerbated its downward momentum. The European Central
Bank ("ECB") probably will do little to support the
Euro so long as it does not threaten inflation. A weak Euro also
eases recovery for German and other European exports to the United
States. So, to some degree, the further weakening of the Euro
at present makes sense, particularly in light of the surprisingly
strong U.S. economic picture.
Still, the dollar cannot whack
the Euro indefinitely. After all, if history provides any guidance,
we are much closer to the later stages than to the beginning
of U.S. economic expansion. Any one of several immediate sourcesfrom
a prolonged stock market contraction to increasing worries about
record-breaking U.S. current account deficits to uncertainties
associated with presidential electionscould precipitate severe
downward pressure on the dollar. As for Europe, accelerating
European growth, from much more modest stirrings, could overtake
U.S. growth within a few quarters. Moreover, as Europe vigorously
attacks business inefficiencies and structural barriers to growth,
its comparative economic performance versus the U.S. could improve
further.
The Euro may be a relatively young
currency, but it is a powerful newcomer. Christian Noyer, Vice-President
of the ECB, summarized the impact of the Euro while speaking
in New Orleans two weeks ago:
- the Euro as a whole accounts for 15% of world GDP (versus the U.S. at 20.5%; Japan at 7.8%)
- the Euro area has the highest share of world trade, with a ratio of area-wide exports to total world exports of 19.5%
- the Euro is the second most widely used currency at the international level
Already,
corporate bond issuance in Euros exceeds dollar issuance (and
that of the legacy currencies previously). In addition, as central
bankers gain confidence in the Euro, they embrace it enthusiastically
as an alternative reserve currency to the dollar. Noyer notes:
"the Euro has not simply replaced the various national denominations(but),
in fact, involves a process of integration of national financial
markets of the Euro area into an area-wide single market, the
size and liquidity of which will exceed that of the constituent
marketsA virtuous circle may therefore developthe increasing
international use of the Euro as an investment and financing
currency may feed back into the depth and breadth of Europe's
domestic financial markets."
The consensus of forecasts, according
to the monthly survey of the Economic Intelligence Unit, see
the Euro at 1.12 twelve months hence. While we are always wary
of the consensus, in this case, if the consensus is achieved,
investors derive a substantial gain form the currency alone.
Consider an investor who chooses short-to-intermediate term AAA
sovereign bonds. He/she mitigates credit risk and the interest
rate risk that would result from further rate increases by the
ECB following this week's meeting. Such an investor also avoids
the systematic risk of equity markets at lofty historical PE
levels. The major risk becomes the currency, and clearly here
we believe that the risk-return tradeoff for the Euro has become
highly positive. Indeed, consider potentially the worst-case
scenariothat the Euro actually turns out to be Humpty Dumpty
and fragments back into the legacy currencies (which appears
highly unlikely). If you bought German bonds, well, you're back
in the Deutschemark just as Germany's economic cycle has begun
to trend decisively upwardsand the Deutschemark is at a more-than-10
year low!
Editor's Note: The Global
Investment Group at Investec Ernst & Company specializes
in non-U.S. dollar denominated investmentsboth stocks and bondsworldwide
and is active in more than thirty currencies. Some investments
are available in pieces as small as $10,000 (US$ equivalent).
For more information, call John Kaupisch at 800-548-6193 or 312-554-0607.
