How to Play the Euro's Comeback
12/18/2012 10:30 am EST
Europe's currency is toughening up, in part because fiscal crises in the US and Japan suddenly seem much more dire. But how long will it last? MoneyShow's Jim Jubak, also of Jubak's Picks, explores the issue.
Pick your metaphor: The tide has turned. The weather is changing. The momentum has shifted with a change in quarterbacks.
Anything works as long as it describes the current reversal in strength by the euro against yen and US dollar, and reminds us that the reversal is itself easily reversed and that we don't know much about the timing of the next reversal.
I prefer "tide" to describe the euro's comeback. It suggests not just the turn in the currency markets, but a change in the flows that all financial assets swim with or against.
The reversal in the relative strengths of these big three currencies will, after all, have an effect on everything from earnings at big US multinationals such as IBM (IBM) and PepsiCo (PEP) to the price of commodities and commodity stocks, to the balance of imports and exports in China, to the growth rate of the Brazilian economy.
The biggest effect, though, is likely to be on the prices of stocks in emerging markets such as China and Brazil. If you're invested there, take note.
The Big Comeback
The euro had been in decline against the dollar and yen since the end of February through July 24. After a rally through October 17, it dropped again until November 13.
During those specific declines and during that seven-month period in general, money flowed into dollars and yen and into assets denominated in those currencies.
- A rising dollar weighed on the price of commodities such as gold and oil.
- Japanese exporters found themselves at a painful disadvantage in selling their goods—such as cars—to European customers who weren't inclined to buy anyway as their economies slipped into recession.
- US companies such as McDonald's (MCD) reported disappointing earnings, as cheaper euros from sales by European units had to be translated back into more-expensive dollars.
For the week ended December 14, the euro finished at $1.3163 against the US dollar, and the yen closed at 83.52 to the US dollar. The euro rose 1.8% this past week to its highest level against the dollar since May 4. The yen dropped 1.3% against the dollar to hit its lowest level since March 21. The yen fell 3% against the euro to hit its lowest level since April.
How big a change is this? On Nov. 9, the euro traded at $1.2694 to the US dollar. The low came on July 24, at $1.2089.
Despite the recent recovery, the euro is still down from its February 28 high for 2012 of $1.3454. That, of course, suggests that the euro could move higher in the coming weeks.
What's Behind the Rally
It's not hard to see why the euro has rallied against the yen and the dollar. It's partly because of positive developments in Europe.
In the past week, Eurozone finance ministers approved both the next big rescue payout to Greece and the first (and easiest) stages of what would be a European banking union. The first took the possibility of a Greek default/economic shutdown off the table. The second demonstrated, for the moment, that European leaders could make progress on their long-term agenda.
Add in the lack of an interest-rate cut from the European Central Bank on December 6—the bank kept its benchmark rate at a historic low of 0.75% for the fifth straight month—and you've got support for the euro coming pretty much from all sides. (The negative news is that the Eurozone economy continues to contract and the recession is both widening and deepening.)
Contrast the non-action by the European Central Bank with the stimulus from the US Federal Reserve and the stimulus to come (maybe) from the Bank of Japan.|pagebreak|
On December 12, the Fed announced that it would replace the $45 billion-a-month Operation Twist stimulus program, which expires at the end of the month, with $45 billion-a-month of outright buying of US Treasuries. Add in the Fed's continuing program of buying $40 billion in mortgage-backed securities every month, and the Fed is committed to pumping $85 billion a month into the US financial system.
And it's committed for a long time. Before last week's meeting, the Fed had said that it would keep short-term interest rates at their current 0% to 0.25% level until the middle of 2015. On Wednesday, however, the Fed said it would keep interest rates at that level until unemployment drops to 6.5%. On the current trend, that could keep rates at current levels until the end of 2015.
And it's only logical to think that the Fed won't ease off on this $85 billion a month in quantitative easing until it sees signs that the economic recovery is sustainable at the current rate or better. Quantitative easing—the Fed pumping money into the economy—could be with us for quite a while.
In Japan, the opposition Liberal Democratic Party and its leader, former Prime Minister Shinzo Abe, scored a landslide victory in elections on Sunday, winning 294 seats (by a preliminary count) in the 460-seat lower house of Parliament. Abe had run on a platform that called for the Bank of Japan to begin "unlimited" buying of government bonds, with a goal of adding stimulus to the economy until inflation reaches 2%.
Japan's economy shrank at a 3.5% annual rate in the third quarter and is expected to show a contraction again in the fourth quarter. The current inflation rate is near 0%.
The Bank of Japan will either go with Abe's program—adding massive stimulus to Japan's economy—or it will resist the call from the political leader in order to preserve its independence, setting off a crisis. Either alternative will take the yen lower.
Clear Skies in Europe, Sort Of
The Japanese election—and the pressure it has put on the Bank of Japan—could mean that country begins the New Year with a financial crisis. The United States is likely to begin the year in an analogous position, with politicians still locked in disagreement about how to fix the "fiscal cliff" created by the expiration of tax cuts and the imposition of automatic spending reductions that take effect after the first of the year.
And then, of course, there's the fight over raising the debt ceiling. There’s nothing like the possibility of a replay of the last debt-ceiling battle, which raised fears that the United States would default on its debt and led Standard & Poor's to cut the country's credit rating to AA from AAA, to stir up confidence.
In contrast, the horizon seems relatively clear in the Eurozone. Oh, none of the core problems have gone away or even been addressed seriously. But Europe's political leaders have kicked some of the big worries a long way down the road.
For example, the recent Greek rescue deal and payouts have potentially postponed the next round of the Greek crisis until 2014. The country looks likely to receive enough cash to meet its needs until then. (The likelihood is, however, that when we all get to 2014, the Greek debt load will still be unsustainable and the Greek economy will still be both in contraction and uncompetitive.)
It's unlikely the Eurozone will do anything but hold the fort until after the German elections in the fall. Anything that smacks of putting German taxpayers on the hook for more funds to bail out Greece, Spain, or Italy could cost German Chancellor Angela Merkel at the polls.
Her preference is for more talk from Mario Draghi and the European Central Bank, along with very little concrete action. And as long as the talk is sufficient to keep fear in check, that inaction is positive for the euro.
Of course, events might not cooperate with politicians' desires to do as little as possible. In Spain, the continued retreat of real-estate prices and the increasing inability of Spanish borrowers to pay (strange how not having a job makes it harder to keep up with the mortgage) keeps adding to the bad-loan problem at the country's banks.
In Italy, the February elections could produce political deadlock or worse. (Surely now, another government led by the flamboyant Silvio Berlusconi?)|pagebreak|
Events in either country could force Eurozone politicians into action and create, first, enough fear to send the euro back down, and second, some stimulus from the European Central Bank that closes the gap with the Fed and the Bank of Japan. And that would be enough to slow—if not reverse—the tide now flowing in the direction of the euro.
All of that makes it hard to project how long the tide will flow in the current direction. I'd say at least until the US stumbles its way to some kind of deal on the fiscal cliff and the debt ceiling. And until the Bank of Japan and the new Japanese government reach some kind of accommodation. And until the February elections in Italy prove really dysfunctional.
The flows could continue in the euro's direction for longer than that if US negotiations break down long enough to lead to a downgrade of the US credit rating. Or if the Bank of Japan caves in to the new government and starts to stimulate at the high level needed to get inflation to 2%. Or if Berlusconi throws his support back to Prime Minister Mario Monti and his technocrats, and the February elections in Italy restore the status quo.
The Biggest Impact
I've mentioned the effect of a strong euro/weak yen-dollar tide on improving sales for weak-currency exporters, and improving quarterly earnings for Japanese and US companies that will translate stronger sales in stronger euros back into weaker yen and dollars. And I've mentioned that a weaker dollar would push up the prices of commodities such as oil, copper, and gold.
But the biggest effect would be on global cash flows into commodity-based economies and emerging markets. Low interest rates in the United States and Japan, and a reasonably reliable expectation that the yen and the dollar will continue to slide (even if only slightly), will power a carry trade that will send hot money into financial assets in countries such as China, Brazil, and Australia.
Look at the interest rate differentials: The benchmark short-term interest rate is at 0% to 0.25% in the United States and Japan—and 3% in Australia, 7.25% in Brazil, and 6% in China.
If you can borrow at low rates in the United States and Japan, and then invest at high rates in Australia, Brazil, or China, who wouldn't? Especially if the currency trend is flowing against the yen and the dollar, so that you're likely to have to pay your loans back tomorrow in yen and dollars that are worth less than they are today.
There's some evidence that we're already seeing fast-money flows into Hong Kong. Hong Kong's Hang Seng Index is up 17.7% since the September 5 low, and 6.8% from last month's low on November 15.
And it looks as if China's government is interested in capturing more of that overseas hot money for its Hong Kong and Shanghai markets. On December 13, the head of the Hong Kong Monetary Authority said that China may relax or abolish rules that require the biggest of overseas investors to keep most of their money in bonds. On December 14, China did abolish the current $1 billion ceiling for investments from sovereign wealth funds and overseas central banks.
How long countries such as China and Brazil will welcome these hot money flows is an open question. These cash flows push up the price of local currencies—albeit very gradually in China—which takes a competitive bite out of local exports.
At some point, that damage to local business can produce interventions in the currency markets. We might see countries selling reserves of their own currencies in the markets in an effort to drive down their currency's price.
For example, Brazil has already warned the United States that the Fed's new round of quantitative easing risks a renewal of global currency wars. Since 2010, Brazil has used measures to control the appreciation of the real whenever its strength sufficiently threatened Brazilian exports. The real ended last week at 2.086 to the dollar. That's roughly a third below the currency's July 2011 peak of 1.52 to the dollar.
This is why the question of how long and strong the tide will run in the euro's favor is critical to determining the effect of a stronger euro and weaker yen/dollar. If the move looks temporary and unlikely to run much further, I think countries like Brazil and China will take only minimal steps to protect their exports. Without those steps, the strong euro is a tide that is likely to lift the prices of financial assets in those markets—and in commodity economies such as Australia and Canada.
But if the tide shows no signs of moderation by, say, February, then I think we could see moves by developing economies that would aim to weaken their own currencies to keep up with a falling yen/dollar.
That would add significant crosscurrents to global cash flows and make it much harder for investors to figure out exactly how the currency tides toward the euro, and away from the yen/dollar, will play out in the prices of global stocks and bonds.Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund owned shares of Johnson Controls as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund's portfolio here.