Euro Weakness: "It's the Dollar, Stupid"

The Euro-gloom that prevailed early last summer, in sharp contrast to the Euro-phoria that had accompanied the new European currency’s launch only seven months earlier, proved irresistible. We purchased some Euros after its fall to near-parity with the US dollar. However, after a three-month rally, the Euro resumed its slide, losing another 10% or so since our initial purchase.

Timing currency fluctuations has never been our strength, but our contrarian long-term approach has a decent record of anticipating major shifts in trends. Our 1995 report The Decade of the Dollar, though early by a number of months, was eventually followed by a sharp and extended rally of the US currency.

Source: Prof. W. Antweiler
Faculty of Commerce and Business Administration
University of British Columbia
2053 Main Mall, Vancouver, BC, V6T 1Z2 - Canada

Contrarian Prerequisites

Three elements are required to make a successful contrarian investment call -- though, as we have demonstrated, none ensures a precise timing.

1.  An aging trend. The passage of time is essential. It allows even the most ignorant groupies to acquire the superficial luster of theoretical knowledge that will help them justify decisions really based on momentum investing.

An aging trend also will have discouraged all but the most opinionated dissenters. In a declining price trend for example, many early contrarians will reluctantly sell their positions close to the bottom, thus amplifying the later stages of the decline. Since Europe’s currencies have been weak against the dollar for five years, this first requirement is easily filled.

2.  A deepening consensus of expert opinions. Since serious academic work requires ample historical and statistical data, well-documented arguments explaining a trend only become available late in the cycle – usually not too long before the trend reverses itself. In addition, while authoritative views on both sides of any trend exist at all times, the dissenting ones seldom get publicized until after turnarounds because the media find it easier and more profitable to sensationalize trends than to question them.

In recent weeks, well-documented articles by credible authors have proliferated in prestigious publications, explaining why the Euro has been weak and should be. Now, less admirable media are making up for their lack of depth with greater sensationalism.

3.  “Straws in the wind.” Often, contrary arguments cannot be as solidly documented as those extrapolating a trend because the contrarian looks forward, rather than backward. Of course, when everyone says it’s raining it can be dangerous to go out without an umbrella. If the weight of evidence of a trend reversal has not even started to build, the thoughtful contrarian should look elsewhere. In the case of the Euro, however, we believe that there are enough straws in the wind to build the outline of a bullish case.

Old Saws

Most of today’s arguments against the Euro have existed since well before the currency’s birth. It is an artificial, political concoction not rooted in profound national aspirations, as money should be. Instead, politicians force-fed it to reluctant populations by imposing common monetary and policy targets onto countries with inherently different growth potentials and economic fundamentals. These targets, budgetary ones in particular, were often achieved by fudging the figures.

Importantly, the Euro is not even a true currency, yet – merely an accounting basket of national units from highly disparate countries. As expected, now that some economies at the periphery of the Euro zone are already overheating while the large core economies are just picking up steam, the European Central Bank is finding it difficult to conduct one policy accommodating all its members.

As if all these handicaps were not enough, the new currency’s credibility has been further eroded by poor communication from the European Central Bank, as well as by often contradictory statements from still-active national central banks. Finally, the prospect of further enlarging the Euro zone by co-opting new, less-developed members (such as Greece and Poland) has diluted the virtuous aura initially bestowed upon the Euro by Germany’s forty-year record of price stability.

But all these arguments had been amply aired even before the Euro’s birth, in 1999, contributing to the widespread skepticism that surrounded the currency’s creation. (I, too, doubted a successful introduction until discussions with European political and business leaders people convinced me that the process had become irreversible). So, it is unlikely that the new currency’s recent decline can be attributed solely to these weaknesses.

Europe Improving Beyond Expectations

Signs of improvement in Europe’s economic climate have been building up in recent months. Unemployment is declining across the region, industrial production is rising, both consumer and business confidence surveys have been getting stronger, and leading economic indicators are pointing to further acceleration. Forecasts of GDP growth for the region, which only a few months ago hovered around 3%, are now approaching 4%. Meanwhile, reflecting global conditions, inflationary pressures have so far remained subdued.

On the surface, at least, Europe’s economic aggregates seem in better balance than those of the United States: government budgets, while still in deficit, have been improving and trade balances are generally positive.

True, this is partly due to the fact that Europe’s expansion is at an earlier stage than that of the United States. Also, the stimulus resulting from the Euro’s weakness and its boost to exports cannot be ignored. Still, domestic demand has been picking up, and investment projects are showing some life as well.

Currencies’ New Paradigm

Until the 1980s, international capital flows were broadly determined by trade performance. A country with a current-account deficit, for example, would need to attract capital flows equal to its commercial deficit to balance its overall payments.

But this situation really was a remnant of the fixed exchange rate system that had prevailed until the early 1970s. Under that system, a country could easily attract international capital to its currency by raising interest rates, since the prospect of higher returns came without commensurate currency risk.

The increasing volatility of currencies and the gigantic development of international financial markets, in the 1980s and 1990s, have turned this old paradigm upside down. Today, international capital flows dwarf commercial flows, and international investors constantly move money around the globe in search of the best available returns. As a result, it is capital flows that now determine trade results. If international capital floods into a country, it boosts local demand and investment along with the currency: the higher demand for imports and reduced competitiveness eventually cause the recipient country’s trade balance to deteriorate.

The most striking example of this new paradigm is the United States, whose trade balance has fallen into ever-greater deficits without effect on the dollar’s unrelenting strength. That strength, in turn, can be traced directly to the apparently limitless investment opportunities offered by America’s “new economy,” and the ease of investing in it through the world’s most agile and creative financial markets.

New-Age Traders, Prehistoric Reflexes

In this context, the continued fascination of new-age traders with interest rates as an indicator of future foreign-exchange trends is astonishing. In a world where major currencies can fluctuate against each other by more than 30% in a year – as the dollar, the Euro and the Yen have recently done – how attractive can the prospect of marginally higher interest returns be?

Yet, traders and currency market seers keep looking at higher interest rates as the main determinant of exchange rates. Of course, given their combined purchasing (or selling) power, their views tend to be self-fulfilling for a while. But Mr. Greenspan, clearly, does not feel that way. In fact, we suspect that he rightly views the strong dollar as a consequence of the US economy’s overheating, so that there is no contradiction for him in raising interest rates in the face of an overvalued currency. Now that other economies seem to have gained enough momentum of their own, success in slowing down America’s economy with higher interest rates should also weaken the dollar.

Structural Weaknesses

There has always been a tendency to look at a currency’s strength or weakness as a one-sided affair. Again today, to justify the Euro’s weakness, analysts are focusing primarily on the inadequacies of the European Monetary Union or the problems of its member countries.

Most recently, analysts have pointed to slow progress on structural reform as the main impediment to Europe’s effort to join into the US-led economic boom of the last several years. This is no surprise, since it could hardly be expected that adding a huge layer of bureaucracy in Brussels to the already oversized national administrations of member countries would improve the efficiency and responsiveness of the region’s economy.

To quote from a recent Goldman Sachs report: “A large part of the Euroland population and many governments have regarded highly progressive tax systems, comprehensive social security, dense product and service regulations, significant participation of governments in private enterprise, and elaborate labor market regulations as important achievements against exploitation by unrestrained capitalists. By contrast, most companies have regarded these features of the Euroland economy as severe impediments to economic growth and urged less government interference in private enterprise. However, since they have had little hope to convince the electorates and the politicians of their point of view, they have often voted with their feet … and invested abroad.”

Better Late Than Never

It is true that the United States has led Europe and Japan in many areas, as a magnet for global investment. The explosion of new businesses and investment opportunities generated by the Internet, networking and telecommunication revolutions has dwarfed those in other regions. Europe, in contrast, has been slower to jump into these new arenas – in part because its populations and businesses were less “wired,” and in part because Europe’s governments viewed with great suspicion the development of largely unregulated markets with minimal government participation.

But the fact is that Europe’s economies are now recovering and, with them, the attractiveness of local investment opportunities. While it is hard to credit government policies for the economic turnarounds in France and Germany, for example, a rising tide lifts all boats. Increased tax receipts and personal incomes, for example, are beginning to unlock some of the structural bounds that have plagued these two countries: taxes are being cut, unemployment costs are coming down, some concessions are wrestled out of labor unions, and the mood toward excess regulation is changing along with the local development of the “new economy”.

As can be seen, many of the elements contributing to Europe’s improvement are inter-related. This is not unusual, as factors that contribute to the strength and equilibrium of economies (or vice versa) tend to feed onto each other to produce long virtuous or vicious cycles.

It’s The Dollar, Stupid

All these improving signals have been visible for a while, but with no visible benefit to the Euro, which has continued to slide against the dollar (and the yen). The main reason has been that the performance of the United States economy has been even stronger -- probably unsustainably so.

In our view, the US boom cannot possibly continue at its recent torrid pace. Even in the absence of a tighter monetary stance by the Federal Reserve, it would have cooled down. The recent collapse of many heretofore high-flying NASDAQ stocks is a mere preliminary tremor. Not only is the stock market not out of the woods yet – as we have argued before -- but the piercing of the financial bubble is likely to affect the economy as well. Already, many hedge funds that had significantly contributed to currency volatility are either closing or getting religion – as with the transformation of Mr. Soros’ hyper-speculative Quantum Fund into an “endowment” fund.

As this happens, a vicious circle is likely to replace the virtuous circle of the last several years. US profit margins will shrink with a slowing economy, unit costs will rise along with inflationary pressures, and investment in America (both financial and industrial) will become less attractive.

Source: Prof. W. Antweiler
Faculty of Commerce and Business Administration
University of British Columbia
2053 Main Mall, Vancouver, BC, V6T 1Z2 - Canada

The dollar is about to weaken. The main question, from an investor’s point of view, is “weaken against what?” It has already lost significant ground against the Japanese yen, which tends to fluctuate based on hard-to-predict technical factors. This leaves the Euro and, possibly, gold as credible alternatives (a gracious plug for our partner John Hathaway’s Tocqueville Gold Fund). The first shoe to drop was the improvement in the Euro’s fundamentals, which we described. Don’t look to Europe for the other shoe: it will drop in the United States, with the deflating of unrealistic investors’ expectations.