the recent EMU numbers are ugly
The euro peaked against the $US on November 25, 2009 at a rate of 1€ = US$1.5139. It now stands at 1€ = $1.2464, which is a decline of 18%. Over that same time frame, the S&P 500 is up about 4%. In contrast, the MSCI EMU (= European Monetary Union) index is down about 2% in euros and just about 20% in dollars.
we all know why
In the simplest terms, the EU was created to give Europe the economic heft it needed to compete with the United States. A side benefit was that it raised Europe’s standard of living by breaking down the then-ubiquitous border controls that inhibited intra-European commerce.
One key feature of the EU is that it is a monetary union, but leaves the determination of the level of government spending to the individual member countries. The rules for attaining membership required that candidate countries display economic solvency and a minimum level of fiscal prudence in spending. The tacit assumption was that any country that made the effort to walk the straight and narrow path in order to get into the union would continue to do so afterward. That, of course, has turned out to be wrong.
This is not 100% the members’ fault. The EU got things off on the wrong foot by running a money policy that was too loose of the smaller countries. It did so to aid Germany, the union’s largest member, cope with a “lost decade” of economic performance as it dealt with the reintegration of East and West, as well as a chronic problem of too expensive labor. Then, of course, it bent the rules to let Greece in and, generally speaking, turned a blind eye to excesses in places like Ireland, Spain and Portugal.
The current crisis was sparked by revelations late last year that Greece had falsified its national accounts over an extended period, thereby allowing it to run up an amount of government debt so large that it’s hard to see how Greece could ever pay it back. EU rules said no bailouts allowed. Kicking Greece out wouldn’t solve anything either, since investors would start to worry that, say, Portugal might be next to be tossed overboard and the funding crisis would migrate there. In fact, markets quickly coined the acronym PIGS (Portugal, Ireland, Greece, Spain) to refer to the EU situation. Violent demonstrations in Greece to protest proposed cutbacks in Greek government spending also raised the worry that Greek citizens had no intention of trying to repay the bills they had run up.
where are we today?
Greece is being bailed out by the rest of the EU, with some help from the Federal Reserve in the US. Portugal and Spain have announced austerity measures. We’re probably on the road to greater fiscal integration in the EU as a way of preventing the Greek situation from occurring again elsewhere.
As the figures in the first paragraph above show, the euro has been crushed. And we should probably expect that economic growth in the EU will be sub-par as formerly profligate governments pare back their spending.
bonds vs stocks
This bad news has expressed itself almost entirely in weakness in the euro and falls in government bond prices. Other than the fact that all the negatives appear to be out on the table now–and therefore one would think that they’re to a great extent already factored into today’s securities prices–this is a real disaster for foreign holders of EU government bonds.
It hasn’t been fun for holders of EU stocks, either. But for the latter, there’s a potential silver lining. About half the earnings of publicly traded EU stocks come from subsidiaries located outside Europe. For those firms, profit growth is going to be surprisingly strong over the coming year. So, too, will gains for export-oriented and import-competing businesses within the EU. On top of that, a currency drop acts somewhat like a decline in interest rates–not only rearranging the composition of domestic growth but adding to it for a while.
Typically, in a case like this the currency moves first and stocks only begin to discount the new realities a month or two later. I haven’t done an exhaustive check, but from the names I’ve looked at, it seems to me that stock market investors are still in shock from recent events and haven’t done much work in figuring out the plusses of the new reality.
Now is the time to do so, in my opinion.
There is a risk to this idea, however–apart from the normal uncertainties surrounding any investment in equities. I think the big political and emotional crisis over the stability of the EU structure is pretty much over as far as the financial markets are concerned. So it’s safe to go in and pick up the pieces. In this regard, I see Euroland now as in somewhat the same position today as the US was a year ago. Valuations are, of course, much higher, so the absolute returns won’t be as great if I’m correct. The point of comparison is the different pattern of stock performance for domestic-only (= bad) and multinational/export-oriented (= good) that the US has shown since march 2009.
If, on the other hand, if you think we’re only in the eye of the storm, it’s much too soon to act.