the shrinking euro (and yen)

the shrinking euro

This time a year ago, it cost $1.36 to buy a euro.  It was $1.39 by March.   The euro then moved sideways vs. the greenback until early summer–when it began an almost continual descent that has the EU currency now trading at just above $1.19.  That figure is down 14% from the 2014 high, and off 12.5% from the year-ago level.

reasons?  

The surprising revelation last summer that the overall EU economy was slowing, not accelerating as most observers, myself included, had expected is the most important, I think.  Sanctions against Russia and recent worries that a new Greek government might repudiate its sovereign debt have just added to the funk.

The Japanese yen has tracked more or less the same course vs. the dollar as the euro–meaning that neither Japan nor the EU has gained/lost competitiveness vs. its main global manufacturing rival.

Looking at the situation from a more conceptual level, both Japan and the EU have relatively old populations and both give much higher priority to preserving their traditional social order than to achieving economic progress.  Neither characteristic argues for long-term economic/currency strength.

consequences

economic

In the short run, currency declines stimulate overall economic activity.  They also rearrange growth to favor exporters, import-competing industries and service industries like tourism.  This means that local currency profits for firms that have their costs in euros and revenues in harder currencies will likely be higher than generally anticipated.

The huge fall in oil prices will still be stimulative, but the edge will be taken off the benefit a bit by the currency decline.

Euro-oriented holders of dollar-denominated assets benefit; dollar-oriented holders of euro assets are hurt.

financial markets

I expect European bond managers will continue to boost their holdings of US Treasuries, figuring they’ll get both yield pickup and an anticipated currency gain.  This flow will keep long-term interest rates in the US a bit lower than they would be otherwise.

Equity managers will shift European holdings more toward multinational firms with dollar-denominated assets and earnings.  Some of this has happened already.  Many times, though, PMs will wait until they see the weak currency stabilize before reallocating.  Personally, I don’t think waiting makes any sense, but that’s what people seem to do.

US firms with European assets and earnings will face the double negative of slow growth in the EU and the diminished value of EU profits in dollars.   I think US-based manufacturers of consumer staples are particularly at risk.

hedging

While the extent of the decline of the euro may be a surprise, the fact that it’s a weak currency shouldn’t be.  This means many US companies that have euro exposure will have hedged away part of this risk.

I have conflicting thoughts on this issue.  Almost universally, investors ignore profits gained by hedging.  The idea, which I agree with, is that in short order the favorable hedges will run out, exposing the weaker unerlying profit stream.  There’s no sense in paying for profits that will be gone in a quarter or two.  On the other hand, while firms always reveal hedges that have gone wrong (and argue that investors should ignore these losses), they don’t always highlight hedging that has worked.  I guess I’m saying that I’d be leery of companies with EU exposure even if reported profits don’t show any unfavorable impact.

 

 

 

recent world currency movements: stock market implications

dramatic changes

Although currency movements sometimes can often be overlooked by a stock market investor immersed in the hustle and bustle of day-to-day trading action, there have been a couple of whopping big moves in major currencies over the past half-year.

Since late July 2012, the euro has risen by 12.5% against the dollar.  Over the same time span, the yen has fallen by about 16.5% against the greenback.  A quick bit of multiplication tells us this also means that the euro has risen by about 30% against the Japanese currency.

To my mind, there’s no really satisfactory general economic theory about how currencies work.  But to give a sense of perspective, inflation in Japan has been, say, -1% on an annual basis over the second half of 2012.  We’ve had +1.5% in the US.  Euroland has experienced a 2.5% rise in the price level.  Inflation differentials imply that the yen should be rising against the dollar at a 2.5% annual rate and against the euro by 3.5%.  The euro, in turn, should have weakened by 1% against the dollar and 3.5% against the yen.  The actual outcome has been far different.

Of course, there are reasons for the spectacular assent of the euro and the plunge of the yen.  Until around mid-year, many observers thought Euroland was coming apart at the seams and rushed to get their money out before the demise.  I’m sure there was more than a touch of flight capital mixed in the outflows.  Thanks to Mario Monti’s and Angela Merkel’s actions indicating the political will to save the euro, capital flows have reversed in spectacular fashion.

Newly-elected Japanese Prime Minister Shinzo Abe made it a central plank of his campaign for office that he intends to force the Bank of Japan to print lots of money.  Why?   …to weaken the yen and to create inflation.  The move could easily end in eventual economic disaster, but for now its main effect has been to drive the Japanese currency down a lot versus its trading partners’.

stock market implications

Generally speaking, a rising currency acts to slow down the domestic economy.  A falling currency gives the economy a temporary boost.

Currency changes can also rearrange the relative growth rates of different sectors.  The best-positioned companies will be those that have their sales in the strongest currencies and their costs (e.g., labor, raw materials, manufacturing) in the weakest.

Japan

The decline of the yen has given Japanese export-oriented firms a gigantic relative cost advantage against European competitors, and a significant, though smaller, one against US rivals–or those located in any country that ties its currency to the US$.  Anyone who sells products in Japan that are imported, or made with imported raw materials, has been crushed.

We’ve seen this movie before, however, on a couple of occasions.  It’s ugly.  Domestic firms lose.  Exporters will make substantial profit gains in the local currency.  But from a stock market view, that plus–with the possible exception of the autos–will be offset for foreigners by currency losses they have/will endure on their holdings.  Stocks in even the most advantaged sectors will deliver little better than breakeven to a $ investor, and will certainly rack up large losses to anyone interested in € returns, in my view.

Euroland

The EU has already had a return-from-the-dead rally, where stocks of all stripes in the economically challenged areas of southern Europe have done well.  The message of the stronger currency is that importers, or purely domestic firms in defensive industries will fare the best from here.    Although I think the preferred place to be from a long-term perspective is owning high quality export-oriented industrials, the rise of the euro has blunted their near-term attractiveness.  One exception:  multinationals based in the UK, because sterling hasn’t participated in the euro’s rocketship ride.

Ideally, you’d want a firm that imports Japanese goods into the EU.

the US

Americans are less accustomed to thinking about currency effects that investors in other areas, where their effects are more pervasive.  With the dollar being in the middle between an appreciating euro and a depreciating yen, currency effects will be two-sided. Firms with large Japanese businesses, like luxury goods companies, will be losers.  Firms with large European assets and profits, like many staples companies, will be winners.  Tourism from the EU will be up, from Japan, down.  One odd effect, which I don’t see any obvious American publicly listed beneficiary–the decline in the yen is causing the cost of living for ordinary Japanese to rise sharply, since that country imports so many dollar-price raw materials.  To offset that effect, Japan is beginning to weaken protective barriers that have kept much cheaper finished goods (like food) from entering the Japanese market.  Doubly bad for Japanese farmers, though.