David R. Kotok
Chairman and Chief Investment Officer
July 2, 2010
Greece’s debt problems put the European Union and the euro zone on American investors’ radar screen. Sentiment quickly shifted against the euro and forecasts of the demise of the euro as a currency and the EU as a political entity abounded. One commentator called the euro “toast.”
Will this greater-EU economy of over 500 million people and of an economic size similar to the United States survive? Will the euro stabilize and improve? We think the answer in both cases is yes.
Motivation is an important element in understanding the EU and the euro. Simply put: for a thousand years, the Germans, the French, and their ancestors spent the better part of their energy and resources killing each other. Their history is a one of inflations and political reactions that changed governments. The most recent dramatic European example was the Weimar Republic hyperinflation that was followed by the rise of Nazism. It took the ashes of World War II to change the European view and fundamentally alter the course of history. France and Germany had a “rapprochement’ and decided to set aside war, for good.
As the post-war rebuilding advanced, political leaders in Europe launched a common market and expanded it to a wider economic zone. In 1992, they ratified a treaty that was negotiated at Maastricht, Netherlands. That treaty launched the euro. It became a currency in an official capacity on January 1, 1999 and expanded to full use in 2002. The euro is only a decade old.
During the development of the euro, it has traded in a range defined on the high side by over 1.50 dollars per euro to as low as 83 pennies per euro. The current foreign exchange rate is about in the middle at $1.20.
Meanwhile, the original 11 countries in the euro zone have expanded to 16. Estonia is destined to become number 17 on January 1, 2011. The trading relationships within the European Union have solidified. Gradual but persistent change has evolved into more open economies and more easily transparent commerce. Cross-border stock exchanges now exist. A shopper in one country can now go online and check prices in another country and drive across the border and shop in the neighboring mall if the price is more attractive. There is no border to cross, no currency to exchange, no transfer or import tax to pay. Travel and commerce between France and Germany and Poland is easier than between the US and Mexico and Canada.
So why are euro skeptics in control of the argument?
The euro zone is enduring its first major financial shock. Greece has failed to qualify in budget terms and has restated its official numbers several times. Greece is about 2% of the euro zone GDP. It is the most profligate budget violator. It has been caught by the market vigilantes. Its sovereign debt rating has been downgraded to “junk” status. It now is receiving financial help from a consortium of other EU members and financing help from the European Central Bank (ECB).
Other countries in southern Europe are victims by association. So markets fear a contagion, and therefore interest rates on the sovereign debt of those countries has risen, while the euro has lost about 20% of its value compared with the dollar.
What investors are missing is the positive impact on northern Europe. German manufacturers and exporters are booming. Dutch firms are, too. Poland is experiencing robust growth. The stock markets will reflect the benefit that those firms have received by the devaluation of the euro against the dollar. In our firm we have taken some of those positions to an overweight.
Investors must not confuse a currency adjustment with a stock market. The Germans got the benefit of the euro devaluation. The Greeks have to pay a price for their budget misbehavior.
Will the outcome be a good one for all of Europe? Certainly for the northern countries, whose business and personal income-tax rates are lower than in the US and whose productivity and profitability are growing sharply.
Will Greece and other southern European countries rein in their budgets and correct their imbalances? In most cases they are already starting to do so. If they succeed, the euro will be a battle-tested currency and resume its ascendancy as a world reserve. European leaders know why they must accomplish this task; they know that the old ways of inflations and war are unacceptable.
When investors realize that the outcome is positive, the stock markets of those successful countries will rise far higher. Valuations of European stocks call for their purchase now.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com