For the last month I have been travelling through Europe and I am always surprised at how beautiful that part of the world is, however this time I was also surprised by the painful strength of the Euro. In some countries, what used to be a good price for food, lodging, and products has now become an extravagance. What was interesting was that depending on what country I was in, Europeans viewed the health of the European economy differently, and this is one of the fundamental issues the EU is facing right now. When the EU has to balance political interests and economic needs with countries like Germany, the U.K., along with sputtering economies like Spain, Italy, Portugal, Greece, and France, the European Central Bank (ECB) finds itself with a big dilemma. One thing that is clear is that the U.S. Federal Reserve (FED) and the ECB are both running into a stagflation type scenario. For those of you that aren't familiar with stagflation, it is a period of inflation combined with stagnation, meaning slow economic growth with rising unemployment. The last time there was global stagflation was in the 1970's during the last oil crisis. Coincidence?
Don't fool yourself. The word stagflation started getting brought up again about this time last year, and in the last 12 months the FED has made historical moves to try to prevent it and stop a recession with rate cuts and other drastic measures. The positive results of these moves are still not showing up and unfortunately inflation is starting to creep up. Europe on the other hand hasn't played all of its cards and is in a situation where it needs to do something like start printing more money or reduce interest rates to keep the economy going. However, the side effect of this is that these moves will weaken the Euro and therefore cause prices to rise; hence inflation. We could discuss this for another 10 pages, but many analysts are starting to concur that the only direction the Euro can go is down. This is because either the ECB will take measures that will either devalue the Euro, or by not acting the economy will start slowing down which will also devalue the Euro. Couple this with the fact that Chinese and Indian investors are starting to invest more in their own countries, therefore pulling out more dollars from European and U.S. treasuries. There is also additional political pressure with the recent rejection by Ireland of the Treaty of Lisbon. This rejection has reinforced the concern that there can be no economic integration unless the countries are actually politically integrated. Put this all together and the Euro loses a touch of its sheen. In fact, many analysts are calling for the Euro to be on par with the dollar within the next five years.
So now that I have made my case for the euro to fall long term, what opportunities exist in U.S. investing for an investor that is holding Euros? An investor that is holding Euros has an opportunity for a dual effect of making a return on a U.S. dollar investment and also reaping the benefits of a contracting currency spread. As an example, if you converted 100,000 Euros to U.S. dollars you would end up with about U.S. $155,000. If you took that $155,000 and invested it for the next 3 years at a 7% compounded return, you would end up with about $190,000. If the investment returned 9% compounded, it would give you just over $200,000. Then, if we saw the Euro come down 20% over the next 3 years against the dollar and converted our $190,000 back into Euros, we would have ¬146,680. All in all our 7% investment return would yield a profit after the exchange of ¬46,000, or 15.5%. Our 9% return would yield a profit of ¬54,400, or 18%. In both cases by exchanging Euros for a U.S. dollar investment the net effect of the exchange doubles the expected rate of return.
The only way for the above scenario to work is to assure that the investment you choose will be one that provides a steady return, such as investment income that can be re-invested, and that the investment also is structured to protect the principal. Without these two important ingredients the above investment scenario will be in vain. Also, receiving the return as investment income that is paid either quarterly or semi-annually will give the risk adverse investor the ability to convert the currency on the way down.
All of the above is important to keep in mind when compared to investing Euros within Europe. Some investors may be thinking that Europe is insulated from what is happening in the U.S. and there is too much risk involved with U.S. investing for steady investment income and a capital gain after conversion. What has become clear is that globalization has made the world smaller, interdependent, and the laws of cause and effect are playing out from one side of the globe to the other. It is important to not underestimate how Europe is starting to feel the effects of the U.S. situation. Many of my colleagues in Europe are reporting that mortgages are becoming more difficult to obtain as the affects of the U.S. credit crisis have also tightened lending standards abroad. The only major difference so far is that, unlike the U.S. where housing fell off a peak, the European real estate market seems to have instead hit a plateau. This will hopefully create a basis for a cyclical slowdown in Europe instead of a bubble bursting like the U.S. I think it would be hard to find detractors that the world, its economy, and the system that is driving it all are changing. If we don't change our investing mindset with it, we risk becoming the typewriter in a computer world
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