| Euro is still undervalued |
Back |
| Since the start of May, we have seen the euro rally from 0.91 to within touching distance of parity with the US dollar. What has caused this 10 per cent appreciation? And where will it end? Niall Dunne says the cause can be expressed in one short phrase: it’s a crisis of confidence. Where it will end is more difficult to predict. |
Back at the start of the year when bullish forecasters were proclaiming that the US economy had come through a recession unscathed, and that the US economy would be the engine of global economic recovery in the year 2002, I was a member of a small minority who disagreed. I warned that the US recovery would be prolonged and moderate at best, because I was concerned that the excesses that had developed in the US economic system during the bull market of the 90’s had not been eradicated by what was proving to be a mild downturn. Unfortunately for us all, that pessimistic forecast has turned out to be accurate.
So where to begin? The market has long known that the USD is overvalued. Purchase power parity studies suggest that a fair exchange rate between the euro and the USD lies in the 1.10 to 1.20 range (you may remember that the ECB chose to launch the euro at 1.17 back in 1998). Subsequently the USD strengthened until the euro was only worth 0.82 USD, in October 2000. The market always knew this was a gross overvaluation, but it’s only recently that the correction has begun.
The trigger for this rally can’t be pinpointed to any one specific moment in time, but the first crack in investor confidence arose because of the US’s Current Account Deficit. In February we started to warn our customers that the size of the trade deficit was becoming unsustainable in the US. Essentially, a country runs a deficit when it spends more abroad than it earns abroad, or when a country imports more than it exports. By March, the US found itself in a situation where it was relying on foreign investors to purchase almost $2 billion worth of USD denominated securities on every trading day, just to keep its deficit from expanding. The US became a massive net importer of goods and services from the rest of the world in the ‘90s (thanks to the strong USD), and had it not been for our voracious appetite for USDs at the time, the market would have been flooded with excess dollars and the exchange rate would have weakened.
But in the ‘90s, we all wanted to be part of the longest bull market in history, and all excess USD’s were soaked up, which sustained the USD’s strength. In February we warned that this level of reliance on external investor’s appetite for US assets was going to cause the USD to weaken, because we believed that as recovery took hold globally, other assets (namely Eurozone and Asian) would start to offer more attractive returns to investors, and funds would begin to divert away from the US. Figures released recently prove this thesis was correct - Eurozone Institutions cut their investment in US equities by 60 per cent in 2001, while the reduction in investment in US Bonds fell by a staggering 89 per cent in the same year, according to the ECB.
With this in mind, I called for an appreciation of the euro in 2002. However, we were not to know of the scandals that were to break. It all began innocuously, with the collapse of Tyco in Houston, Texas. Initially, the market discounted the news as an isolated incident, but we feared that Tyco would prove to be the tip of the iceberg, that would send investors scrambling for safe-havens away from US assets. Sadly, corrupt governance and accountancy malpractice now appear to have been endemic in Corporate America, and markets across the world have suffered by association, irrespective of guilt.
And recent initiatives to restore investor confidence have failed. President Bush’s proposals have fallen on deaf ears, since it has emerged that he engaged in precisely the activities he is criticising now, when he sat on the board of a Texas energy concern in the late ‘90s. Additional criminal investigations for fraud are announced every day, and some in the market are speculating that confidence cannot be restored until early next year, when company’s full year accounts are audited under new, more stringent guidelines.
So that’s how we got here. The market held unwavering confidence in the US economic miracle while the bull roared, and it only began to ask questions when the bear growled. The question that must be asked now is what lies ahead?
I for one still believe the euro is undervalued. And I have reason to believe it is set to break parity. In a very significant, yet not widely reported statement, Bush recently said that the appropriate exchange rate for the USD should be left up to the market to decide. This effectively killed the US Treasury’s stated ‘strong dollar policy’ in one blow. Perhaps the US has finally realised that when you have to introduce import tariffs to sustain your domestic industry, then your currency is too strong.
And the one concrete measure that Bush introduced in an attempt to alleviate investor’s concerns might actually prove to be the stimulus that sees the euro break parity. Bush has declared that all Executives with responsibility for financial statements must be willing to attest to the accuracy of those statements by August 15th, or else face harsh penalties. Further investigations and earnings revisions seem inevitable with this deadline looming, and they might well see the market trade lower, and provide the impetus for the euro to break parity.
Perhaps even more frighteningly, the equity market is still overvalued from a historical perspective. The S&P 500 is trading at a price earnings multiple in the low 20s, which is expensive against an average P/E multiple of 15 for the last 30 years. This suggests that the market could fall further.
Yet some observers argue that the stock market is not an accurate reflection of the real economy. On that basis they say that the USD will not collapse because the real US economy still shows signs of health. If only that were so. Second quarter growth has markedly slowed when compared to Q1 in the US, unemployment is still rising, and consumer confidence is shaken because Middle America is seeing its wealth evaporate as the market tumbles. On this basis I can now forecast that the US Federal Reserve will not even risk raising interest rates this year; there is even an outside chance that they will be forced to cut again if the equity market collapses.
So how does this impact us?
Well, I forecast that the euro will break parity before the mid-August deadline discussed above. Foreign exchange markets are often driven by psychology - and as a result moves tend to be over-exaggerated. As a result, if the euro does break the key psychological level, it could rapidly rally toward 1.10. However, I don’t think that will be allowed happen. If the euro rallied so sharply, both the Eurozone and the US would suffer as a result. The Eurozone has benefited from the recent appreciation because it has eased Eurozone inflationary pressures, and allowed the ECB to keep rates at low, growth encouraging levels. But if it rises significantly beyond parity, it would start to hurt Eurozone exports. The head of the IMF recently suggested that a ‘disorderly’ collapse in the USD would be detrimental to the market as a whole, and traders now fear that any moves significantly beyond parity would trigger intervention to halt the fall. Yet with more corporate scandals set to emerge, with the equity market falling, and with real-economy indicators also disappointing, I think that the euro will trade higher in the months ahead. For year-end, I now forecast a EUR/USD rate of 1.03.
(Please note that this article was written before July 15th). |
Niall Dunne is a treasury economist in Ulster Bank.
|
| Article appeared in the July 2002 issue.
|
|
|
