The Euro Is in Trouble

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As an EU-area passport holder, I love the idea of a united Europe -- but I'm very bearish on the euro itself.

The euro-to-dollar rate has slid from $1.60 last summer to around $1.25 recently. I believe it will continue to sink lower in the future -- possibly all the way to dollar-parity ($1 = 1 euro).

A primer on Europe
Europe has a very cyclical economy. Germany, the biggest EU member, relies on exports -- its trade surplus is more than $300 billion -- which are drying up in the current global slowdown. Unemployment has been rising lately, too. All those wonderful places that had real-estate-booms-turned-real-estate-busts, such as Spain and Ireland, are also pulling the economy lower.

Euro-zone countries will likely have to pay for much of the cleanup in Eastern Europe -- cleanup that, in my opinion, is beginning to look more and more like Asia around 1997, at the onset of a major financial crisis.

Earlier this year, I wrote about what to avoid in emerging markets. One of the key measures was to stay away from countries that had more short-term obligations than reserves. Among the weakest of those countries are Hungary, Slovakia, Romania, Bulgaria, Ukraine, the Czech Republic, and Croatia -- all in Eastern Europe.

Looking across the continent
From what I've seen and heard, the picture is very similar all over Eastern Europe: high current account deficits, fixed or inflexible exchange rates, and a flight of speculative capital that is putting big strains on the fragile banking systems. Where the exchange rates do float, they've declined quite a bit -- even though central banks have intervened aggressively to maintain an orderly exodus.

Over just the past six months, Poland's zloty is down 28% against the euro, Hungary's forint has declined by 21%, Romania's leu by 18%, and the Czech koruna by 12%. At the same time, the euro itself is down sharply against the dollar, as the European Union's budget deficits are forecast to rise from 2% to 4.4%.

Purchasing power parity is higher for the euro than it is for the dollar. It takes 0.85 euros to buy in Germany what a dollar buys in the U.S. -- against 0.91 euros in France, and 0.94 euros in Ireland. That's out of balance with an exchange rate of about 0.80 euros to the dollar.

But keep in mind that purchasing power parity and exchange rates can diverge dramatically. Last summer, the euro was massively overvalued -- but given the economic problems I foresee in Europe, I think it could swing to being massively undervalued. Although 1:1 parity would be a big move, let's not forget that the euro has been as low as $0.82.

You can trade the euro via the CurrencyShares Euro Trust (NYSE: FXE  ) , but given my outlook, I would not recommend any long positions -- and only sophisticated investors should deal in short-selling. With the euro down so far since last July, countertrend rallies are to be expected. For instance, late last year, the euro jumped from $1.24 to $1.45 right around the time the Federal Reserve lowered the federal funds rate to its current range of 0 to 0.25%.

In my view, the next cuts will come in the euro refinancing rate, courtesy of weak economic data from the region. This will shrink the euro's current interest rate advantage, pushing the currency down. That would make betting on leveraged currency ETFs like Proshares Ultrashort Euro (NYSE: EUO  ) the right move, although such ETFs carry big risks.

The effect on stocks
International investors have to be careful with European stocks, since a big drop in the euro could cut 20% or more off your returns over the next 12 to 18 months. For example, although European exporters like Daimler (NYSE: DAI  ) and BMW (Other OTC: BAMXF.PK) often get a boost from a weaker home currency, U.S.-based investors could see a net loss in dollar terms.

In contrast, multinational companies in the U.S., such as Oracle (Nasdaq: ORCL  ) , McDonald's (NYSE: MCD  ) , and Campbell Soup (NYSE: CPB  ) , have suffered lately because of a strong dollar. Yet those negative effects should be offset by the fact that their share price is also measured in stronger dollars.

If you invest abroad, you must stay aware of how currency moves affect you. If you're not careful, they can often turn what would be a gain into a loss.

More on currencies:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. BMW is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (14)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 18, 2009, at 2:23 PM, sim7396 wrote:

    "Europe has a very cyclical economy." Wise words, that's absolutely true. Other very cyclical economies are the US, Japan, China, Latin America, Australia, the Middle East, India, hey wait! The whole world economy is very cyclical! Duh

  • Report this Comment On March 26, 2009, at 2:26 PM, ivanmartchev wrote:

    Thank you for the insightful comment.

  • Report this Comment On July 07, 2009, at 11:29 PM, koba wrote:

    It's July now... As of today, 1 EUR equals to ~1.39 USD, what's the possibility of sinking lower in the future to the dollar-parity ($1 = 1 euro) ? ;)


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