The Outlook For The Overvalued Euro

Russ Koesterich:  Now that a second Greek bailout deal has been reached, I’m getting lots of questions from investors about my outlook for the euro currency. The questions run the gamut from whether Greece will remain in the euro bloc to how the euro will likely perform going forward.

First, in regards to whether Greece will remain in the euro or not, the latest Greek bailout agreement, announced earlier this week, certainly mitigates the short-term risks of Greece exiting the euro and of a disorderly Greek default. In my opinion, Greece is likely to stay in the euro currency union, at least for now.

Still, looking forward, Greece has significant obstacles to overcome if the euro is going to remain its currency in the long term and if it’s going to avoid an eventual default. These challenges include a rapidly shrinking economy that will find it increasingly harder to repay its obligations; a still sizable debt burden even after recent write-offs; and growing social frustration with a prolonged recession and austerity.

Now, as to the value of the euro, the bailout agreement actually had little immediate impact on the currency’s value. Investors, it appears, had already been expecting the deal. But currently, I believe the euro appears overvalued, at least as compared to the US dollar, and is likely to weaken over the course of this year.

The chart below nicely demonstrates how the euro has become more overvalued against the dollar this year so far. It shows the trend of the dollars-per-euro nominal exchange rate divided by the purchasing power implied exchange rate, i.e. the nominal exchange rate adjusted for price levels in Europe and the United States. If the euro was not overvalued, you would expect the line in the chart to be flat at 0%.

One explanation for the euro becoming more overvalued versus the dollar is that the euro has been the ironic beneficiary of the deleveraging of the European banking sector as banks have been selling foreign assets and repatriating back into euros.

Another likely explanation is that the Federal Reserve is seen by many investors as more aggressively pursuing unconventional monetary policy than the European Central Bank (ECB). Until it started buying peripheral bonds last fall, the ECB didn’t take part in any quantitative easing, unlike the Fed. In addition, the ECB has held interest rates higher longer than the Federal Reserve to combat inflation, though this is expected to change as the bank looks to support growth.

As such, the euro is likely to weaken versus the dollar in 2012 as the ECB continues to loosen monetary policy and the European Union struggles with a recession. What does this mean for investors? A weaker euro will help cushion the European economies and provide a tailwind for Europe’s export and manufacturing sectors. Germany, due to its strong manufacturing sector, is likely to be the biggest beneficiary (potential iShares solution: iShares MSCI Germany Index Fund (NYSEArca:EWG)).

Source: Bloomberg (on the chart as well)

The author is long EWG

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility.

Written By Russ Koesterich From The iShares Blog 

Russ  Koesterich, CFA, is the iShares Global Chief Investment  Strategist as  well as the Global Head of Investment Strategy for  BlackRock Scientific  Active Equities. Russ initially joined the firm  (originally Barclays  Global Investors) in 2005 as a Senior Portfolio  Manager in the US  Market Neutral Group. Prior to joining BGI, Russ  managed several  research groups focused on quantitative and top down  strategy. Russ  began his career at Instinet in New York, where he  occupied several  positions in research, including Director of Investment  Strategy for  both US and European research. In addition, Russ served as  Chief North  American Strategist for State Street Bank in Boston.

Russ holds a JD from Boston College Law School, an MBA from Columbia  Business School, and is a holder of the CFA designation. He is also a  frequent  contributor to the Wall Street Journal, New York Times,  Associated  Press, as well as CNBC and Bloomberg Television. In 2008,  Russ published  “The ETF Strategist”(Portfolio Books) focusing on using exchange traded funds to manage risk and return within a portfolio.

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