European Currencies Are Riding The Appreciation Wave

With the exception of a brief period in the mid-1980s, Europe has never been a cheap place to live. With the United Kingdom's pound breaking through the $2 level last week, London just might be the most expensive place on the planet for an American. The last time the pound breached this level was in the early years of Margaret Thatcher's term as prime minister in 1981 -- just a month before the marriage of Prince Charles and Lady Diana.

The strength of the euro (FXE) and the pound (FXB) may make traveling to Europe prohibitively expensive, but it's been a boon for U.S. dollar investors investing in European stocks. The German stock market has already returned 9.8% so far this year in local currency terms. But the appreciation of the euro has boosted that return to 14.4% for U.S. dollar investors. Europeans investing in the United States over the past few years have much more reason to be grumpy. Since the dollar peaked in 2000, the MSCI's U.S. index is up 7% in dollars, but down a whopping 35% in euros.

If currencies are a proxy for the stock of a country's economy, the steady rise of the euro and British pound against the U.S. dollar is one of the clearest signs yet that after years of stagnation, Europe's economy is back. The International Monetary Fund [IMF] predicts the eurozone economy will grow slightly faster than the U.S. economy this year -- 2.3% versus 2.2% -- which would be the first time that has happened since 2001. Interest rate movements also portend a stronger euro. With signs of inflation bubbling up in the eurozone, the European Central Bank has signaled its intent to increase interest rates to 4% by June.

What applies to Europe, applies even more in the United Kingdom. The IMF predicts that -- thanks to strong business investment, solid consumption growth and rosy corporate profits -- the British economy will grow faster than both those of the eurozone and the United States. Strong growth is already pushing up prices as U.K. consumer price inflation hit a 10-year high of 3.1% last month. Housing prices rose 3.5% just last month -- the fastest pace in five years. The pound's trajectory through the $2 level was spurred by expectations that the Bank of England will raise interest rates to 5.5% next month -- pushing rates higher than U.S. rates for the first time since January 2006.

European Currencies: New Challenges for New European Growth

Strong currencies are, of course, a double-edged sword. While European shoppers enjoy bargain basement prices in Manhattan, European exporters must compensate for higher prices of their exports by jacking up productivity. That's not an easy task in the land of eight-week vacations and 35-hour work weeks. Germany's machinery industry -- exporting factory equipment as a vital part of the German and eurozone economic revivals -- has it especially tough. German exports are getting more expensive just as demand from the United States is slackening and competition from U.S. dollar-based Asian economies is growing. French cosmetics giant L'Oreal SA (LRLCY.PK) is also feeling the heat, with its Q1 sales dropping as the prices of European-manufactured Armani perfumes and Lancome skin creams have skyrocketed. British fashion group Burberry PLC also announced that the pound's appreciation against the Japanese yen will knock £7 million off its revenues in the last half of its fiscal year.

Coming interest rate hikes to combat inflation in both the British and eurozone economies are also likely to crimp growth. In the United Kingdom in particular, over-indebted consumers, sky-high housing prices and surging inflation have some economists concerned that Britain is set for a slowdown after more than 14 years of economic growth that has outperformed most major economies.

European Currencies: New Euro Strength or Old Dollar Weakness

The evolving conventional wisdom in Europe is that the euro's strength is based on Europe's strong economic recovery and unusually strong growth. That's all a matter of perspective. As Steve Forbes has pointed out, while a 2.3% growth rate in the United States counts as a "growth recession," in Europe it's a reason to throw a party.

Scratch the surface, and you find that the strength of European currencies has at least as much to do with dollar weakness as Europe's overnight transformation into a global economic powerhouse. Dollar bears have long pointed to the rising U.S. current account deficit, which still stands above 6% of GDP -- as a fundamental -- and unsustainable imbalance.

U.S. Treasury Secretary Hank Paulson's silence about the latest dollar weakness says a lot about the Bush administration's "strong dollar" policy. U.S. officials recognize that a weaker dollar boosts exports and, in the long run, helps reduce the U.S. trade deficit. Dollar depreciation is the most painless way to redress such imbalances without causing a U.S. recession. This thinking is panning out just as expected. With exports selling for less overseas, U.S. exports to the EU jumped 23% to $38.8 billion for the first two months of this year while U.S. imports from Europe expanded just 3.9%.

Europe's Currencies: Whither From Here?

There is more than a slight hint of triumphalism in the European business press about the recent strength of European currencies. It is funny how overvalued currencies bring that out in countries. Just think of Japan 20 years ago. Even the normally staid Economist ran a regrettably snide story last week about how "America is still tops... as it is the world's biggest debtor nation; it guzzles the most energy; and it has the biggest prison population." And any headline figures associated with Europe expressed in dollars today -- the size of the economy, wages, the market capitalization of European stock exchanges -- is exaggerated by a euro that is close to 24% overvalued according to the Economist's own Big Mac Index.

Here's the reality. Currencies come and go in and out of fashion -- largely due to the animal spirits of the time. In the long run, currencies converge towards purchasing power parity. Today, it's more like $1 in the United States buys you what £1 does in London, as an ad for New York City touts in London's Victoria Station. That equation -- which is not a huge exaggeration -- means that London is now twice as expensive as Manhattan. Today, the pound and the euro are as overvalued as they have ever been. U.S. investors -- and European shoppers in Manhattan -- should enjoy the ride while it lasts. It won't forever.

Comments

[Michael Bom...:]

Hello Nicholas,
Good summary of who wins, who loses, and for how long. If you are interested, I just recently did some analysis of the historical correlation between the Pound rates and the iShares MCSI UK Index that seems to agree with your estimations of the UK.

2007 Apr 23 07:47 AM