December 1, 2011

Currencies are like ghosts — you can never quite get your hands around them, yet they can haunt an economy’s growth rate or an investor’s portfolio forevermore. Perhaps that is because the value of a dollar or a euro is at best a guesstimable number — dependent on the present moment’s madness of crowds and popular opinion, or the next minute’s rationality of longer-term fundamentals. Relative annual price swings of 10 to 20 percent vs. alternative choices are commonplace. And this appears to be the case for the euro when compared with the dollar, pound, yen and perhaps even the upstart and tightly controlled Chinese yuan. It could go up or down — anywhere, really — based upon this week’s policy decisions involving the European Union, the International Monetary Fund, the G-5 central banks and, of course, the markets’ herd-like interpretation of them.

So where is the euro headed? More than likely down, perhaps significantly, for several reasons. First, and most important, the euro’s fate will be a function of the euro zone’s stability and eventual growth rate if it can keep its dysfunctional family together. While the departure of one or two smaller members of the European Union (read: Greece and Portugal) might strengthen the euro over time, a similar fate for Spain and Italy would sink or even end it. Its sinking is a diminished probability based on this week’s policy announcements, but it remains, in market parlance, a fat-tail, black-swan event — a factor to consider. Even assuming the family hangs together, there are legitimate questions about the ability of the 17 euro-zone countries to grow. Restrictive fiscal policies imposed by Germanic overseers promise to prolong the recession in almost all countries — including Germany. And as an economy declines, so too does its currency. A country’s currency is similar to a growth stock: If its growth rate shrinks, so do its figurative price-earnings ratio and its market price.

One of the reasons for the euro’s relative strength in recent months has been the yield advantage when holding it. The dollar, pound sterling and yen all offer close to zero percent interest rates while the European Central Bank’s rate is nearly 1 percent higher. Perhaps as early as Dec. 8, that difference will narrow significantly as the European Central Bank (ECB) joins the rest of the developed world in its fight against deflation instead of inflation. And if fiscal-policy straitjackets restrict recovery in 2012 and beyond, the ECB’s ability to return to a relative tight money regime compared with its fellow central banks will be limited. The euro’s strength has, for years, been based on its nearly identical twin-like comparison to the Bundesbank and the historical German mark. Now, however, with the ECB’s easing and the prospect for a trillion euros of check-writing to support Euroland bond markets, its currency may be a ghostly image of the mark of old.

Neither the U.S. economy nor U.S. stock indexes will benefit from the euro’s decline. A declining euro means a rising dollar in relative terms, so our exports will necessarily become less competitive. During the Great Depression, the country that devalued its currency the quickest and the most was the country that was least affected by depression and that recovered the fastest. This truism will aid Euroland, and hinder the U.S. recovery.

In addition, a majority of U.S. companies in the Standard & Poor’s 500 earn close to 50 percent of their revenue from global cash registers — and the euro zone has the largest one. Unhedged currencies for these companies, such as Procter & Gamble and Coca-Cola, will result in reduced profits as their euros buy fewer dollars in exchange.

Granted, market fundamentals and what Warren Buffett has called a “weighing machine” are often countered by technical flows more representative of a voting machine. Repatriation of Euroland’s overseas investments to meet margin and capital requirements may continue to support the currency. And hedge funds and market speculators may be heavily one-sided in anticipating the euro’s probable decline. But the arguments otherwise are many: a possible catastrophic breakup, negative growth even if the European Union holds together, near-subzero interest rates and the eventual printing of trillions of additional euros. In doing so, the ECB will join the Federal Reserve, the Bank of England and other central banks in a concerted effort to reflate their respective economies. Inflation lies ahead. Ghostbuster or not, you should vote against the euro, and prepare for repercussions in the United States.

The writer is founder and co-chief investment officer of the investment management firm Pimco.