Foreign Exchange Market

Ode on a Grecian burn

PUBLISHED : Monday, 21 May, 2012, 12:00am
UPDATED : Monday, 21 May, 2012, 12:00am


Related topics

Have you sold all your euros? Made an exit from European equity markets? Or possibly taken short positions against the euro and stand to reap some impressive rewards? If so, you might be feeling a little smug at the moment.

However (there is always a 'however' in these matters), a convincing case for complacency has yet to be made, even for those of us who live in Asia, far removed from the travails of Europe.

Because of the increasing integration of financial markets and the speed at which information is conveyed, every time an event occurs - albeit in a minor market such as Greece (which accounted for a mere 2.3 per cent of the euro zone's economy last year) - there is talk of contagion.

The first impact is likely to be on the highly vulnerable economies of Spain and Portugal, followed by Ireland, which is still struggling to get off its knees. Italy, which defies gravity when the nation's lifestyle is compared with its fiscal deficit, will probably be the next to fall.

All these nations, of course, are united by this currency, and it is precisely the global nature of the euro that causes the problems.

As the euro devalues, goods made in the European Union become cheaper on world markets, and the knee-jerk inclination to seek production in lower-cost places, such as Asia, diminishes.

Then there is the question of European demand for imported goods. In China, for example, Europe was the destination for 18 per cent of exports. However, in April, the brokerage CLSA estimates that the exports to the euro zone dropped 2.4 per cent from April last year.

So, here's a double whammy of increasing competition from Europe on the output side coupled with falling demand. Then there is the matter of market impact. Big European banks hold large amounts of euro-zone sovereign debt. There is a real worry the crisis will spread to the bank sector, triggering fresh rounds of government bailouts.

The net result here should be a massive devaluation of the euro. But over the past year, the currency has fallen only 10 per cent against the US dollar. Yet even within this period, the euro has shown an ability to bounce back - in October, it was back where it was in March 2011. The extraordinary resilience is partly because the Europeans themselves are not shifting out of their common currency. They are hoarding it to pay off debts and other liabilities.

We are already seeing brave talk about how the euro could do very nicely if Greece withdrew from the common currency. It is even suggested that, if some of the other weaker countries reverted to their national currencies, the euro would have a better future.

However, things rarely work out so neatly. Currencies are ultimately matters of faith. No longer can you exchange a pound note for gold; like other currencies, the British pound is a piece of paper based on confidence that it can be freely traded and that it somehow contains intrinsic value. That confidence can rapidly fade for a new currency like the euro if its component parts start to slip away.

Meanwhile, the great European electorate appears to have rejected the gospel of austerity that has been the orthodoxy of policymakers from London to Berlin to Paris and Athens. In each of these places, electors in recent local and national elections have severely punished ruling parties who follow this line.

It also happens to be a line that equity investors like, and, as long as it holds, it explains why European stock markets have not fallen even further.

Where does this leave investors in places such as Hong Kong? The brave will already be trying to identify high-value European stocks whose price has fallen as they became entangled in the carnage. But even today, few of these are trading at truly bargain basement prices. The German market, for example, is still trading on an average price/earnings ratio of 12.

Yet there is nervousness in global markets and it has spread with little discrimination from battered Greece to New York and even Hong Kong. As ever, this presents buying opportunities because sentiment-driven markets quickly turn the other way.

Meanwhile, the best strategy for those on the sidelines of Europe is almost certainly to stay there.