Euro could go 20% lower, says CrossBorder Capital’s Mike Howell

Mike Howell, managing director of CrossBorder Capital, says the data on eurozone liquidity points to a further 20% weakening in the single currency.

In a jaw-dropping turnaround eurozone equities have leapt from the bottom of every advisor’s investment picks to the top in barely a year. Strangely, the outlook 12 months ago looked to us much better than today, justifying the subsequent sharp share price rally. Looking ahead into the rest of 2013, we do not think that likely returns from eurozone investment compensate for the bigger risks.

Let’s be clear. We are not taking here of a disintegration of the euro. Its integrity looks safe, but what is at issue are three things: the value of the euro against major national currencies, such as the US dollar; the underlying health of the eurozone economies and whether its banks and national governments will continue to be funded.

In this context it is puzzling that the ECB has just allowed its balance sheet to shrink in size by a whopping one fifth. Correspondingly our indexes of ECB liquidity have plunged dramatically in just a few months. Eerily, this also happened ahead of earlier eurozone crises. If the monetary shoe were on the other foot and the US Fed had just let its balance sheet skid 20% lower, we doubt Wall Street would be still be setting new highs. Money moves markets, and the key lesson that Fed chairman Ben Bernanke has taught us since the 2008 Lehman Crisis is that the size of central bank balance sheets is directly and positively related to the level of asset prices and very negatively related to risk premia.

Yet some pundits argue in a topsy-turvy way that the shrinking ECB balance sheet somehow represents an easing of eurozone monetary conditions. Clever Frankfurt spin-doctors have turned black into white! But we just don’t get it. Whichever way we look at the data, the markets now have less funding, not more, and therefore will struggle in the face of any future crises. Moreover, the only reason why the region’s banks arguably need less funding must be that they too are shrinking their balance sheets, or in other words slashing lending. This plainly is not what high street banks should be doing in a recession.

So, what to do? Bottom line is plan a holiday in Europe, but do not pay upfront. The euro is set to skid lower, perhaps by as much as 20%. The value of the single currency, both as a unit since 1999 and as a de facto basket before, has fluctuated in a near-ten year cycle of alternating strength and weakness. The trend seems to rest on the convergence and divergence of the regional economies. Periods of economic divergence, such as the wave of Mediterranean socialism in the early-1980s; the impetus given to Germany by the fall of the Berlin Wall, and now the effects of the debt crises in Greece, Ireland, Spain and Portugal, all drive down the value of the euro. But periods of economic convergence, such as the drives towards Maastricht and the Singe Currency, cause euro strength.

Unquestionably, we believe you are looking at further significant euro weakness ahead. The US dollar will be a key winner. The trigger for this euro fall may be another eurozone crisis that forces the ECB to react and open up the money taps again. Currencies are all important drivers of the business cycle. With the competitiveness of eurozone business lately compromised by sharp falls in the value of the Japanese yen and British pound, many French and Spanish firms, among others, are pleading for a lower euro. Should they call Frankfurt or pray to Rome?

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