The Euro: Why the Tortoise Could Yet Beat the Hare

By: Wilfred Hahn | Fri, Jul 1, 2005
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"Plodding wins the race." - The Tortoise (from Aesop's Fable, The Tortoise and the Hare)

W e think now is as good a time as any to state the long-term affirmative case for the euro ... and an overweight in selected European equities and midterm bonds.

Readers may remember the rather comical practice of Valéry Giscard d'Estaing as he led the proceedings of the European Union's (EU) constitutional convention during its fourteen month sitting until July 11, 2003. Quoting a report carried in the Irish Times the following day:

"The Convention on the Future of Europe has ended with a final display of soaring rhetoric. Its president, Mr. Valéry Giscard d'Estaing, closed the last session after a number of last-minute changes to the draft constitution, including provisions for an official EU flag, anthem, holiday and slogan.

But he saved his final words for Wu Kei, a green tortoise with a dragon's head that Mr. Giscard has placed on his desk during each convention session. 'The last person I wish to thank is my tortoise Wu Kei. She has followed - or led - our trip. When we were in the middle of the stream, she guided us, as she did for the first Chinese emperor, until we reached the river's banks. And I expect, as many of you probably believe, that, since the beginning, she knew where she wanted to go,' he said. Mr. Giscard then produced a few lettuce leaves and fed them to the ornamental tortoise. The tortoise said nothing."

The story of his tortoise may seem rather trivial. But actually, its significance is more than just "nothing." His choice of mascot (or talisman) is rather apt in a number of ways.

Aesop's fable of the Tortoise and the Hare comes to mind. You'll recall that the hare lost a race against the tortoise because of his complacency. He chose to sleep; supremely confident in his abilities but totally oblivious to the real progress of the race.

With respect to the global competition playing out between the US and Europe, for reasons that we will examine, it is not necessarily a fore-gone conclusion that the Hare will win. There is a convincing case, we think, that the euro may eventually yet see a new high.

The Zigzags of Harebrained Currency Markets

It's no surprise that the consensus opinion has shifted radically against the euro in recent weeks. Currency movements, as with any market trend, of course do not move in predictable nor straight lines for very long. There are always interruptions to be encountered - economic and financial reversals that are significantly large enough to test, shift or whip-saw popular opinion.

As it was, quite a few factors had been shaping up to trigger one of these countertrends (declining euro/US-dollar yield spreads, slowing economic growth in Europe, unsustainable "dollar-bear" hysteria ...etc.) even without the psychological damage of the "no" results in the recent constitutional referendums in Holland and France.

And so, the same crowd that only earlier this year thought it was a near-certainty that the US dollar would continue plummeting, is suddenly now convinced that, whatever the miasmic political stuff going on in Europe, it means the sure demise of economic Europe. Really? Such a shift in less than a fortnight?

If there has been any surprise in our view, it is that the euro has not been weaker to date. All the same, the "trigger" crowd is likely to be as wrong now as it was when the dollar was at recent lows.

The USD (US dollar), for both fundamental and psychological reasons, has enjoyed a fairly substantial rally against the euro so far this year ... up 11.7% at the maximum point. In our view, the move hardly qualifies as the end of the bear market in the US dollar.

For one, counter movements of this magnitude are not unusual. In fact, there were four counter moves of greater magnitude during the D-mark's enormous rise between 1985 and early 1996. (See Figure #1.) The D-mark was the most prominent forerunner and backbone to the euro. And yet, the D-mark at that time powered on to further highs - levels, by the way, which in equivalent euro terms today have still to be exceeded. Other examples could be cited.

While the dollar has fallen substantially against the euro (at worst, over 39% from its October 2000 high) the cumulative decline to date is hardly excessive when compared with the slumps in previous down markets. (See Figure #2) We cite these facts for perspective only. The fundamental case drives our long-term view, not chart patterns.

All the same, a number of questions remain open: Is it likely that the euro will yet rise further against the dollar? Or, has a new dollar bull market begun?

As mentioned, we conclude with an affirmative for the euro as the longer-term structural case is still compelling in our view. New highs - though perhaps not welcome in the Euro Zone - in time are still likely for a number of reasons, as we'll briefly outline.

Of course, nothing is a certainty in a world of globalized money. But that said, we admit to being a little more comfortable now that we are again almost alone in our view.

In the Hole: A New Dollar Bull Market?

We want to get to the main reasons why we conclude that the US dollar will yet fall to new lows against the euro.

But first, a few points and disclaimers to better put our perspectives into proper context.

1. Agenda? Lest we be accused of any other motive than preserving and growing our portfolios, for the record, we are not apologists for Europe ... nor for that matter, the Anglo-Saxon world of free-markets. No, we are not rooting for one "team" over the other. We want to look at facts, theory and probabilities. Both Europe and America have their inherent flaws and weaknesses. One calling the other black is the kettle berating the pot. But, there are evident some significant differences between the policies of the two that can make a decided difference in this relative game over the longer-term.

2. Beware of market strategists - particularly those in the Anglo sphere - who have suddenly become political experts on Europe. (Technically, that also includes us.) Gauging from some of the ridiculous statements being passed for informed comment recently - from outright histrionics about the coming demise of Europe to grossly misinformed comparisons between Europe and the US - one can't help observing that many of these commentators seem hardly even aware of realities in their own countries. Just which nations have the largest budget deficits, external imbalances, unsustainable debt-pyramids and economic excesses? Just were do we find the main epicenters of worldwide asset inflation?

Reading the dire dialogue about Europe one would never know that the US or Japan would be deserving of mention.

3. Economic vested interest. In the current day of advanced globalization, skittish crossborder capital mobility, and the pervasive global influence of the MNC (multinational company), we also are of the view that monetary and economic interests lead political behavior, rather than the other way around.

This would be nothing new, as it is already a rabbiteared view. But, it seems to have been forgotten in the dialogue about the economic aspects of Europe.

In this vein, why is it necessary that Europe must have a political union anytime soon in order to continue a successful economic bloc with a single currency?

As was the case, the European Union had already been considered a success without political union only a few months ago. And the last we checked, there still was a line-up of countries that want to join the union. In that respect, not much has changed.

To comment on this line further, a political union is not really required - certainly not anytime pronto - not as long as Europe has a single currency and an independent central bank. And, that they do have, and not a bad one at that.

In all fairness, the record of the European Central Bank (ECB) is less shameful than that of the US Fed, which time and time again has shown itself to be the friend of Wall Street and Washington, not sound money nor the private saver. We agree that neither central bank is perfect and that neither are the custodians of a hardcurrency. But neither is the euro reckless funny-money.

4. Lighten up on the politics. As for the political aspirations of Europe, we demur. To us political neophytes, only a few conclusions appear sensibly obvious. For one, we see the constitutional "no" votes as a positive thing for Europe in the longer run.

More worrisome, we think, is the possibility that the "no" votes were also an expression of anti-Islamism and anti-Americanism as much as it was a protest against presumptuous European politicians. With Turkey now at Europe's door for the first time since Suleyman and other Ottoman rulers tried to storm Vienna in the 16th and 17th centuries, the Dutch and the French may understandably be the least comfortable with this development. After all, they have among Europe's largest Islamic populations.

With respect to anti-Americanism - or more accurately, anti-Anglobalization, as Niall Ferguson has coined the term - the recent "locust" phenomenon in Germany underlines the reality that Europeans are not about to give themselves over to rapacious "market economics."

In France, a detailed analysis of the electoral results also shows that "antiglobalization" was a major root of the disgruntled populace. Chirac's comment of some years ago still rings appropriate: "We want a market economy, but not a market society."

5. Finally, some long-term perspectives. In view of the above, let's also realize the massive improbability of the progress of Europe to date. From the ruins of WW II, Europe has again risen to world prominence. Never before in history has it ever occurred that so many countries and people - perhaps as many as 465 million - have voluntarily come together in a time of peace.

There has not been a dictator that has swept across Europe to forcibly put them together. All past empires, the Ottoman, Roman, Seljuks, Greek ... etc. all occurred at the behest of brutal force and war. The unification of Europe, on the other hand, is peaceful. Single sovereign nations that possess hundreds of years of history and identity, are willingly coming together if for no other reason than economic advantage.

For the man in the street, that motive has always been the main reason to go along with the euro-politicians. Recently, however, the benefits of further political convergence have not been so compelling.

Just Who Is Sleeping?

Despite the improbable ascension of Europe, one would be hard pressed to find much acknowledgment of this achievement in the Anglo sphere. Why this was so used to always puzzle us.

The attitudes of policymakers and leaders in North America towards Europe have consistently carried a tone of mockery - "schadenfreude" at every turn. The commentary from the press and Wall Street clearly promoted a message of European pessimism and certain failure. Why was the coverage so one-sided and ill-informed?

Such biased reports in the media are endless. We could cite fifty examples of this biased perspective in the past month alone. To illustrate, here are some recent classics:

"Europe's systemic problems of labor inflexibility, weak productivity growth and a large pension overhang are going largely unaddressed and will continue to act as a drain on [economic] growth." Or: "In general, European consumers lack (Editor's comment: lack?) the frenzied gusto of their American counterparts." (These are just two examples of a long litany of such slanted Ameri-centric statements by Stratfor.)

Here is a more recent example:

"German private households ignored the attractions of historically-low interest rates and for the first time paid back more money than they borrowed last year. 'There is nowhere else where a country comes even close to such weak growth rates', [said an economist from Barclays Capital ...] There was little change in the net take-up of property-related borrowings. [...] The Bundesbank attributed the high propensity to save to high unemployment levels and efforts to build up savings for retirement." (Financial Times, June 21, 2005)

Note that in the above statements, no mention is made of America's real and equally-troublesome pension and employment problems, nor the looming consequences of rampant, debt-laden consumerism.

In view of such slanted comments (the first set praising irresponsible spending and reckless policies, the other implicitly castigating simple common sense - saving for retirement) from such respected sources, we must ask: Just who should be accused of taking a nap? To recall, it was a nap that cost the hare his victory that was the sure consensus of the forest dwellers in the famous Aesop fable.

At a minimum, Europe is deserving of some credit ... perhaps even the benefit of doubt. Some minor budget wrangling and constitutional disagreements will not necessarily bring the process to an end, much less so the doom of the euro. A little squabbling happens in the best of families.

Such issues should be seen more as a distraction to the true essence of the long-term "plodding" stratagems of Europe.

Four Snares for the Rabbit

Strategists, who like to place their overweights on the side of sustainable, longer-term trends, will not want to lose sight of these longer-running structural arguments that are in favor of the euro for the long haul ... if not for at least one more upward leg against the US dollar.

Focusing on the big picture, herewith four arguments to ponder, the last of which is the most sobering:

1. Tortoise vs. the Hare: The Race is On

Europe (or at least its major core members) and America definitely are contenders. The EU and America are indeed engaged in a calculated economic contest. This is a fact ... an outgrowth of present-day geo-politics. Core EU members, whether openly stated or not, have been striving to organize a counterweight to America's world supremacy right from the close of World War II.

As such, the two Wests are headed for more competitive clashes. This rivalry is mainly economic and financial, but it is still a game played for the big carrot. Though some may still think that world primacy will be established militarily in the future, this contest will more likely will be won by "soft power."

Military actions today are only seen necessary in the non-developed parts of the world, or in areas driven by ideological and religious fanaticism that is insensitive to economic incentive. This late in the globalization of the world, economic and monetary policies appear to be the lethal siege instruments of the times - the equivalents of the catapults and battering rams of the Middle Ages.

In this game, we think, the Anglo-world is looking increasingly vulnerable. No doubt we are biased about the Anglo world because we live there. But we worry about how vulnerable it is becoming. Unlike France, Germany and other European countries, it is a committed "market society." The accepted raison-d'etre for the legendary Anglo consumer has increasingly become more consumption, financial wealth (whatever its fleeting conceptions) and the economic incentivization of everything.

That has opened the doors to rising indebtedness, international imbalances, protracted wealth skews ... etc. While this is leading to a great world-wide imbalance (probably the largest in financial history), there is no longer any appetite to turn back ... the point of no return already having been reached. As such, the only acceptable policy option is to continue in the same direction as before for as long as possible - more debt and lower real interest rates.

2. A Calculated, More Durable Long-Run Strategy

For its part in the great global economic sweepstakes, the US has relied upon an assorted group of tactics in recent decades - asset inflation (both securities and real estate) statistical gimmicks of many kinds, debt-stimulated growth, a massive restructuring of its economy towards consumption, and the pursuit of capital efficiency (as differentiated from capital productivity). The latter requires a longterm capital investment structure, a corporate strategy hardly in vogue in the present day of the coveted executive share option. Overall, these are among America's prime means of gaining its muchadmired economic growth, helping to project its economic influence upon the world.

While these tactics are not sustainable strategies by any stretch of the imagination, they have nonetheless been very effective over the shorterterm, greatly exaggerating its dynamism. Even most European financial economists have been taken in by these prestidigitations.

Europe, on the other hand, shows little interest in such short-term tactics for the most part. They instead pursue plodding measures, playing the longer-term game of the tortoise. While they have their own set of problems, their game plan is very different, much slower and low-key.

A major problem for Europe economically, is that it has very low population growth. In fact, many of its countries - Germany and Italy, for example - have negative population growth and a fast-aging society. That means that Europe's economy will appear to be more slow-growing than other countries and regions where populations are growing faster. This is one of the main reasons why it appears that America has a generally stronger, more dynamic economy than that of Europe. America, with its faster-growing ethnic societies has an annual population growth of 0.9% versus 0.3% for the EU overall.

Of course, differences in population growth indicate little about actual economic dynamism - though there may be confusion on this point. For example, Europe as a whole has enjoyed higher economic growth and productivity than America when viewed over the past few decades on a per-capita basis. Be that the case, this "optical" problem of slow economic growth can be countered in two ways: Either by promoting immigration; or as is more the case in Europe, by expanding its borders to include populous countries that have much lower income levels (per person).

As these countries join the same monetary bloc of the euro-zone, they are spurred to hyper-growth as they catch up with the rest of Europe in terms of economic productivity and levels of financial intensity. While that process may take many decades, it is nonetheless sure to be very effective in boosting the overall growth and apparent economic dynamism of Europe. And indeed this is - and will be - happening in Europe over the next decade and more.

For instance, consider Turkey and the impact that this one country may have on overall European economic growth. While the jury is still out as to whether Turkey will ever be part of political Europe, it remains a reasonable probability that it may enter into an economic association of some kind.

By conventional economic accounting, Turkey is the 23rd largest economy in the world with an economic output per-person of only 29% of the average of Europe. With a population in excess of 65 million (and growing rapidly) this will present significant leverage to pan-European growth. As Turkey's economic integration becomes ever more certain, this country will boom economically, strongly pulling up Europe's economic growth rate. Indeed, that already is the case even now.

Seen in terms of the global economic competition, Europe's geographic expansion outwards is a much more durable and sustainable process than the one America has pursued (as mentioned - overconsumption driven by massive debt-growth, numerous wealth bubbles, a decimated capital structure and a virtual loss of financial sovereignty with its massive external deficits.)

If we were to venture a guess, this is one of the reasons why Europe will likely eventually end up the victor in terms of clear, global economic and financial supremacy. This could occur much sooner than many might imagine. It also could take a few more decades.

3. The Dollar: A Currency Between a Dragon and a Woman Spurned

A fact that we think is critical not to lose sight of is this: Never before has such a huge financial chasm occurred between the country of the world's reigning reserve currency (the US dollar) and a newly-industrializing country (NIC), China ... especially so at a time that an alternative reserve currency, has debuted on the world stage (the euro). China, Japan and other Asian countries are accumulating enormous currency reserves (plus $2 trillion at the latest count) even while America rather nonchalantly runs up record-sized external deficits. That fact intertwined with the reality of a split (postcold- war) West presents some vulnerabilities for these two competing reserve currencies of the dollar and the euro - both of which are freefloaters. The former is vulnerable to a mass exodus of portfolio capital, the latter to a massive influx.

Why? If bullying comes to shoving, the countries with big surpluses and reserves (such as China and Asia at large) logically will be more inclined to switch between the two reserve currencies, moving from the weaker to the stronger. The euro would be the obvious favorite in this situation.

Should a crisis hit, repatriating capital back to the Chinese yuan or Japanese yen would be unattractive. It would drive up these currencies while magnifying losses on existing holdings in the depreciating reserve currency, the US dollar. We are not necessarily predicting that this will happen. But if ever a great tsunami wave should rip through the currency markets, at the very least, what we can be sure of is that the bloc of Asian countries that now hold a sizable chunk of the world's currency reserves will not be switching their euros en-masse into dollars. In fact, the more astute among them will be doing the opposite, even now.

4. Facing the History of Funding Crises.

Finally, speaking of tsunamis and currency markets, take a close look at Figure #5 below. It points to a condition of worsening vulnerability for the US dollar. Any country that has ever fallen into the extremes of the bottom-left or right quadrant (relative to the rest of the world) has experienced a major currency "funding crisis." To date, there has only been one exception - the US. What makes this situation even more remarkable is that US is the largest country relative to the size of the rest of the world ever to reach such an extreme in modern financial history. It's enough to make you want to run like a rabbit.

Currencies Compared: The Clean Olympics

All things considers, looking ahead and addressing foundational, causal economic theory and sustainable economics, we are inclined here to give the tip of the hat to Europe and the euro.

Yes, currently, European economic growth is slow. That is a fact. But it also is not bad seen in comparison to the US.

But if we are going to make a fair and competitive comparison between Europe and the US in any kind of economic analysis, we must first agree upon some rules. Let's use the same measuring tape and insist on drug-free results. After all, if economic performance were an Olympic event, the US and some other countries would be ejected for substance abuse.

We will not have the space to deal with the statistical misinterpretations and definitional differences that often lead to incorrect comparatives (slower population growth, hedonic statistical adjustments, different accounting conventions, societal preferences ... etc.) The US economic strength, that most observers so laud, is a result of shorter-term performance enhancements (see our Global Spin of April 2005 for a broader analysis) of declining savings in relation to income, rising international indebtedness, a skewing wealth distribution curve, capital consumption and overconsumption (to only name the major ones). These are all performance stimulants with only temporary effects. The rabbit may run faster, but it will also suffer cumulative physiological damage that will affect its longer-term endurance.

Fundamentally, we think that the euro remains the lesser worry of the world's fiat currencies. The euro bloc of countries is running trade and current account surpluses (ex UK) as compared to the massive deficits of the US (running above 6.0 % of GDP and sucking up roughly 75% of the world's excess savings).

Europe's economic model of greater savings, higher investment and dis-intermediating the growth differentials between its core and the newly joining country members (the latter being expected to experience rapid rates of financialization, and percapita GDP growth) has legs for at least another decade. Yes, this stratagem may be vulnerable to limitations on the Islamic edge of Europe - countries were it is not easily assumed that economic incentives will buy their loyalties - and instabilities in the Caucuses and other hot-spots.

But it is also not a plan built on asset bubbles and unstable debt loads, but rather new investment and savings.

Final Conclusions

The fundamental "bear" case for the dollar remains compelling for the long-term. At this point, an economic slow-down has been priced into euro bond markets. It is certainly possible that there may be more political squabbles that can spook potential euro buyers. In the meantime, the euro has fallen sharply (which is stimulative for Europe) and longterm rates are lower. To date, the ECB has not lowered short-term rates and despite overheating in some peripheral EU countries, there are not nearly the asset bubbles, nor credit bubbles as in the United States and elsewhere. (See Figures #3 and #4.)

We see the constitutional issue as a positive development for Europe in the longer run. In the meantime, there is little reason to believe that the economic integration is at risk due to constitutional issues.

A factor that may sustain the dollar's reprieve for sometime longer, is the possible development of a new "carry trade" - financing short-term in the euro, and going long higher-yielding dollar assets. There is some indication that this is already occurring. Will it become a large factor, perhaps driving a multi-year dollar run? We don't think so. The world is already flooded with dollar assets and moreover, the US is still showing a rising current account deficit.

Now is a good time to raise positions in European equity markets and to hold on to mid- to longer-term euro bonds. Relative equity valuations remain attractive.

And, importantly, the longer-term case for the Europe remains "ploddingly" constructive even while popular sentiment is at its blackest.

"Keep your boasting till you've beaten," answered the Tortoise. "Shall we race?"

"That is a good joke," said the Hare.

"Plodding wins the race," said the Tortoise.


Wilfred Hahn

Author: Wilfred Hahn

Wilfred Hahn
Hahn Investment Stewards & Company Inc.

Wilfred Hahn

HAHN Investment Stewards & Co Inc.
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Wilfred Hahn is intimately familiar with the many facets and challenges of the world of money, having worked in the global financial and investment industry for over two decades.

Business and research travels have brought Wilfred to 40 countries around the world, allowing him a unique opportunity to keep abreast of global developments and to maintain an international network of contacts. He is a published author and has written on global financial markets, ethics and stewardship issues. When Euromoney Magazine asked fund managers around the world to name their favorite domestic and international research analysts, Wilfred was chosen one of them. Many foreign publications around the world have quoted Wilfred, including the South China Morning Post, Wall Street Journal, New York Times, Frankfurter Allgemeine, and the Financial Post. He has made numerous appearances on various television and radio broadcasts.

Prior to founding Hahn Investment Stewards, Wilfred was head of the Global Investment Group of the Royal Bank of Canada. In this position, he built the global discretionary business of this institution, comprising the activities of staff in nine countries and assets of clients totaling in excess of $10 billion. The group's many clients around the world included pension funds, corporations, mutual fund unit-holders and private individuals.

Prior to the Royal Bank he co-founded Hahn Capital Partners Inc. - a global investment counseling firm that was sold to the Royal Bank of Canada. Earlier in his career Wilfred was Senior Vice President, Director of Research of Prudential Bache Securities. There he gained extensive global experience, establishing a high ranking as a financial market strategist. Earlier, Wilfred was a partner in the investment banking firm of Gordon Capital Inc.

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