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By: Costas Bocelli — July 19, 2012

Here's a Strong Play for a Weaker Euro

The writing is on the wall...

We’re well into the third year of the European sovereign debt crisis.  We've seen bailouts for Greece (two so far), Ireland, Portugal and Cyprus, plus various patch work measures in an attempt to stem the crisis.

But recently, the stakes have been raised, forcing European leaders to finally make hard decisions and take real action.  As a result, you’re seeing the effect play out directly in the currency markets.

What’s changed?  Contagion has finally hit a serious nerve and has spread to Spain, the fourth largest economy in the Eurozone and bigger than all the bailout countries combined.  Currently EU leaders are hammering out a 100 billion euro aid package to recapitalize Spain’s banking system in an attempt to avoid a full blown sovereign meltdown -- a cost that the Eurozone cannot currently finance.

Further, if conditions deteriorate, the third largest monetary union partner, Italy, could soon follow and put the very existence of the Eurozone in jeopardy.

To combat this, European leaders have begun the process of forging fiscal and banking reform that will eventually bring a more uniform balance among the member economies.  However these reforms will take months, if not years, before they are ratified and have any long lasting substantial effect.

The problem is that time is now running short... and Spain and Italy can’t wait for those reforms to take shape.

Monetary Policy to the Rescue

The European Central Bank (ECB) has pitched in quite a bit.  They’ve slashed interest rates three times to a record low 0.75%.  And, at their next upcoming meeting, they are expected to cut another 25 basis points.

They’ve given European banks access to three-year loans at bargain basement rates -- the take-up totaled over 1 trillion Euros.

They also basically forced banks to withdrawal their overnight reserves parked with the ECB after they cut the deposit interest rate to absolute ZERO from 0.25%.  In a flash, 600 billion Euros were left scrambling to find their next low yielding home (like German Bunds and US treasury bonds) or, as hoped, to find their way into the real economy.

The recent actions have resulted in a ballooning balance sheet that is now bigger than the Fed’s and has also sent the Euro/USD currency to fresh two-year lows...

And based on all the continued signs of deterioration throughout the Eurozone, you'd have to conclude that the ECB is far from finished.

Not only is the ECB going to continue easing interest rates, but it may soon revive its Securities Market Program (SMP), a program that has been dormant for roughly a year.  With yields in Spain and Italy still uncomfortably high and the liquidity effects of the three year (LTRO) loans waning, the ECB will essentially have to restart the SMP bond program -- their version of QE.

In other words, they will be printing even more money, which will continue to send the Euro/USD trending lower over the longer term.  The next stop is likely 118 or perhaps even lower -- it will depend on market conditions and how the sovereign credit markets are behaving.

Why the ECB will Continue this Policy...

The immediate and direct impact from buying more sovereign debt is to drive down stubbornly high yields in Spain and Italy, two fragile economies that can’t take much more heat.

The indirect impact is to boost growth and stimulate the Eurozone economies.

You see, a cheaper currency (lower euro value) is a boon for exports and creates an international competitive advantage.  China has been doing it for years and has built the second largest economy in the world using this policy.

If the ECB steps up monetary easing -- and it looks like it will have no other choice -- the idea is that market pressure will recede in Italy and Spain, and Eurozone economic growth expands from a devalued currency.  Theoretically, this would buy time for the fiscal and structural banking reforms to be enacted.

How Much of an Impact Can Debasing a Currency Really Have?

A great deal.  Let’s take a look at the other side... 

While the euro has been trending lower, the US Dollar has been trending higher, so we should see signs of the opposite effect taking place and see some sort of negative impact, right?

Perfect example:  Johnson &Johnson (ticker: JNJ), the large multinational drug maker, just reported earnings on Tuesday.  They announced that second quarter revenue declined and management reduced full year earnings guidance.  One of the major reasons cited was because of “recent currency trends”. 

In other words, the stronger dollar (currency) became a headwind and is negatively affecting overall profitability.  I’m sure we’ll see more examples of this as US companies with multinational sales exposure report earnings.

How to Take Advantage of a Weakening Euro

Many European countries have slipped back into recession, which will most likely be confirmed by next month with the release of Q2 GDP data.

As a result, valuations and stock prices have been widely discounted, with several high quality and profitable companies trading on the cheap.

With a devaluing euro currency -- a trend that will most likely continue -- this should be a huge tailwind for European blue-chip multinational companies.

For longer term, value oriented investors, now may finally be the right time to have some exposure to this space.

I’ll share with you two ways that you can take advantage of the weakening euro...

The first is a diversified approach.  Consider the SPDR Euro Stoxx 50 ETF (ticker: FEZ).  It’s basically the Eurozone’s version of the Dow Jones Industrial Average Index.  The ETF is comprised of 50 large multinational European companies that are based in the monetary union.

It’s trading near the low end of its long term trading range and currently carries a modest 10 price/earnings valuation.  Also, the ETF distributes consistent dividend income, currently yielding over 4% annualized.
 

If you're interested in looking at an individual company, you could consider the German multi-national technology conglomerate, Siemens (ticker: SI).

The stock is also considerably lower from recent highs, but it trades at a slight premium of 15 times earnings because of its current competitive advantages and its long historical track record.  The stock also distributes dividend income -- currently yielding over 3% -- which is paid annually for its ADR share holders (NYSE: SI).

The bottom line is that many European multinational blue-chip oriented companies have been significantly discounted and now are beginning to look quite compelling at these valuations.

And with the euro currency likely to continue its long term weakening trend, it should only provide more tailwinds for investments like these.

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