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tdp2664 InvestorPlace The currency markets are giving European policymakers a vote of no confidence in their handling of the euro zone’s sovereign debt crisis, but it’s likely only a temporary verdict — and one that has little implication for investors in U.S. stocks. The euro has been generating hyperventilating headlines recently, ever since it broke below the psychologically significant $1.30 level against the U.S. dollar — a 13% drop from its May peak. Although it’s true that a declining euro helps lift the dollar, and that a strong dollar generally has been bad for equities since the Great Recession began, the latest plunge in the common currency generates more light than heat when it comes to American equity portfolios. For one thing, the value of the euro always has been a rather poor indicator of economic stress in the 17-member zone, as well as the wider European Union, the world’s largest economy. Furthermore, the correlation between a weak dollar and a strong stock market hasn’t been all that pronounced for some time. But most importantly, currency movements over the longer term will depend on how central banks in the U.S., China, Europe and Japan react to any global economic slowdown, notes Mike Shedlock of Sitka Pacific Capital Management. Not short-term, year-end positioning by currency jockeys on institutional trading desks. Take a step back and you’ll see that there’s been something of a decoupling between the stock market and the dollar in 2011. Not only has the old correlation between the asset classes weakened, but the equity market has been far more volatile than the greenback this year. The S&P 500 was up as much as 11% for the year-to-date at the end of April — and off nearly 13% by the beginning of October. That’s a swing of almost 25 percentage points. By contrast, the U.S. Dollar Index, which measures the greenback against a trade-weighted basket of six other currencies, is up about 2% on the year and has traded in a much narrower range of just about 10 percentage points. Click to Enlarge And as for the euro? Well, it has been remarkably volatile for a long time — and a lousy proxy for the economic fortunes of the continent. True, the common currency has bounced all over the place, but it hasn’t really gone anywhere in five years. For all the recent hand-wringing, the euro, since its inception, has averaged about $1.20. It briefly broke through that level when the euro zone’s sovereign debt crisis initially flared up (recall that plenty of pundits at the time expected the euro to reach parity with the dollar right quick), and yet the currency recovered. Indeed, today’s euro level of about $1.30 — more than 10 cents higher than its bear-market low — make the currency market’s outlook appear almost optimistic compared with the panic back then. And although a weaker euro means a stronger dollar, which isn’t necessarily the best thing for U.S. stocks, it also helps the European Union with its two greatest problems: a lack of economic growth and far too much debt. Every central bank in the world secretly wants a weak currency. A weak currency makes a country’s exports cheaper, which boosts demand and lifts GDP — at least in nominal terms. If the euro were to stay stuck at its current level for several months, that could add as much as 0.5% to the region’s GDP, economists reckon. As for the continent’s other major problem, it’s an axiom of economics that debtors love inflation — and Europe is awash in debt. When a nation’s currency becomes debased, the real (or inflation-adjusted) cost of servicing that debt goes down. It’s essentially a soft way to enact a sovereign debt default — one without catastrophic consequences for global credit markets. The euro is weak and might to get weaker in the near term, but the flow-through effect on the dollar and equity prices is nothing to lose sleep over. Ultimately, Europe’s fate will be decided by the bond market, not the currency market.
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