Amid the euphoria over the euro, the new currency's potentially rapid rise could spell problems for Europe.
Most money managers generally agree that, in the long run, the introduction of the new currency is good news for European stocks, as companies continue to restructure, governments reform their finances and Europeans increase personal and institutional stock investments. Already, Euroland blue-chip stocks soared 8.54% in the first four trading days of 1999, according to Dow Jones Euro STOXX 50 index.
But that rosy scenario could be darkened substantially, depending on how the euro fares in the short term.
Said David Buckle, senior asset allocation analyst at Putnam Investments, Boston: "One of the questions that starts to come up, (is) `What happens if this European slowdown occurs, how do we know that this doesn't blow the issue?' "
Key to answering this question is how strong the euro will be, how quickly it might appreciate and whether the new European Central Bank will intervene to prevent an overly rapid ascent.
While initially weak, the euro could surge because of major shifts of currency reserves by European and Asian central banks into the euro at the expense of the dollar, announced plans by major Japanese insurers to allocate huge chunks of new cash flow to euro-denominated assets, and growing individual and retirement savings by Europeans.
"We could see the euro going through the roof," said Nigel Morgan, chief economist at Old Mutual International Asset Managers (UK) Ltd., London. Or, the European Central Bank could cut interest rates further, he said.
Others think the euro is at greater risk from a falling U.S. dollar. With the sizable U.S. current account deficit, zero savings rates and falling corporate profits, the dollar is "very vulnerable" and could plunge to 1.50 deutsche marks from 1.67 now, said Albert Edwards, global strategist for Dresdner Kleinwort Benson, London.
"World growth has only been sustained because the U.S. has allowed devaluations (to occur) elsewhere," Mr. Edwards said. If there's a risk of recession in the United States, the Federal Reserve will devalue the dollar to spur growth -- which poses major threats to Euroland and Japan, he added.
In fact, Mr. Edwards believes global securities markets are entering an "Ice Age," driven by price stability and falling corporate earnings. "What will survive the Ice Age is the cockroach" -- that is, less sexy bond coupons and utilities stocks, he said. He urges investors to boost their bond holdings.
In a commentary written last month, Barton Biggs, chief global strategist for Morgan Stanley Dean Witter & Co., New York, warned that if the dollar/deutsche mark ratio averages 1.60 this year, real growth in Europe would be around 1%, inflation would be about zero and corporate profits would fall 10% to 15%.
"A disappointment of this magnitude would almost certainly cause stock prices to drop, especially since valuations are 20 to 25 times estimates that are too high," he wrote.
On the other hand, some managers think the menace of a strong euro has been overplayed. Putnam's Mr. Buckle, for one, believes Europe "will just tick along, and not fall into a heavy slowdown."
Michael Turner, head of global fixed interest for Edinburgh Fund Managers, Edinburgh, Scotland, said the euro will climb modestly, probably between 5% and 10% this year from its Jan. 7 close of $1.172. Some managers think the European Central Bank will intervene if the euro rises beyond $1.25.
What EFM managers cannot fathom, Mr. Turner said, is why the euro isn't stronger against the yen at present. He expects the euro will trade between 155 and 160 yen by year end, up from 131.60.
"If it happens, it will be sooner rather than later," he said.
Said Eric Taze-Bernard, who heads external distribution and international private banking at Paribas Asset Management, Paris: "Our view here is there should be a moderate upward drift in the euro against the major currencies, primarily because of international portfolio rebalancing and the attraction of European assets in the rest of the world."
While concurring that the euro will take a more moderate rise, William Chan, currency strategist at HSBC Asset Management Ltd., London, believes more than half of the impetus for a strong euro stems from an expected weakening of the dollar.
The dollar is particularly vulnerable to problems in Latin America, he noted. If Brazil devalues the real, U.S. stocks will get hit, which in turn will hurt the dollar, he said.
Still, the Federal Reserve has room to cut the discount rate, probably by more than 50 basis points from its current level of 4.75%, Mr. Chan said.
In contrast, the European Central Bank has less room to cut its discount rate from 3%, he said. The euro is strengthened from Euroland's position as a net exporter, with a current account surplus around $100 billion, compared with the U.S. current account deficit of $190 billion, he added. Also, 11 European central banks will have excess reserves of about $150 billion that now are mostly invested in dollars but will be reinvested in euros.
And while some worry about a correction in the United States, Peter Dencik, managing director of Singer & Friedlander International Asset Management Ltd., thinks the U.S. stock market will surprise some. "I wouldn't be surprised if you saw the Dow Jones (industrial average) coming over 10,000," he said.
Some fret that U.S. valuations are too high -- price/earnings ratios are at 38 times trailing earnings -- but Mr. Dencik said it depends on which valuation measure is used. Using earnings yield, which relates stocks to the bond yield, equities don't look too expensive, he said.
Still, the risk of a strong euro is causing some managers to shy away from European industrial stocks, whose exports could get battered.
Rory Powe, head of the European equity team at INVESCO Asset Management Ltd., London, predicts a polarization of stocks in Europe, with more aggressive companies that have pricing power triumphing. Domestically oriented companies also will thrive, he said.
But he warns to stay away from manufacturing sectors that rely on exports. "In fact, avoid manufacturing full-stop," he said. The winners for the next five to 10 years will be in the service sector. Even traditionally manufacturing-oriented Germany will switch to service companies, such as software, health care and telecommunications firms, he said.
"What's interesting in Europe is the emerging strength in new industries. Most should not be affected by a strong euro, because they are not affected by exports," he said.
Old Mutual's Mr. Morgan thinks stocks in some of the smaller countries could gain, as they have to be more aggressive to survive. And many note the marked rise of blue-chip stocks, as managers diversify their portfolios across Europe.
Singer & Friedlander's Mr. Dencik thinks it will take a "second generation of risk diversification" for European investors to start looking at alternative asset classes such as small-cap stocks, private equities, corporate bonds and real estate.
