A falling dollar could be one of the downside risks facing the Eurozone’s recovery next year, with every 10% change in trade weighted EUR/USD reducing Eurozone earnings by nearly 7% according to Morgan Stanley analyst Matthew Garman.
Eurozone sensitive to exchange rate
“We estimate every 10% rise in the trade-weighted euro subtracts around 3% from European earnings,” writes Garman, but since the Eurozone is more sensitive to exchange rate fluctuations than Europe as a whole, it would take an even bigger hit. “Eurozone companies generate 14% of their revenues in the US, and around 55% outside of the Eurozone. This would suggest that a 10% rise in the trade- weighted euro would knock around 7% off Eurozone EPS.”
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Eurozone profits for 2014
Garman isn’t optimistic about Eurozone profits for 2014, with most of the leading indicators that he’s looking at pointing towards a slower recovery than we’re used to. Profitability and margins also didn’t fall as far in this recession as they have in previous ones, so there are fewer easy gains to make.
But even if everything inside Europe goes well, having such a significant external risk should worry investors. Most people still think that tapering is going to start toward the beginning of 2014, and the impact it will have on the US economy is hard to predict, with analysts confidently making very different predictions. The dollar also faces a significant political risk. Even if you believe that neither party will actually allow a default, every time we go to the brink, foreign creditors will have to reevaluate the role that dollars and Treasury bonds play in the global market.
Axel Merk of Merk Investments has written that he thinks the euro is strengthening despite public perceptions that it’s in a precarious position. He doesn’t think that there is necessarily a connection between the underlying market and the strength of a currency, and even though Europe has challenges it’s not as if the U.S. has resolved its long-term fiscal obligations. “While the dollar may experience short-term strength from time to time, as is being evidenced this month, our medium to long-term outlook on the dollar remains bearish,” writes Merk.