Stephen Jen and Luca Bindelli, economists at Morgan Stanley, have a theory why the euro is going gangbusters against the greenback, and it has more to do with money flows than the belief that the European currency is about to replace the U.S. dollar as the world's reserve currency.
They believe that the euro is overvalued because institutional investors around the world have been diversifying out of their home markets at the same time as European investors have largely been diversifying within their home market – investing their money in other member countries but staying put in the so-called euro zone.
“One perverse implication is that, when the euro zone economies finally achieve economic convergence, the benefits of diversifying within the zone should decline and European [investment funds] will need to diversify more outside the euro zone than within the zone,” the economists said in a research note. “In our view, that will be one powerful structural factor weighing on the euro, unwinding a major distortion in the currency markets in the next few years.”
As for the U.S. money managers – mutual funds, insurance companies and pension funds that collectively control about $22-trillion (U.S.) – the trend toward diversifying beyond the U.S. dollar is big. For mutual funds alone, according to Morgan Stanley, their non-U.S. equity exposure has grown from just 13 per cent in 2003 to 23 per cent today.
But again, rather than ditching the greenback out of fear about the U.S. economy or the recognition that Europe was suddenly the greatest place on Earth, these investors were simply taking advantage of globalization.
“[All] along, capital flows were probably the dominant force propelling the euro higher, out of line with the underlying real economic fundamentals. Only seven years ago the euro was ridiculed by investors,” the economists said. “Economic fundamentals don't change so drastically in a short seven years.”
The euro has risen 30 per cent against the U.S. dollar over the past two years.
