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Beacons point the way in stormy euro zone

Here's the conundrum for investors considering how to play Europe: While the day-to-day political news can be relentlessly unsettling, there are economic bright spots.

The euro has been on the rise against the U.S. dollar for the past few months, reaching $1.3169 last week, although it closed at $1.2836 on Wednesday. And for investors facing yields of about 1.8 per cent on 10-year Government of Canada bonds, the 5-per-cent yield on Spanish paper can seem very attractive indeed.

But tread carefully when investing in the euro or the sovereign debt of the 17 countries in the euro zone, experts say.

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"I still think it's still too early for the average investor to commit a meaningful proportion of funds to the euro zone," says Paul Taylor, the Toronto-based chief investment officer with Bank of Montreal Global Asset Management. "It's still too tentative a situation – it's too fluid. There is still a measure of a leap of faith at this stage."

HSBC's year-end forecast is for the euro to trade higher, at $1.35, says Robert Lynch, the New York-based head of G10 FX strategy, Americas, for HSBC Bank USA. He adds, however, that with politics often driving currency markets, there is always the risk that a political decision could cause a flareup, leading to a price swing that could have a dramatic impact for investors.

"If you're someone who just bought euros at $1.28 or $1.30, and some unexpected negative development were to develop in Europe, and it brings [the euro] down to the lows that we've seen over the summer, well that's a huge event for you," Mr. Lynch says.

Investors can take comfort, however, in how consistently over the past three years European officials have taken the steps needed to bring flareups under control, he says.

It's a pattern acknowledged by Peter Schaffrik, the London-based head of European rates strategy for Royal Bank of Canada. There is "a very, very clear narrative in which direction this European crisis is evolving," he says, one that can help investors overwhelmed by continuous, sometimes conflicting stories about the euro zone.

The three threads of that narrative include "old school" fiscal tightening, more European co-operation and European Central Bank intervention. The first involves governments making adjustments to get "their fiscal houses in order" – moves that Mr. Schaffrik says are much sharper and more successful in the euro zone than in Britain or the United States.

Europe has also become more co-operative by almost every measure, he says, from bailout funds to oversight. And the central bank has indicated that it will intervene more forcefully; it detailed this month how it plans to buy sovereign debt in stressed countries if necessary.

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"We are constructive optimists" on Europe, Mr. Schaffrik says – not Pollyanna-ish, but encouraged by the steps being taken.

"We think growth is going to be poor, we think that the fiscal adjustment has many more years to run, we think the social and political strains are for real, but we also think – where we place more emphasis – is that real development is happening."

He cites as examples Spain's trade balances – it has moved from a huge importer of goods to a net exporter – and Irish wages, which he says have dropped 20 per cent to 25 per cent.

When it comes to bonds, RBC is upbeat about peripheral ones, especially those that will be targeted by the central bank, Mr. Schaffrik says. The bank has promised to buy bonds in crisis countries that seek European aid, to help reduce their borrowing costs and keep the euro zone united. Spain is expected to ask for a bailout before the end of the year.

In particular, Mr. Schaffrik says, RBC likes the two-year, three-year and even four-year Spanish bonds, and Italian bonds.

As for the euro, investors should shy away from making a play for it against the U.S. dollar, says Adam Cole, RBC's senior currency strategist, also based in London. Both currencies are weak, he says, which explains why, despite the bad news in the euro zone, its currency is staying strong against the U.S. dollar.

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Mr. Cole argues that because the U.S. dollar trades as a safe haven and the euro as a risky asset, investors would be better to "cross the euro against another currency that has similar risk properties." His choice: the Canadian dollar. "The long euro versus the CAD is a trade we like at the moment," he says. (The euro closed Wednesday at $1.2684 Canadian.)

Mr. Taylor believes that the euro is probably overbought – which explains why it has appreciated from $1.20 to around $1.30 (U.S.) in a short time. But the central bank's move to keep the euro zone together will help over the long term, he says. He expects the euro to "firm modestly" against the U.S. dollar over the next 12 to 24 months.

As for bonds, Mr. Taylor suggests that investors who want exposure to European debt choose a fund or a co-mingled vehicle – "to get adequate diversification, by currency and by credit in European bonds."

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