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Thank Europe for a stronger dollar
France and Netherlands' rejection of the new European Union constitution set the U.S. up for a stronger dollar and lower interest rates. Here's why.
By Jim Jubak
Thanks, Europe. The U.S. dollar, U.S. interest rates and the U.S. housing boom needed that.
The recent very loud "No" votes (actually "Non" and "Nee") in France and the Netherlands against the proposed new constitution for the European Union make it likely that, for the next six months at least, the dollar will continue to rally against the euro, interest rates on the U.S. 10-year Treasury bond will stay stuck below 4% and, with interest rates on mortgages so low, the housing boom will keep on booming.
Let me explain why a vote so far away on an issue that so few U.S. investors or homeowners care about will turn out to have such an impact on our lives.
First, the facts
On Sunday, May 29, the French voted 55% to 45% to reject the proposed new constitution for the European Union. The following Wednesday, June 1, Dutch voters rejected the constitution by an even wider 62% to 38%. In order to take effect, the document had to be ratified by all of the European Union's 25 current members. Now those efforts are being shelved.
This doesn't kill the European Union, by any means. The Treaty of Nice, which was the legal basis for decision-making in the union before the vote, remains in force. The euro remains the European Union's joint currency, and the European Central Bank remains in charge of the union's monetary policy and interest rates.
Second, the emotions
To understand the financial shockwaves set off by the vote, you have to look at the emotions that fueled opposition to the constitution. In France, the vote was a protest against an already slow economy. The French economy is projected to grow by just 1.4% this year, according to the Organization for Economic Cooperation and Development, and unemployment is running at 10.2%.
But many of those who voted "No," according to exit polls in France, also feared that closer integration of the French economy into the European Union under the proposed constitution would give bureaucrats in Brussels and bankers in Frankfurt the power to impose what is known in France as the "Anglo-Saxon model."
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Many economists favor applying some -- or all -- of that model to France in an effort to increase economic growth and productivity. But most French workers see this "reform" as an excuse to cut vacation hours, lengthen the work week, cut social and unemployment benefits, and open up the French economy to an influx of cheap workers from the new, less-developed Eastern European countries that have just joined the European Union.
Third, the blame
In this atmosphere, the referendums in France and the Netherlands -- where opinion polls show that Dutch voters shared many of the fears of the French -- turned out to be less votes on the proposed constitution than votes on the sitting governments in those countries and on the monetary policies symbolized by the euro.
In France, the government of President Jacques Chirac got blamed for the worst of both worlds. It was the Chirac government's fault, everyone in France agreed, that the economy was growing so slowly and there were so few jobs. And no one gave the government any credit for the few halfhearted steps it had taken toward reforming the economy by trying to cut spending on social services and reducing the number of jobs (and wages) in the public sector. To economic reformers, the steps were too tentative to improve the economy's performance. To most of the French work force, these small steps were too much, since they were just the opening of a campaign to turn French workers into American-style wage slaves.
But not all the blame stuck to domestic politicians. In the Netherlands and France, the European Central Bank and its currency, the euro, drew a good share of the anger. A third of Dutch voters cited opposition to the euro as their reason for voting against the constitution. The Dutch guilder had been undervalued in the currency conversion, and that had led to higher prices for Dutch consumers and an economic slowdown, voters told exit pollsters.
Fourth, the fallout in Europe
The "No" votes in France and the Netherlands seriously weaken the governments of those countries. In the aftermath of the vote, Chirac almost immediately fired his prime minister. But the new prime minister, Dominique de Villepin, has a reputation as a distant aristocrat, and this shuffling of deck chairs isn't likely to reverse the current government's unpopularity. That makes the Chirac team very, very unlikely to propose any measures that would further alienate voters. And this weakened government is extremely unlikely to pay any attention to pressure from the European Central Bank to control spending or cut its deficit.
Which wouldn't be so much of a problem for the European Union and the euro if the French weakness wasn't duplicated in so many of the economies of the countries that made up the core of the pre-expansion union. Germany is growing even more slowly than France. Economic growth in Germany is forecast at 1% for 2005, and its unemployment rate is 12%. The country's ruling party has just lost an important state election that throws its future into doubt. The Italian economy is not only growing slowly, with 2005 growth estimated at just 0.5%, but the government of Silvio Berlusconi doesn't have much room to maneuver. In 2003 and 2004, the country's budget deficit exceeded the European Union's guidelines calling for a deficit of less than 3% of GDP.
It's pretty clear what will give first in Europe. Cutting spending to keep deficits to the European Union guidelines is out the window. Even before the referendum on the constitution, the Chirac government had thrown in the towel on this one by announcing a "special" supplementary increase in wages for government workers. The pressure to spend, even if it means busting the budget, is likely to be irresistible.
So now, the betting is on for when the European Central Bank will cave and abandon its inflation-fighting first take on setting interest rates. The bank has kept its short-term interest rate at 2% for the 12 countries that adopted the euro even as economic growth slowed. At its regular rate-setting meeting June 2, the bank lowered its growth forecasts for the euro-zone economies to 1.4% in 2005 and 2% in 2006, but left short-term interest rates at 2%. Now the financial markets are sensing an interest-rate cut is in the winds.
The justification for that 2% rate has gradually slipped away as the bank's projections for inflation have declined. The June 2 forecast calls for inflation of 2% this year and just 1.5% in 2006. That latter figure is well below the banks' stubbornly defended target of 2% inflation.
Finally, what this means here in the U.S.
Financial uncertainty in the European Union pushes the U.S. dollar higher and U.S interest rates lower. Let me count the ways.- A European interest-rate cut would increase the spread between U.S. short-term rates, now at 3.25%, and European rates at 2%. That would help the dollar and increase demand for U.S. Treasury bonds. That increased demand should drive U.S. bond prices higher and yields on those U.S. bonds lower.
- Slower growth in the European Union increases the likelihood of a euro-zone rate cut. (See No. 1 for the effect.)
- Budget-busting by European governments pushes more euro-denominated bonds onto the market. More supply usually leads to lower prices. And nobody wants to hold euro bonds if they're about to lose value.
- Uncertainty about the euro -- you can even find articles speculating about the death of the euro in the European financial press -- reduces demand for euro-denominated financial assets among the Asian central banks that had been looking to diversify out of U.S. dollars. (By the way, I think the euro is here to stay, and the speculation about its demise is exactly what you'd expect in the first aftershocks of these "No" votes.)
All this leads to a stronger dollar and lower interest rates in the U.S.
Not maybe by a whole lot. With the dollar having retraced seven months of declines against the euro, I'd expect the pace of the euro's decline to gradually slow over the next few weeks. If this move is like most currency moves, history suggests that with the dollar up 11% year to date, the rally is likely to take the U.S. currency up another 4 points against the euro. The huge U.S. trade deficit, which weighs on the dollar in the long term, hasn't gone away. Interest rates on 10-year bonds in Europe are now about 3.5%, in the U.S. they're 3.9%. That's not the kind of huge gap that leads to another big leg down in U.S. interest rates as investors snap up higher U.S. yields.
But the stronger dollar and lower rates could possibly be here for quite a while. While that gap between U.S. and European 10-year yields may not be big enough to trigger a further big decline in U.S. long rates, it is enough to keep U.S. rates down at current levels. Especially if you add in uncertainty's effect on the euro.
Some economists are beginning to argue that the reason U.S. 10-year rates are so low despite eight interest-rate hikes by the U.S. Federal Reserve is because the world's financial markets are awash in savings from Asia. With all that money looking for safety, U.S. Treasurys at 3.9% look pretty good.
Everything that happened last week in Europe just made them look even better. And I think we're looking at a six-month period while Europe recovers its confidence after those "No" votes.
If U.S. interest rates stay below 4%, is it safe to stop worrying about a housing bubble? Thats the topic Ill explore in my next column.
Changes to Jubaks Picks
Sell Smithfield Foods
There was nothing wrong with the earnings that Smithfield Foods (SFD, news, msgs) reported on June 3 for the fourth quarter of fiscal 2005. (The company's fiscal year ends in April, so Smithfield Foods is now working on its first quarter for 2006.) Earnings hit the 73 cents that Wall Street expected and, after you strip out all the one-time gains, were up 16% from the fourth quarter of fiscal 2004. But I'm selling the shares as a short-term trading call. The stock's price performance against all other stocks (its relative strength) has been falling. The company also faces two quarters of very tough comparisons with big earnings increases in the comparable periods of fiscal 2005. That, plus the stock's pattern of faltering in the summer months, leads me to this sell. If you're a long-term investor (with a holding period longer than the 12 to 18 months of Jubak's Picks), you ought to carefully consider just hanging on through the weakness. The shares are up 17% since I added them to Jubak's Picks at $24.63 on Aug. 20, 2004. (Full disclosure: I will sell my shares of Smithfield Foods three days after this column is posted.)
Buy Joy Global
It's really tough to find manufacturing stocks in this market with significant headroom. So many have had great runs but look like they've topped out because the cycle in their industry has just about hit its revenue peak. Joy Global (JOYG, news, msgs) is an exception, in my opinion. The company is now set to reap the benefits of the 25-year slump in the mining-equipment sector. (You might know this company under its pre-bankruptcy name of Harnischfeger Industries.) During that downturn, mining companies have shunned new equipment as the industry consolidated and as equipment from shuttered mines was transferred to more productive mines. But now, with the companies in the coal- and iron-mining sectors looking to increase output any way they can, mining companies are buying equipment again. And, thanks to that same long downturn, they've only got three suppliers left to buy from. Lehman Brothers estimates that sales for Joy Global in this cycle will peak somewhere around $2.5 billion annually: In the fiscal year that ended in October 2004, sales came to $1.4 billion. Lehman Brothers figures that would result in peak earnings per share in 2009 of $3.75, better than double the $1.71 a share that Wall Street expects the company to earn in the fiscal year that ends in October 2005. As of June 7, I'm adding the shares to Jubak's Picks with a June 2006 target price of $48 a share. I'd set a stop loss on these shares at $28.
New developments on past columns
5 stocks for an up-and-down year
On Friday, June 3, L-3 Communications Holdings (LLL, news, msgs) announced that, as Wall Street had suspected, it would indeed buy Titan (TTN, news, msgs) for $2.08 billion, or $23.10 a share. (L-3 Communications also will assume $508 million in debt.) The price is a good one, only a 1% premium to Titan's recent price, and will add, by my estimates, 5 cents a share to L-3 Communications' earnings per share in 2005, and another 25 cents per share in 2006. The deal combines a maker of high-transmission rate, highly secure communications gear for civilian and military markets (L-3) with a service and engineering company (Titan) that specializes in classified military work. Of Titan's 9,000 employees with security clearance for classified work, some 5,000 have top-secret clearance. The combination will enable L-3 to compete for business selling global networks for the secure transmission of intelligence data. Titan also opens up the Navy as a new potential major customer for L-3 Communications. As of June 7, I'm keeping my target price at $90 a share but stretching out the deadline to June 2006. I'd set a stop of $64 a share. (Full disclosure: I own shares of L-3 Communications.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: L-3 Communications and Smithfield Foods. He doesn't own short positions in any stock mentioned in this column.
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