Euro's Plight A Challenge

July 20, 2012

The euro’s growing problems are forcing big decisions on investors—and quickly.

The euro has gone into a tailspin as a pair of ugly news stories put further pressure on the currency. How should ETF investors react to this news?

Friday the 13th was earlier this month, but last Friday was a brutal day for investors holding euros and euro-denominated assets. First we had news of a Spanish bank bailout which was met with much consternation.

Many in the market questioned the efficacy of the move, especially as the yield on 10-year Spanish sovereign debt hit a new high of 7.28 percent—a number considered by many to be unsustainable. The €100 billion bank bailout package is viewed as a stop gap measure that glosses over the real problem: the insolvency of the Spanish government.

Things got worse over the weekend, as six more Spanish regions asked the central government for financial support, after Valencia asked for help on Friday. That sent yields on 10-year debt up to 7.57 percent, and the euro down to a two-year low against the dollar of $1.2067, according to Bloomberg data.

As if all the Spain news weren’t bad enough, a story also came out revealing that the ECB will no longer be accepting Greek government debt as collateral in their monetary operations.

This development, which comes as no surprise considering the capitulation in price of Greek debt in recent weeks, has had a greater impact in driving the price of the euro down because the decision bring into focus potential ripple effects.

For the ECB—and, by extension, the European Financial Stability Facility (EFSF)—to function properly, it’s imperative that any capital pledges be made with liquid, reliable assets. In the ECB’s mind, Greek debt no longer fits that description. This is not really news in and of itself.

What is news, is how this is being interpreted.

With Valencia asking for help from the Spanish government to stave off its own municipal bankruptcy, the question the market is asking is: How long until Spanish debt joins Greek debt in being unwelcome?

Worse, yet, with Italy’s funding issues persisting despite a relatively successful auction earlier in the week, how long until Italian government bonds are deemed unworthy?

You can see the potential chain reaction is more important than the actual headline. With European bank and sovereign downgrades coming in at a rapid-fire pace, investors are right to focus on what is coming as opposed to what just came.

That fear has led to big selloffs in the Euro and European equity markets. The CurrencyShares Euro Trust (NYSEArca: FXE) is down, as of this writing, 0.80 percent. The iShares MSCI Spain Index ETF (NYSEArca: EWP) is down 6.76 percent.

But even large-cap multinational stocks viewed as relatively safe from European contagion like those in the BLDRS Europe 100 ADR Index Fund (NYSEArca: ADRU), are getting hammered. Its shares are down 1.56 percent today. In other words, it’s a bloodbath.

So what should ETF investors be doing in reaction to this news?

The first order of business is determining whether you think the latest developments signal a broader deterioration of European sovereign debt quality. If so, and the spike in Spanish and Italian yields continues, the likelihood of the ECB removing their debt from acceptable collateral lists also increases.

In that case you want to exit any outright positions in the euro, such as FXE, for example. The next step would be bolting from European-focused ETFs whether they’re single-country funds like EWP or broad equity portfolios like ADRU.

If only it were that easy. Your developed markets portfolios are also at risk, especially those which exclude the U.S. like the iShares MSCI EAFE Index Fund (NYSEArca: EFA).

Europe represents more than 60 percent of EFA and, as you can see, it has been dragged down by Europe’s weakness over the past year.

So while the solvency concerns surrounding Spain have driven the price of EWP down more than 40 percent in the past year, the systemic weakness in Europe has dragged EFA down along with it.

Today’s news may end up being a blip on the radar making Europe a screaming value, but for those worried about the knock-on effects the time to act is now.

Just know that you have to look at more than just your currency exposure.



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