Blog : Penny Stocks and a Euro Devaluation

by Ed Zwirn on May 31st, 2014

Those of you betting the proverbial ranch on the decline of the dollar should bet again.

In a move likely to strengthen the U.S. dollar, at least against the euro, many are expecting the European Central Bank's governing council on Thursday to announce an interest rate cut. Especially in the wake of recent European Parliament elections, the results of which indicated an increasingly dissatisfied electorate, speculation is mounting that the ECB will bow to pressure and cut its key lending rate to below zero.

It is true that speculation to this effect has ramped up markedly after the European elections, which saw nationalist parties capture around a quarter of the vote. Americans take it for granted that their central bank will have to stimulate their own economy with a politically paralyzed and debt-ridden government being unable to do so. Multiply these assertions several times over, and you get an idea of what is going on in Europe, where the governments and the bank must face down a much slower rate of recovery (from a much lower bottom) than here.

But there is more than post-election speculation going on here. As ECB President Mario Draghi pointed out at his May 8 monetary policy press conference, real GDP in the euro area rose 0.2% in Q4 2013 (vs. 2.6% in the U.S.), marking only the third-consecutive quarter that the European economy registered in the plus zone. Eurozone inflation came to 0.7% in April, making the ECB's target of 2% inflation seem very distant.

"There is consensus about the projected path of inflation, and so there is a consensus in not being resigned to this and accepting this as a fact of nature, which would lead to consensus about action, but, as I said before, after having seen the staff projections that will come out in early June," he said then about the possibility of stimulative action coming out of Thursday's ECB meeting.

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The result, if this comes to pass, will almost certainly be a market devaluation of the European currency, as traders awaken to the certain knowledge that so much more of the stuff will soon be printed. As the products of European companies in effect become cheaper, this will boost the continent's export figures, while doing the opposite to U.S. (and other) manufacturers trying to peddle wares to the Old World.

If the ECB issues such an announcement Thursday, the European policy shift would come as the U.S. Federal Reserve is in the process of proceeding in the opposite direction. While the Fed is locked into near-zero short-term rates for the foreseeable future, it is unlikely to lower them even further, as the ECB seems poised to do. But the Fed is lowering the volume by $10 billion each month as it tapers off on its purchases of Treasury paper and mortgage-backed securities. When the Fed issues its next announcement on June 18, it will almost definitely continue tapering, lowering the purchases to $30 billion a month.

The net effect of this will be to strengthen the dollar against the euro (all else being equal) and therefore worsen the trade position of the U.S. relative to Europe. As I wrote in my most recent investment blog, this effect may have already taken place as early as Q1, when the descent of the GDP into negative territory was propelled in part by a worsening of the balance of trade, driven by a rise of imports from Europe. A euro devaluation could further increase this pressure on U.S. GDP growth in time for July 30's advance Q2 estimate. The euro is currently quoted at about $1.36, and there is talk that it could go as low as $1.23 this year, a devaluation of around 9.5%.

The upshot for penny stock investors: With many stock market indices at all-time highs, there is no denying that there is a danger of retreat. That being said, the hunger for yield that drives penny stocks and other speculative investments will continue unabated as there is virtually no chance of the Fed's allowing risk-free interest rates to rise from near-zero any time in the foreseeable future and do even more harm to exporters. In addition, countries with debts to pay off have every reason to hope that a healthy rate of inflation will help them to pay them off with cheapening currency.

This low-yield environment helps speculative investments in general, but the devil may lie in the details. Penny stock companies with little exposure to cross-Atlantic economic turbulence stand to unambiguously benefit as investors pile on risk in search of return. On the other hand, companies with cross-currency exposure stand to either win big or lose big in this potentially volatile scenario. In any case, many investors of all sizes and stripe may do well to reevaluate their portfolios on Thursday.