The biggest threat to the euro – and how to profit from it

Europe's problems go a lot deeper than Greece.

If you didn't already know that, it became pretty plain yesterday.

Germany, France and Italy all saw their economies shrink in the final quarter of 2012, compared to the third quarter. Overall, the eurozone economy shrunk by 0.6%, a bigger drop than expected.

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It's all pretty grim. It also puts even more pressure on the most important relationship in the eurozone the one between Germany and France...

Why Greece didn't leave the euro...

For most of last year, the biggest threat to the euro was the Grexit' the danger that Greece would drop out (or be kicked out) of the zone, resulting in a chain reaction of fellow members leaving.

That threat receded as the Greeks voted to stick with the status quo, and the European Central Bank (ECB) stepped in to promise unlimited government bond-buying, if necessary. Markets strengthened, along with the euro.

Now Greece is hardly out of the woods yet. Between the fourth quarter of 2011 and the fourth quarter of 2012, the economy shrank by 6%. The Greeks may yet get sick of this.

But I'm rapidly coming to the conclusion that by far the greatest risk to the euro is an exit by Germany, not Greece, or one of the other peripheral countries.

Let's think about this for a moment. The peripheral nations are in a lot of pain. That's why pundits argue that they will vote to leave the eurozone: simply because the populations can't stand it any longer.

But it's not that simple. The first problem is this: people in the peripheral nations are only too aware that they are suffering. But they don't necessarily link that suffering to the euro in itself. They're more likely to link it to the intransigence of their fellow members the Germans in particular.

So there's no direct link in the average voter's mind between the single currency and their economic woes. That's why we haven't really seen any major anti-euro political movement yet. There's a hint of it in Italy, but I suspect that's more about blackmailing other members to gain influence: Italy knows it's too big to fail, so the European Central Bank had better fall into line, or else.

Secondly, for the peripheral economies, the euro represents a major advance for them. Many of the Club Med' countries have only recently (in historical terms) become democracies. Being able to join the euro and the ranks of the firmly developed economies is quite an achievement. Leaving again would feel like a step back. Nobody wants that.

And thirdly, ditching the euro is hardly an easy option. It's not as though these economies will recover the morning after they return to the drachma or peseta or escudo. Inflation will rocket, savers will be ruined, and you'll have a lot of potential for unrest and unpredictable side-effects. That's not something you vote for lightly.

... and why Germany just might

So, thinking about it like that, the fragile countries are not in a good position to leave the euro. They might need a weaker currency, but they'd much rather have a weaker euro, not a return to their old currencies.

And the peripheral nations now have a champion, in the form of France. French president Franois Hollande is agitating for a weaker euro. But the Germans are not so keen.

Jens Weidmann, head of the German central bank, told Bloomberg: "I fear a politicisation of the exchange rate". Other German officials may not be quite as hard money' as Weidmann, but with a German election up ahead this year, Angela Merkel has to tread a line between creating more eurozone upheaval, and being seen as bowing to the demands of other nations.

So we've got a situation whereby France and a majority of the other eurozone nations need and want a weaker currency. None of them are prepared to take the consequences of actively marching out of the euro. Germany on the other hand, is having its arm twisted to bail these countries out (as it sees it), at the risk of inflicting higher inflation on its own citizens.

If Germany were to leave the euro, its new currency wouldn't collapse. If anything, it would soar. We might see that as a big problem for an export-dependent nation, but estimates by various investment banks suggest that Germany could tolerate a much higher exchange rate before it caused it real pain.

So here are the choices: if you are Greek, you have a choice of doom by deflation, or doom by rampant inflation. Your best hope of a more moderate path is to get a far weaker euro. Given the options, throwing your lot in with the French and pressurising the ECB to weaken the single currency, looks the best of a bad bunch.

If you're German though, your choice is: bail out all these other countries and put up with inflation. Or leave them to it, get the strong currency you desire, and keep pumping out top-class export goods that other nations will buy anyway. The only thing keeping you onside is an emotional attachment to the eurozone project'.

So what does it all mean investment-wise? A German exit would take ages to play out. It's not going to happen soon. But the Germans are not going to get the kind of euro they want.

Indeed, I'd be surprised if the euro gets much stronger this year from here. Given the litany of whining that has already started up, I hate to imagine the reaction if it actually gets to $1.40 or more, from where it is now. The ECB will come under pressure to act, or to at least keep talking it down.

So if you are the spread betting type, you might want to have a punt (bearing in mind it's highly risky). Our expert trader John C Burford regularly covers the euro in his free email, MoneyWeek Trader you can sign up for it here.

For those who aren't so keen to spread bet, a weaker euro would be good news for European stocks: those in the periphery particularly. Markets have taken a bit of a hit recently as the currency has strengthened, but I'd still be happy to buy. Peripheral markets aren't as cheap as they were, but if you keep drip-feeding money into them, I don't think you'll regret it in the long-run.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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