Making the case for Europe

It has been widely accepted that the U.S. has led and continues to lead the global recovery. Even from an investor’s perspective, no one can dispute the fact that U.S. equities have outperformed the world average in the past six years. Coming out of the 2009 market lows, the S&P 500 returned over 160 percent, while S&P Euro 350 investors enjoyed a 124 percent return over the same period.   

Clearly, European equities have lagged behind their U.S. peers. However, with U.S. company valuations becoming quite stretched, some investors are questioning the viability of continued stellar market performance in the U.S.  

Maybe it’s time to consider a reallocation to another region, specifically the eurozone. I can still recall in 2008, 2009 and even 2010 when doomsayers kept warning us that it will take many years for the economy to come around. They were certainly right about that, but what they did not expect was the Fed’s determination to support the economy for this long. The market’s expectation for rising interest rates has been pushed back every year for the past five years. Although the U.S. economy is on much better footing now than it was at the height of the crisis, equity markets recovered long before that. This begs the question, should Europe not follow the same market return pattern? 

 

What risks are the eurozone facing?  

The eurozone still faces significant challenges. High unemployment, lack of earnings growth, and unresolved problems in the banking sector are the most obvious ones that come to mind. An inflation rate of just 0.5 percent compared to the ECB’s goal of just under 2 percent is also a concern, making the threat of deflation seem even more real.  

Moreover, the euro has gained 6.5 percent against the U.S. dollar in the past 12 months. This has resulted in declining import prices, ultimately jeopardizing the fight against inflation. The threat of deflation coupled with the tremendous amount of spare capacity in the eurozone may be the impetus for the ECB to introduce further stimulus. Consequently, this can only provide a boost for equity markets in the 18-nation currency bloc. 

 

What makes Europe attractive?  

It’s primarily a valuation argument served with a side of hindsight acquired from the U.S. experience. In particular, European equities are cheaply priced compared to their own historic valuations. Also, on a relative basis compared to their American and emerging market counterparts, European equity valuations appear very compelling.  

However, critics argue that eurozone equities are trading at significant discounts to their U.S. peers for good reason: low or no earnings growth. If we don’t expect any significant growth out of the area, how can we expect European companies to increase their profit margins?  

Firstly, companies can continue to cut costs just as their U.S. peers have done for the past six years. Secondly, stock prices will not necessarily be driven by individual company fundamentals but by monetary policy. Contrary to the U.S. Central Bank, which has started tapering, the ECB will continue an accommodative monetary stance and may even employ some of the same unconventional tools already tried and tested by the Fed.  

The positive effect of the ECB’s loose monetary policy on European equity valuations is already evident. As seen in the aftermath of ECB president [Mario] Draghi’s remarks in July of 2012 committing to do whatever it takes to support Europe’s recovery, European equities outperformed their U.S. counterparts to date. Over that 22 month period, the S&P 500 lagged the S&P Euro 350, returning 42.78 percent and 49.97 percent (in USD terms), respectively. 

With the economy forecast to grow around 2.8 percent this year, the U.S. is still poised to lead the global recovery, while the eurozone is finally expected to be a net contributor to global growth, coming in with 1 percent GDP growth. From an economic recovery standpoint, the U.S. is definitely winning the race. 

However, let’s not forget that despite the slow and gradual economic progress made in the U.S., Wall Street recovered way ahead of Main Street. Europe’s experience could be the same. 

Please take a moment to reflect and ask yourself: “Shouldn’t we expect the same outcome in the eurozone as the U.S., and if so, do you have any exposure to the region in your investment portfolio?” If not, then you may want to reexamine your geographical allocation.  

If you still feel uncomfortable with the lackluster growth prospects in Europe, focus on European companies with a global client base rather than the ones that solely depend on European economies for their survival. 

 

Disclaimer: The views expressed are the opinions of the writer and while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.  

Mario-Draghi

ECB President Mario Draghi in July 2012 committed to do whatever it takes to support Europe’s recovery,
AFP/Getty Images

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