Europe’s Delayed Comeback


by Richard Gueren, Managing Editor

Europe, a beautiful continent rich with history, is poised for a gradual economic recovery in the months ahead.  That is good news since the GDP of the European Union is bigger than that of the US or China, as Barron’s recently pointed out.  In addition, the global economy would love for Europe to grow again because Europe is a destination for goods across the world.  However, beneath the positive headline numbers are worries than can be overcome with a focus on growth and prosperity.

First, some good news.  After 18 months of being stuck in recession, the 17 nations that use the euro have finally emerged from recession with modest growth of 0.3%, according to the Eurostat statistics agency.  Eurostat also said that the strongest growth rates were recorded in Portugal (1.1%), while France and Germany both grew at rates of 0.5% and 0.7%, respectively.

However, the depressed economies of Spain, Italy, and Greece continued to contract.  Spain contracted at a 0.1% rate, Italy contracted at a 0.2% rate, and Greece contracted at a stunning 3.8% rate.  In addition to economic troubles, some countries must deal with political instability. Italy must contend with the possibility that its coalition government may collapse.  There have been weeks of tension over the political future of the former premier of Italy, Silvio Berlusconi after Italy’s supreme court found him guilty of being at the center of a vast tax fraud conspiracy at his Mediaset broadcasting empire. Berlusconi has said he would pull out of current Premier Enrico Letta’s fragile left-right coalition if members of the senate vote to strip him of his senate seat.  Most observers of this fight do not expect it to become that bitter.  “I am confident, I believe there won’t be a crisis,” said Economy Minister Fabrizio Saccomanni.

However, analysts at JPMorgan Chase have warned that Italy could be the riskiest of all the EU coalition governments.  “The wear and tear of governing has created a series of cumulative pressures, which look a lot like the proverbial straws on the camel’s back. At some point one of them is likely to cause a break (our instinct tells us risks are probably highest in Italy),” said Alex White, European economist at JPMorgan, in a research note published on Tuesday.  As far as Italy’s economy is concerned, it is the third largest in the Eurozone, behind that of France and Germany.  Thus, any prolonged uncertainty could risk throwing the whole continent into economic chaos.  In addition, Italy has a massive debt pile equal to about 130% of GDP.  Therefore, a breakdown of the coalition or messy political dynamics threatens to push up yields on its government bonds which would further increase debt payments.  In a country with structural problems such as a massive black economy, rigid employment laws, low productivity, declining competitiveness, and an ineffective judicial system, a long term solution is needed right now in order to avoid the distant and incoming crisis in bond markets.

Another economy that could pose real problems for the durability of future Eurozone growth is Greece.  For starters, the economy has shrunk by 25% since its recession first began six years ago.  Its economy contracted at a rate of 3.8% in the second quarter of 2013, following a 5.6% slump in the first quarter, and a 6.4% contraction in 2012.  The unemployment rate has reached euro area highs of 27%, and youth unemployment now sits at a staggering rate of 62.9%, according to Eurostat.  Total public debt held in Greece sits at a stunning 160% of GDP, way above the 120% level the International Monetary Fund considers “sustainable”.  Therefore, with Greece’s massive debt pile and frayed social fabric, European leaders will have to come to the rescue of Greece eventually.

Unfortunately, the solutions implemented by Europe so far have not only fallen short, but have underperformed in terms of Greece’s economy.  Any solution, therefore, would most likely be crafted in Germany, which is Europe’s largest economy.  However, with a national election approaching in September, any talk of new loans or debt relief for Greece is expected to be off the table.  Since bailing out southern Europe is very unpopular in Germany, don’t expect to hear of Greek debt relief in the next few weeks.  However, the problem is unavoidable and will only get worse as Greece’s economy fails to perform.

On the other hand, some observers are also talking about the fact that European Stocks have underperformed that of the US recently.  The question for an investor is how to make up that underperformance in Europe’s stock market, the Stoxx Europe 600.  These same investors say that the worst economic news has already been priced into European equities, and that they are poised for a rebound.  They say that the bar is set so low for Europe at this point, that any economic news will be treated as good news.

Consider what equity strategists at UBS, a Swiss financial center, have been saying.  The strategists have upgraded their position on continental European equities to overweight from neutral, citing “upside” European macroeconomic data.  The data “continues to surprise on the upside, the fiscal drag is dissipating and imbalances are normalizing.”  “We still see the U.S. economy growing more quickly than Europe in 2013 and 2014, but there are finally signs that momentum may be turning in Europe,” adds the UBS team.  “Given the depressed nature of European earnings in relation to the U.S, there is more ‘bang for your buck’ in terms of a recovery in European macro.”  The UBS move echoes one made by Nomura Securities, who cite a “risk on” stance towards Europe.  In addition, JPMorgan is content with its overweight exposure, especially with supportive data coming through.

JPMorgan praised “more monetary policy support and a move from destructive austerity” from European governments, but did caution the level of economic strength in Europe: “We note that this does not mean that Europe will become an economic locomotive, as supply-side economics and macro stimulus are sorely missing.”  Consider the fact that, according to Barron’s, the Stoxx Europe 600 is up 7.5% this year, but the US S&P 500 and Japan’s Nikkei 225 have rallied 20% and 42%, respectively.  Europe is “very under invested from a global investor perspective,” says Thanos Papasavvas, fixed income strategist at Investec Asset Management in London.  “We see Europe and the UK a becoming particularly attractive,” says Nigel Bolton, chief investment officer and head of the European equities team at BlackRock in London.

And so, in short, this is the debate the global investor community is currently engaged in.  Is Europe behind the worst in terms of their economies, or is there more news that could throw the region back into an economic crisis? Those who say that the worst is already priced into the markets are recommending a transition into European equities.  And so far, there are real signs of this transition.  In a survey published by Bank of America Merrill Lynch on Tuesday September 17, 2013, fund managers’ allocations to European equities have hit pre-crisis levels.  According to the monthly fund managers’ survey, allocations to European stocks hit their highest level in September since May 2007.

Some 36 percent of global asset allocators were overweight Europe — more than twice August’s 17 percent.  The firm insisted that the shift in sentiment towards Europe has been “swift”. The bank’s European investment strategist, John Bilton, described investors’ belief in Europe’s economy as “robust”. But there are also a group of observers who say that the current risks in Europe outweigh the potential benefits. “There is the problem of effectively no demand in the global economy because most of the demand was debt-driven,” Satyajit Das, author of “Extreme Money” and a well-known pessimist about the recovery, told CNBC recently. The rally is driven by three things: faith in the austerity package; the ECB’s (European Central Bank) magnificently empty statement about doing whatever it takes; and third, the banking union, which stabilized the banking sector, except the Germans have just taken the guts out of that. These three things have all gone.” They point to a potential political meltdown in Italy and Portugal, more banking troubles in Cyprus, and risks associated with the German national elections and their willingness to aid Greece.