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Strong Growth Prospects for Europe as Recession Ends 

Neil Dwane 

Viewpoints 

4/15/2014 

CIO Equity Europe Neil Dwane says there are several reasons to be optimistic about European equities: the recession is ending, the euro is strong and many high-quality companies in the euro zone have been overlooked by investors.

Key Takeaways

Europe’s recession is finally ending; better access to credit means improving growth prospects.
Europe’s central banks remain clearly committed to accommodative policies.
Investors have missed out on structurally sound, high-quality companies in Europe.
While first-quarter earnings in European markets were disappointing, investors should remain optimistic about growth.

Our Outlook: Continued Financial Repression Means Risk Assets Should Be Considered

In keeping with our long-term investment theme, we believe that financial repression will continue with low or negative real rates in many markets. However, economic growth will remain relatively weak around the world. As a result, developed-market central banks are likely to be behind the curve, maintaining accommodative monetary policies longer than the markets expect, and will tolerate higher levels of inflation. In this slow-growth, low-yield climate, there may be a risk associated with not allocating a portion of long-term assets to risk assets, as money in cash will be repressed, which will erode the savings power of investments.

Current State of Journey Toward “United States of Europe”

In this environment of continued financial repression, Europe’s policymakers promise both that they have the situation under control and will be able to generate growth. But in the three-year period through the end of 2013, economic growth slipped through their fingers. The job of ramping up growth will prove difficult because of continued deleveraging and levels of corporate and consumer confidence that remain fragile. To achieve their political and economic goals, policymakers have put Europe on a path to creating the “United States of Europe.” Many of the three key pillars that we have previously mentioned are necessary for this voyage are being slowly put into place:

Europe needs a banking union. We will soon see a roadmap for how the European Central Bank (ECB) and politicians may agree on how banks are to be supervised and regulated. Obviously, we don’t expect a pan-European deposit insurance or resolution scheme in early 2014, since the stronger countries have no interest in bailing out bad banks from the previous cycle. Over time, though, we believe politics will resolve these issues.

Fiscal integration is critical for the EU.

It was important to the future of the EU that Germany’s Chancellor Angela Merkel was re-elected in 2013, because she is looking for more, not less, Europe. She wants to encourage France, Spain and Italy to become more integrated into her vision for Europe, with more assignment of joint liabilities, but she will not issue “get-out-of-jail-free” cards by handing out money to the Greeks, Portuguese or Irish. Austerity driven out of Germany will thus remain key for the EU, and the Germans expect this to be a long-term journey, requiring both commitment and persistence.

The lender of last resort must be put into place.

If the ECB perceives the euro to be under threat, the ECB charter allows it to defend the euro as a currency. ECB President Mario Draghi thus has all the ammunition he needs to defend the European Union if another financial crisis occurs in the next few years. As a result, the euro and its architecture are becoming more transparent.

Recovery in Europe Is Proceeding Slowly but Surely

Europe’s economic recession is gradually ending, though we don’t see a rapid return to growth. Europe, over the last 10-20 years, has been content with 2%–3% nominal growth compared with the 5%–6% the American economy has been used to. Importantly, during 2012, the “all it will take to protect the Euro” comments from the ECB have significantly improved the tone and tenor of the prospects emerging in International Monetary Fund forecasts. Europe was going through a credit crunch, and by backstopping the European credit market, and allowing access to credit, the growth forecast has improved. This recovery is still fragile, but it is gaining momentum and in terms of sentiment it has helped international and domestic investors as we see payoff from the austerity of the few last years.

Draghi to Favor a Stronger Euro

Since 2007, many central banks—both in Europe and the US—have implemented aggressive easing policies; the UK, for example, increased its amount of pound sterling issuance fivefold. Yet in Europe, the ECB’s balance sheet may begin declining. The reason: After efforts in 2012 to keep the European banking system liquid, health is gradually returning to that sector and loans are being repayed. This is a key reason why the euro remains a strong currency even as the euro zone remains weak. We think Draghi and the ECB will continue to stand behind a stronger euro, because, despite causing pain for weaker peripheral countries, it’s forcing necessary restructuring and competitiveness in much of Europe, including Germany.

Mixed Progress in Europe’s Troubled South

Italy is finally beginning to turn the corner economically. We now have a genuinely constructive government there, and labor-market and other reforms are being pushed through. The important thing to remember is that in the north of Italy, there are companies that are as productive and profitable as any found in Germany. Furthermore, the more light that is shined on Italy’s “dark” (non-taxed) economy, the easier it will be for the government to raise revenues to reinvest in the rest of the country’s economy.

Greece’s gross domestic product in the last five years has fallen nearly 40%, and it’s no surprise the equity market is cheap with a price-to-earnings ratio (P/E) of 5. This means that, over the next 10-12 years, investors have the potential to earn an attractive return. Yet many investors are still overlooking the scale of serious restructuring in this country. We remain very constructive on Greece and are selectively constructive on other peripheral countries.

Corporate Europe Is in Good Health

Many high-quality companies in the euro zone have been overlooked by investors, who by and large have not realized that these companies don’t need a lot of economic growth, don’t need a rising tide and are structurally very strong. Combined with a general lack of an equity orientation in Europe, the result is that many of these companies remain undervalued and have missed the global rally of the last four years. Yet there are three compelling reasons for investors to take a new look at European equities today.

1

Attractive Income Potential from Dividend-Paying European Equities

Dividend payouts in Europe are stable and solid relative to otherequity asset markets. As a result, we believe it makes sense for income- focused investors around the world to start focusing on European equities—particularly fixed-income investors who have been taking what may be outsized risks to get the income they need. Income investing in the equities space is different. By investing in high-quality companies that pay dividends, equity investors don’t have to take a lot of risk other than that of simply being in equities themselves.
2

European Markets Are Not Artificially Inflated

In recent years, US corporations issued record levels of bonds and pushed equity markets to new highs. Europe has not done this yet, though there is a potential for it to do so. Of course, during this time, US equities outperformed European equities, but it is important to note that the largest buyer last year of US equities was corporations; they are essentially selling to themselves. That makes US companies more leveraged, from our perspective, which puts European corporations in a stronger position in 2014 and beyond
3

Europe’s Recent Underperformance and Current Strength Points to Strong Upside Potential

The past two years has shown a very aggressive re-rating of equity markets, but not because of earnings growth. Clearly, we need to see an upward earnings trend in the US and particularly in Europe, which had fairly disappointing first-quarter numbers. Still, we remain optimistic that European equities will manage to turn the corner and continue to offer investors attractive investment opportunities, particularly given Europe’s 40% underperformance against US equities in recent years. Market-watchers who are concerned that the “great rotation” has not yet happened should realize that many investors were already quite long equities in certain regions—but not in Japan and Europe, where asset allocation to equities has historically been very low. As a result, we may yet see a great rotation, but perhaps not in America.

Conclusion: Bright Prospects for Europe

Prospects for global economic growth remain muted, with financial repression continuing to force central banks into an accommodative stance. This is keeping rates artificially low, forcing investors further out on the risk-reward spectrum. At the same time, our outlook for Europe remains positive. We believe that the recession in Europe is ending and that we are in the early stages of a genuine, albeit gradual, recovery. Continued solidification of the euro, increased access to credit and an abundance of overlooked, quality companies are combining to suggest that Europe’s recovery will be both real and sustainable.





The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
Dividend-paying stocks are not guaranteed to continue to pay dividends. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. Past performance is not indicative of future results.

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AGI-2014-04-15-9461 

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