Jeffrey Mortimer, CFA | Director of Investment Strategy, BNY Mellon Wealth Management
My family and I were lucky enough to celebrate New Year's in London last year, with close friends from my business school days. They are Parisians living in the UK and I can recall many conversations in which we lamented recession conditions across Europe. After Big Ben chimed the 12th time, I pondered what 2013 would bring for the troubled region.
A year later, we are facing another winter, another holiday season, and another New Year full of challenges — but also of more possibilities. To be sure, conditions are still somber in Europe, with stagnant growth, low inflation, high unemployment and restrictive fiscal policies in many countries. But as we head into 2014, we may see some green shoots in Europe that suggest better times ahead.
The MSCI Euro Index, representing 10 developed countries of Europe, is up a healthy 25.8% (local currency) year to date through November, within sight of the 29% return of the S&P 500 over the same time period. Markets typically lead the way in a recovery, sometimes before a recession has officially ended. Investors who wait for the all-clear may miss out on gains. After all, the U.S. didn't get out of recession until June 2009, which was three months after the market hit bottom. Since that low, U.S. stocks are on pace to end the year up 195%.
The eurozone, representing 17 countries, officially exited recession at the end of the first quarter after reporting two straight quarters of positive Gross Domestic Product (GDP): 0.3 in the second quarter, and 0.1 in the third.1 While Europe's recession ended in January, Eurozone equities started rising six months prior. Since the market bottom on June 5, 2012, Eurozone stocks are up 69%.
While third-quarter GDP could conceivably be revised down into flat or negative territory, investors have reason for optimism. For one, projected GDP in countries across the region is expected to rise in 2014 after recent dismal performance. As outlined in Exhibit 1, Euro Area GDP has been slowly improving over the past two years and is expected to be 1% in 2014. France, Spain and Italy are on the same path, with slightly lower growth forecasts for next year. Only Germany, the largest country in the Eurozone (by population), has bucked the trend and remained in positive territory, although its growth fell for the past two years.
Of course, a 1% growth rate is tepid at best, and suggests we will see a muted recovery in Europe that will be weaker than the slow and modest turnaround we experienced in the U.S. But when it comes to the situation in Europe, it has almost become a question of degrees. In other words, when conditions stop being really bad and are just "not great," it starts to look good.
We also have seen a commitment by the European Central Bank (ECB) to encourage growth. The road to healing began last summer when ECB President Mario Draghi vowed to do "whatever it takes" to jump start the region's economy. A surprise ECB rate cut in early November was the latest positive news for the region. Certainly Europe cannot grow its way out of a recession through cost cutting alone. Policy makers have recognized this and are demonstrably transitioning from austerity to growth policies.
Another positive sign is the path of the Leading Economic Indicators (LEI) Index, which tracks GDP over time. The LEI Index is an important barometer of economic growth and measures seven key metrics including new building permits, economic sentiment and the Euro Stoxx Index level. It also includes the Purchasing Manager's Index, which tracks new orders, inventory levels and other variables that serve to illustrate the overall health of manufacturing. As outlined in Exhibit 2, the LEI Index turned positive in early 2013, after troughing in 2009 and 2012.
A number of European country markets have begun to outpace the S&P in the past four months. For example, Germany's DAX Index is up 13.6%, while the MSCI Italy Index is up 16.4% and the MSCI Spain Index is up 19.4%, versus just 7.9% for the S& in the same time period. Four months is just a blip on the radar but it could very well indicate the beginnings of a turnaround.
Unlike the U.S. or China, Europe is more self contained in that its growth trajectory has a limited impact around the world. If GDP rises significantly in the U.S. or China, growth around the world can benefit significantly as well. Rising GDP in Europe will not have the same ripple effect.
However, a strengthening Europe with easy monetary policy — at a time when the Federal Reserve is poised to start raising rates in the U.S. — will likely result in a weaker euro versus the dollar over the long term. That would make European goods and services competitively priced, which could have a positive impact on corporate earnings.
As Europe begins this next phase of muted growth, there will likely be bumps along the way. One potential pitfall will be the so-called 'value trap,' where investors will look at any inexpensive stock as a good buy. Some stocks are cheap for a reason, and it will be more challenging to identify them in an environment of slow growth. It will be up to active stock pickers to identify companies and sectors with the most attractive fundamentals and long-term potential.
Heading into 2014, we all would like to see a stronger rebound in Europe and a clearer picture for what lies ahead. But what we have seen thus far indicates that European equities are now offering attractive investment potential
I was recently back in touch with my old friends from the UK We reminisced about all of the changes over the past year. They, too, are seeing signs of improvement across Europe. We may not be ready yet to uncork the champagne for a full-on economic Renaissance in Europe, but it could be a time to realize that better times do, in fact, lie ahead.
1 Source: Bloomberg
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