The euro zone is expected to remain in recession, recovering slowly in the second half of this year. The European Central Bank (ECB) recently revised downward its GDP forecast for the year to -0.5%. One may reasonably question the wisdom of investing in any of the euro zone national equity markets this year. We believe there are, nevertheless, some attractive investment opportunities in this region, for two main reasons.
GDP And Stocks
The first reason is that there is surprisingly very little correlation on a year-to-year basis between GDP growth and stocks, even in terms of direction. Analyses by our friends at Ned Davis Research have demonstrated this. The lack of correlation is particularly evident in Europe. Last year, while GDP growth in Germany slowed from 3.1% the previous year to 0.9%, and slowed in France from 1.7% to 0%, the ETF that tracks that tracks the German equity market, iShares MSCI Germany (EWG), gained 32.8%, and the French ETF, iShares MSCI France (EWQ), gained 24.4%. One reason is that the stock market usually leads the economy. By the time GDP figures are released and then often significantly revised, the underlying data is well-known and largely factored into the market. Leading economic indicators are generally better predictors of market developments.
Also, European stocks are strongly affected by financial developments. European firms depend on banks for 80% of their debt financing needs. Any indication that credit conditions will tighten quickly impacts equity prices. Last year, when ECB President Mario Draghi stated the central bank would do “whatever it takes” to protect the euro, support the euro zone’s financial system, and keep credit flowing, the subsequent “relief rally” more than offset concerns about the slowing economies in the region. Investors remain optimistic that the tail risk of a major financial crisis in Europe has been greatly reduced. Even the results of the Italian election, which implied a rejection of economic reform and austerity policies, were taken in stride by financial markets after an initial sharp downward jolt, to Italian equities in particular. Bond spreads versus Germany’s remain well below those of 2012.
Economies vs. Markets
The second and more important consideration in deciding whether to invest in Europe is that there are great differences among the euro-zone economies and equity markets. The largest euro-zone country, Germany, is clearly doing better than its neighbors. While foreign demand has been weak in the region, export growth to emerging markets has been healthy. Germany’s competitiveness has so far permitted it to overcome the headwind of the strong euro in recent months. Its fiscal accounts are in balance, in contrast to the situation for most advanced economies. Incomes and household consumption are rising, and low interest rates are stimulating residential construction. Germany also benefits from being considered a safe haven by investors. Germany’s equity market is our first choice within the euro zone. The German ETF, EWG, has just about recovered from a drawback, shared by most euro-zone markets, that was prompted by the Italian elections. It has gained 2.47% year-to-date.
While the French equity market’s performance thus far this year has been very close to that of Germany, the two economies appear to be diverging as French President Hollande struggles with growing signs of a very significant real estate bubble, disturbingly high unemployment, fiscal imbalances that severely limit the government’s scope for stimulating the economy, and strong resistance on the part of his supporters, in particular the trade unions, to needed economic reforms. The OECD’s leading indicators and the latest PMI (Purchasing Managers Index) readings point to France’s relative weakness. France’s industrial production dropped by 1.2% in January. A period of underperforming equities looks likely.
Italy and Spain are the third and fourth largest economies in the euro zone. Both economies are depressed, with Italy’s GDP some 10% below its pre-crisis levels. Both countries have enacted significant and much-needed economic reforms. In the case of Spain the PMI increased significantly in February, from 48.1 to 58.6, and industrial production ticked up in January by +0.6% over the previous month. Spain’s economy does appear to be turning the corner, while Italy’s recovery is less clear so far. Its PMI declined in February from 47.8 to 45.8. Its industrial production for January is not yet available. Both economies have had to face a stronger euro in the opening months of this year, which has had the effect of offsetting the improvements in competitiveness they had achieved. Going forward, their ability to progress will depend on the future course of the euro, since the opportunities for further competitiveness-enhancing reforms appear limited by the political situations in both countries.
Spain’s equity market has recovered strongly from its August 2012 lows, and year-to-date the Spanish ETF, iShares EWP, is up 2%. It is likely to do a little better than the euro-zone average this year. Italy is a more risky call due to the unsettled political situation. Italy’s equities experienced a strong sell-off in February as a result of the elections, dropping by 12%; and they are still down by 6.8 % year-to-date, as measured by the iShares MSCI Italy ETF, EWI.
Italy: Picking Up The Pieces
The unresolved government situation in Italy is indeed a mess. Whatever government emerges, further economic reform initiatives seem unlikely, at least in the near future. But the agenda has already been set by the outgoing Monti government, and many reforms have been established as laws. Some easing of austerity measures is likely and probably would be good for the market. We should remember that Italy has a history of weak governments and profligate fiscal policies. Its economy has lagged those of other European countries. Still, there are some positives for Italy. With the exception of 2009 and 2010, the Italian government has run primary surpluses (that is, excluding interest payments). Neither Spain nor France can claim the same. Italy’s private sector carries relatively little debt and has a high net worth. Italian banks are in a stronger position than those in many other euro-zone countries. It was the public sector’s heavy indebtedness, along with financial contagion, that caused investors to pull out of Italian equities during the euro zone financial crisis. With Italian equities very cheap and still near multi-year lows, we see the possibility of their outperforming the German, French, and Dutch markets over the next 12 months as the economy recovers.
The strongest recent performance by a euro zone equity market has been that of Ireland, gaining 34.3% last year and already up 10.9% this year. Ireland returned successfully to the bond market today, drawing at least 12 billion euros of bids for its 10-year bond. This is an important milestone marking its impressive recovery from the bailout in 2010. We have only two hesitations now about taking a position in Ireland. The first is to question whether, after the large run-up to date, the rally in Irish stocks might be due for a pause or even a correction. The second is the relatively small market capitalization of the Irish ETF, the iShares Ireland Capped Investible (EIRL), which has a liquidity ranking by Ned Davis Research of only 2 out of a possible 5. This limited size is understandable for the equity market of an economy that constitutes only 1.8% of the euro-zone economy, but limited liquidity is a drawback for our firm.
There are options for investors who would rather not try to decide which of the euro-zone markets is most likely to outperform. The highly liquid iShares MSCI EMU Index ETF, EZU, tracks the MSCI EMU index that covers all countries in the European Monetary Union. It is up just 1.55% year-to-date. There is another interesting, but also limited, liquidity option, the WisdomTree Europe Hedged ETF, HEDJ. This ETF invests in euro-zone equities of companies “with significant revenue from exports” and is hedged against changes in the euro/US dollar exchange rate. If the euro were to decline relative to the dollar, as some are predicting, this ETF should perform better than an equivalent unhedged investment. It has a lower concentration in the financial sector than EZU, only 8.27% versus 20.74%. HEDJ is up 5.58% year-to-date.
Finally, we note that the European markets we continue to favor outside of the euro zone are Sweden and Switzerland. The iShares Sweden ETF, EWD, is up 9.9% year-to-date following a 24.57% gain in 2012. The iShares MSCI Switzerland ETF, EWL, is up 9.44% year-to-date following a 21.85% gain in 2012. We remain negative on the United Kingdom, where the economy appears to be dipping back into recession. The iShares MSCI UK ETF, EWU, is only marginally positive this year, +0.67%, after gaining a respectable 15.33% last year.
This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, www.cumber.com. He can be reached at Bill.Witherell@cumber.com.