When fiscal woes in Greece, Portugal, Italy, Spain and Ireland spurred fears about government finances and economic health across Europe, riskier investments generally slumped. Conversely, whenever European officials announced plans to resolve the contentious and complex issues, investors moved back into riskier assets. For example, after a harsh 2011, in which the MSCI EAFE Index of developed markets fell 15.7%, encouraging signs of a solution in Greece led to an 11% rise in the index through the first two months of 2012.
Some investors, weary of the roller coaster ride, have turned away from European investments. Instead, they’ve focused on assets such as stocks in the United States, where improving economic conditions proved more soothing, and government bonds from emerging markets. But even these holdings weren’t immune to mood swings when EU developments seemed especially dire.
Still, international stocks and bonds remain an essential component of any well-diversified investment portfolio. While the turbulence proved unsettling – and likely is expected to continue into 2013 – developments in Europe certainly could prove advantageous down the road for disciplined long-term investors who capitalize on currently depressed valuations and wait out the bumpy road to resolution, says Wayne Bowers, the London-based chief executive officer of Northern Trust Global Investments.
How Did Europe Get Here?
According to the terms of the 1992 Maastricht Treaty, which created the EU, member countries agreed to keep inflation rates at or below 1.5%, budget deficits at or below 3% of gross domestic product (GDP) and a debt-to-GDP ratio of no more than 60%.
The trouble is, some of the member countries suffered from a lack of fiscal discipline, sluggish economic growth or both. So when the global financial crisis hit in 2008, the ensuing worldwide recession hit some nations harder than others.
“For countries already on the edge, when their economies contracted and tax revenues plummeted, the problems worsened,” says Radhakrishnan Gopalan, an assistant professor of finance at Washington University in St. Louis. “So they borrowed more, which set off a vicious cycle and pushed them over the edge.”
Most notably, at the end of third-quarter 2011, Greece’s debt-to-GDP ratio stood at an unsustainable 159%. The country’s woes were at the forefront of reports out of the EU as it requested bailout funds from the European Central Bank (ECB) and received multiple installments, provided it enacted austerity measures to reduce government spending. Yet severe government budget cutbacks in Europe historically have led to recessions.
“There is no easy solution to the Greek problem. It will be with us for years to come,” Gopalan says.
What’s the Global Impact?
Seemingly unfounded, Bowers says, are investors’ fears that Greece is the first in a line of dominoes poised to topple should Greece default on its debt – which he sees as likely – or withdraw from the Euro but stay within the European Union – which he also considers a high probability.
For example, Portugal, Spain and Ireland are in the early phases of four- to five-year terms of governments elected on pro-Euro platforms. Hard choices remain, but each is dedicated to remaining in the Euro and European Union.
“The market is fixated on [expecting that] whatever happens in Greece will happen in the other countries, but I think that’s an absolutely wrong assumption,” Bowers says. “In Ireland, Spain and Portugal, a clear majority of the population voted for pro-austerity/pro-Euro governments, so why would the leaders change their minds and follow Greece?”
Italy’s next elections are slated for spring 2013. Bowers sees a similarly pragmatic outcome from its EU commitment debates, because if Greece exits the Euro in the coming months, the fallout still will be very fresh in the Italian electorates’ minds.
“Let’s say Greece drops out of the Euro. It’s reasonable to assume the drachma would then trade at a large discount to the Euro,” Bowers says of the Greek currency. “As a result, the values of homes, savings and earnings in the country will plummet overnight and any loans held outside of Greece will become incredibly expensive. I think that would swing the majority of the Italian people to a pro-austerity/pro-Euro mindset.”
More broadly, Northern Trust anticipates a modest economic contraction in Europe to last through 2012, as cost-cutting measures reduce consumption levels and high interest rates inhibit lending, says Jim McDonald, chief investment strategist for Northern Trust. Despite the gloomy outlook, the impact on the global economy may be minimal.
“Although a struggling EU economy would hold back the world economy, we believe a mild recession will be much more manageable,” McDonald says. “Meanwhile, the better the growth is in the United States and emerging markets, the more time Europe has to deal with its issues due to rising consumption. I believe that’s sometimes an underappreciated factor in Europe’s repair efforts.”
What’s Next?
While the European economy limps through the balance of 2012, McDonald asserts analysts will focus mostly on two concerns: liquidity within the European financial markets and the fiscal restoration efforts of the troubled countries.
The liquidity anxieties induce flashbacks of 2008, when the U.S. financial crisis all but locked up funding sources, which contributed to the global recession. Cognizant of the far-reaching implications when banks stop lending money, the ECB developed a long-term refinancing operation (LTRO) for European banks. In the first installment of the program in December 2011, more than 500 banks borrowed €489 billion (roughly $650 billion) in three-year loans with a 1% rate. In the second installment in late February, 800 banks borrowed €530 billion (roughly $700 billion) with the same terms.
“The LTRO was a game-changer with regard to risk for banks,” McDonald says. “It bought the banks and governments in Europe significant time to come up with longer-term structural changes.”
The solvency concerns are much more difficult to address, both in scope and process. Bailout funds that allowed Greece to stave off default through the first quarter of this year, as well as Portugal and Ireland in 2011, came with contingencies demanded by leaders of the two strongest economies in Europe: German Chancellor Angela Merkel and French President Nicolas Sarkozy. The stern conditions included reducing expenses and raising revenues – discipline that more likely will stabilize the long-term prospects of the EU.
“Really, Germany and the ECB could solve this entire crisis overnight by issuing Eurobonds that allow all of the countries in the EU to borrow at lower rates,” Gopalan says. “But that would not force a change in the profligate spending or labor policies that drive costs higher in some countries. Chancellor Merkel and the ECB are not going to stopgap the problems but want to see real changes.”
McDonald expects the EU to largely endure: “The incentives to resolve the issues are so high, and the cost of blowing it is so high, that we believe the leaders and their countries will reach acceptable agreements.”
Still a Valuable Asset Class
Achieving a state of calm where fiscal responsibility and realistic government budgets define EU member countries won’t be easy. Proclamations of support and action plans must be supported at all levels to move forward.
“Given the democratic tradition in Europe, any significant change in the terms of the EU agreement must go back to the individual governments and then back to the people. Then, once the leaders come back together for the final solution to the problem, that will make it easier to implement and it will have more credibility over the long term,” Bowers says. “Unfortunately, the markets do not seem to respect the democratic framework of the European Union or its member state governments and the necessary time it will ultimately take to fulfill the legal process.”
In turn, assets flowed out of Europe, especially in 2011, and drove down the prices of non-U.S. stocks and bonds, which caused yields on bonds to propel higher. Valuations reached attractive levels, especially for long-term investors who could wait out the recovery.
Most notably, Bowers says, valuations on large-capitalization multinational companies that are based in Europe have been very compelling. Many are enjoying sales growth in Asia, where economies have proven more resilient since the global recession, and the United States, where signs of economic improvements built through the first part of 2012.
“The situation had no effect in terms of what the companies do or their fundamentals,” Bowers says. “As a result, we believe there have been some tremendous long-term buying opportunities.”
McDonald suggests investors watch for renewed interest in Europe-based bonds from private investors and ignore the day-to-day machinations of the political process. Toss in a healthy dose of patience, and investors certainly could be rewarded once current challenges are history.
