Ever since Greece has secured a third bailout, worth 85 billion euros in loans over the next three years, it seems that the Greek chapter is finally coming to a close, for now. If all other factors remain constant, it should be the best of times for the European economy; oil prices are still falling, interest rates are low, the cheapened euro currency has made exports more competitive, and the ECB has been buying bonds to ensure interest rates in the longer term would be lower. Yet in spite of these factors, there does not seem to be substantial economic growth in the European economy.
Europe in Depth (Debt)
More than six and a half years ago, Portugal, Ireland, Italy, Greece and Spain, gathered under the unfortunate acronym of PIIGS, had accumulated too much debt relative to the size of their GDP such that they are unable to refinance their government debt without the help of third-party financial institutions such as the European Central Bank (ECB), the International Monetary Fund (IMF) and the European Financial Stability Facility (EFSF) which was created in 2010 specially to address and assist the European sovereign debt crisis. The unsustainable nature of these debts was eventually uncovered during the global financial crisis in 2008 as it became increasingly difficult for governments, firms and households to obtain new loans or roll over existing debt. Ensuing recession from the financial crisis has not only caused affected governments to cut down on fiscal spending, but unpredictable economic conditions has shown that it can also quickly increase debt to an uncontrollable level. To make matters worse, a New Greek government revealed that previous governments had been misreporting government budget data. In late 2009, the crisis began.
With what may seem like impending loan defaults, investors began panicking and started to demand higher interest rates on their bonds. When Europe is unable to repay its bond holders, it increased the sovereign risks of its nation. The higher the sovereign risk, the higher the probability of a sovereign default. In 2010-2011, Greece, Ireland and Portugal received their first European-IMF financial assistance package.
Fast forward to 2015, Europe is still plagued with many economic challenges. Greece has just received its third bailout. In Q2 2015, France and Italy which accounted approximately 40% of the European economy plateaued. When Chinese demand has proven to be the key for German businesses such as investment goods and luxury cars in recent years, a slowdown in the world’s second largest economy and Germany’s third-biggest trading partner would undeniably hold Germany back. This is not to mention the impact of the Volkswagen scandal which has eroded the powerful “Made in Germany” brand.
Boom or Bust for European Equities
Despite the risks involved, there is still a glimmer of hope. As mentioned earlier, it should be the best of times to invest in European economy. The fall in euro’s value against the dollar has made European goods more competitive, and that includes equities as well. The drop in oil prices has also increased more disposable income for consumers around the world, and these factors combined does seem to bode well for global-minded investors who are looking to buy economical fares.
John Manley, New York-based chief equity strategist at Wells Fargo Asset Management is also in favour of buying European equities as signals have already shown it is now time to buy.
It is understandable that first time investors may find investing in Europe for the first time, akin to putting yourself in uncharted waters. However, investors should view the current situation in Europe as an opportunity to diversify their portfolio instead. One of the best options to gain a comfortable level of international exposure to European stocks is the Vanguard European Stock Index Fund (VEURX). It provides investors with not only a low-cost exposure, but it also holds more than 1,200 stocks across the European region. In addition to stock market risk, investors have to also note that this fund is not only exposed to currency risk, it may also have a higher degree of country risk as it invests solely in stocks of European countries.
Alternatively, investors who are looking to minimize their risk could look at WisdomTree Europe Hedged Equity ETF (HEDJ) which is designed to provide exposure to European equities while concurrently neutralizing currency risks between the Euro and the U.S. dollar. The component securities in the index are weighted based on the annual cash dividends paid as well.
Of course, not all European stocks will perform in the same manner. Some investors may believe that certain companies in certain sectors may be performing better than others. For example, investors who may have more confidence in the powerful engine and heart of the Euro: Germany, may want to consider the Deutsche X-Trackers MSCI Germany Hedged Equity ETF (DBGR). This fund not only offers exposure to German stocks, it concurrently provides hedges against any fall in the euro. Holding 55 stocks in its basket, this fund is heavily concentrated on the top ten firms with more than 59% of assets.
Of course, it may not be advisable to put all your eggs in one basket, investors should proceed only having done proper and in depth research into any prospective investments.
There would certainly be mixed prospects for Europe moving forward. It seems that the economy remains in weak health. Unemployment is still above 11%, nearly doubled that of the United States. Even a recovering Spain has reported a worrying high unemployment rate of 22.5% in June 2015. Nonetheless, there is always a silver lining among every grey cloud.
The ECB’s QE efforts to spend more than a trillion euros buying bonds in an effort to fend off deflation risks is likely to last until end of September 2016. Even Sweden’s central bank, the Sverges Riksbank, which has a benchmark rate of -0.35%, surprised markets on 28 Oct 2015, with a decision to reload its QE bazooka. This is expected to spur growth once Europe began to recover on a whole. In the near term, we are likely to see further weakening of the euro dollar as the supply of money in the economy increases. While exports may become more competitive, imports would also appear more expensive to consumers. This may not necessarily be a bad thing as the international climate in future would certainly change; the Chinese economy could for instance, weaken further and so threatens to weaken demand for high-quality imports like German cars. With a weakened euro, a massive amount of 508.2 million consumers in EU-28 may help to drive up domestic demand instead.
We know that bond price and interest rates always have an inverse relationship. Buying large quantities of bonds would only increase the prices of bonds, hence suppressing interest rates in the longer term. When interest rates are low, consumers have little to no incentive to save and it spurs investments because businesses invest in productive equipment which creates employment and therefore more goods and services.
This is where it gets tricky. When easy money is used to boost the economy and in turn push up inflation slowly, it may be quickly boosting everything else from bank lending to shares to property prices and economic growth and eventually inflation. No doubt, low inflation is necessary to keep an economy healthy, however keeping rates too low for too long may find the economy being addicted to debt to the extent that an interest rate rise to curb inflation may spiral the economy back down to square one again. We have already seen share prices hitting all-time high when China gave rise to a debt-fuelled growth model causing its stock market to crash in July 2015, and Europe needs to find a balance from repeating those mistakes. QE on its own is unlikely to be sufficient for the stagnating economy, there is a need for stronger growth strategy to stimulate demand.
Europe is still mired in economic difficulties as a result of the global financial crisis and it is undeniable that there would certainly be risks involved as Europe begins its recovery. As EU and China becomes increasingly intertwined in trade, the near term may also offer a golden opportunity for China and the EU to solidify the fundamentals of their joint partnership. If successful, a combined population of 1.9 billion people from China and EU does shows the potential to bring about mutual prosperity between both countries. Jean-Claude Juncker, the EU Commission President for 2014-2019’s commitment to job creation and growth may very well seem likely to move Europe from recovery to prosperity in the near future.
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