The Opportunities and Risks in the Eurozone
The eurozone remains buffeted by opposing forces. On the positive side, short-term economic indicators have turned higher, quantitative easing (QE) has finally been introduced, and it appears that Europe’s political class has managed to, once again, find a short-term fix to avoid the trauma of a Greek exit. However, a host of issues have yet to be confronted, let alone solved:
- Structural impediments to growth
- Dangerously low inflation
- Rising populism following five years of little growth and painful austerity
Despite these challenges, over the past three months investors have adopted a "glass is half full" view and bid up European stocks and bonds, in the process pushing a significant portion of the European sovereign debt yield to historic lows. Whether you attribute the newfound appetite for risk to QE or simply the realization that things are not quite as bad as some thought, for now investors are willing to give Europe the benefit of the doubt.
Although the long-term challenges bedeviling Europe have not dissipated, we would endorse the notion that European equities represent an opportunity. We see relative value in European stocks, particularly the cyclical names that stand to benefit the most from a stabilizing economy and a "risk-on" regime. As we expect the euro to continue to depreciate against the dollar, European equities are also likely to benefit from higher exports, an important consideration given that 50% of revenue for European large-cap companies comes from outside the eurozone. However, the other implication of a weaker euro is that dollar-denominated investors should consider hedged exposure to European equities.
However, we see fewer opportunities in European fixed income. A quarter of European sovereign debt now offers a negative yield. Other than a couple of niche areas—for example, European high yield—there are fewer opportunities, particularly if a weaker euro further erodes the return from already low yields.
The risks to this view are both short and long term. In the near term, Greece and, ironically, the United States represent risks to the procyclical view. While the United States is still likely to outgrow the rest of the developed world, an unexpected slowdown would still endanger European corporate earnings. Longer term, most European governments will need to be much more aggressive in adopting structural reforms if they are to overcome anemic growth, itself partly a function of deteriorating demographics.
For more on Europe: It's Not as Bad as You Think, The Gift of The Mario, Risks: Politics, Populism and Population, read this month's Market Perspectives.