The Case for Investing in Europe

The Case for Investing in Europe

The past year has seen a flood of negative headlines from Europe: bank bailouts, political upheavals, spiking bond yields and falling stock markets.

For some investors, these headlines can trigger an emotional response to reduce exposure to European markets, especially the stockmarket.

We always revert to academic evidence rather than rely on media noise, emotional responses or speculation when determining how clients should invest their funds.  Using the evidence, we believe it is prudent to maintain exposure to European stocks. Here’s why:

Economic Growth doesn’t materially impact stock prices – we first wrote an article on this topic back in October 2010: Article

Statistics show that only 17% of the movement in stock prices can be explained by economic growth – the remaining 83% is due to countless other factors.

In fact, recent research shows that even if you had certainty of what a country’s economic growth was going to be for the next 12 months, and decided that if the result was negative you’d move out of the stockmarket into bonds, your investment returns would be worse than if you just stayed in the stockmarket.

To illustrate this, below are the results over the past 112 years by country comparing a ‘Timing’ scenario [Scenario A] (where you moved into bonds if it was known that the coming calendar year produced negative economic growth) and just staying in the stockmarket [Scenario B]:

 The case for investing in Europe (1)

* Only in stockmarket when next 12 months delivers positive economic growth, otherwise 100% in Government Bonds.

Source: Marlena Lee, ‘A Century of Global Returns’ from 1900 to 2011 (112 years)

 

Australia was the only country to provide a better outcome, but the 0.05% improvement would have been consumed by transaction costs.

Eurozone solutions may be at hand – September 2012 has seen some decisive moves from Europe’s policymaking machinery:

  • Germany has supported the Eurozone’s permanent rescue fund,  the European Stability Mechanism;
  • A blueprint for joint European banking supervision has been released (with the record for European diplomacy suggesting that once a proposal exists, something, eventually, tends to be agreed upon); and
  • The European Central Bank has announced that it would buy unlimited amounts of bonds of troubled Eurozone countries who adhere to a rescue plan . This provides greater certainty of how sovereign rescue plans would occur in the future. However, things can still go wrong, such as what happens if a Eurozone country falls short of reform and its rescue plan targets?

Taken together, these actions make a big change. At best, they constitute the foundations of a more sustainable Eurozone and a solution to the Eurozone debt crisis. Bond yields on Spanish and Italian bonds have already fallen in recent weeks, reducing the economic and budgetary pressures on these countries.

Safety is expensive right now – an investor with a narrow focus on protecting their capital today, without considering how they will fund their income needs in the future, may find that their standard of living goes backwards over time.

For most people, investing is actually not about wealth based goals, but about income based goals. Wealth doesn’t maintain your standard of living in retirement – income does.

The graph below shows the real return (meaning actual yield less inflation) for US Treasury Bills over the past 112 years:

 The case for investing in Europe (2)

Source: Marlena Lee, ‘A Century of Global Returns’ from 1900 to 2011

The graph shows that being in US Treasury Bills now – the generally accepted ‘riskless asset’ – means your portfolio is actually failing to keep pace with inflation. This means the purchasing power of your money is going backwards.

Whilst government debt in Europe today is too high, after World War 2 it was worse. What followed was a long period of negative real interest rates, which posed a challenge for retirees then as it may do today. Bond yields in Australia have also fallen significantly in recent times. Clearly, the message here is diversify to include shares.

European companies are innovating – it’s a tough time to be a company in Europe right now. To be profitable or even just survive, companies need to innovate and be more efficient in how they produce goods and services.

Compare this to Australia, where government policy has lost focus on productivity gains due to the ‘easy’ tax revenue from the resources boom.

In the medium to longer term, European companies could be far more efficient than Australian companies and have a competitive advantage when it comes to offering services to our existing export markets in Asia.

Currency – the Australian dollar remains at close to historic highs against the Euro. Now, predicting the future direction of currencies is probably the hardest forecast in financial markets. However, our banks continuing reliance of overseas debt funding and a slowing Chinese economy is likely to continue to dampen commodity prices and may result in the weakening of the Australian dollar.

If the Australian dollar does fall from recent highs against the euro and US dollar, an unhedged international share portfolio would benefit even if the prices of the underlying stock portfolio remain unchanged.

Not all headlines are bad – the bad news has been dominant in global markets in recent years, but other things have been happening. And any investor wanting an antidote for the grimmer headlines might like to reflect on the following recent news snippets:

  1. Germany’s Finance Ministry says the nation’s tax income was nearly 9% higher in July from a year earlier – helped by recent wage increases and underlying the continuing strength of the economy. – The Associated Press, 20 August 2012.
  2. Sweden’s centre-right prime minister has backed a cut in corporate tax for his Nordic state as it defies the gloom of the euro zone. – Reuters, 18 August 2012
  3. UK jobless claims unexpectedly fell in July and a wider measure of unemployment dropped to its lowest in a year as the Olympic Games created jobs, showing the labour market’s resilience. – Bloomberg, 15 August 2012
  4. Norway’s sovereign wealth fund – the largest in the world – is planning to take on more risk as it seeks to exploit its role as a strategic investor. – The Financial Times, 20 August 2012

None of these headlines are news to the markets and pointing them out this way does not constitute a forecast. But it is worth reflecting on the fact that the economic and financial news in Europe is not all bad at the moment.

Sometimes, as citizens, consumers and investors, we can become overwhelmed by negative headlines and can end up making counter-productive decisions about our lives based on events that we have no influence over.

The fact is markets quickly incorporate news, good or bad. For every person who capitulates and sells stocks based on news, someone else with a less negative view and/or a longer term horizon is on the other side buying.

Author: Rick Walker

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.