Just a few years separated from total financial collapse, Europe is bouncing back.
Equity prices are recovering, interest rates for eurozone sovereign debt have declined to manageable levels, and the European Central Bank has initiated monetary policies designed to ensure Europe’s economic revival stays on track.
Although the relative performance of stocks from countries like Germany (EWG), France (EWQ), Italy (EWI) and Spain (EWP) has lagged U.S. stocks over the past few years, the pieces for a European bull market seem to be in place. Let’s examine some of the reasons why.
The Troika Acts
At the onset of the eurozone crisis in 2009–10, Greece’s sovereign debt exceeded $400 billion and France owned 10% of that debt. These conditions fueled fears a Greek default would lead to financial contagion that would ripple into and adversely impact stronger and more fiscally fit eurozone countries. Similar fears existed about Italian and Spanish debt. Furthermore, European banks owned a significant portion of sovereign debt, putting the solvency of the banking system at risk.
The European Union, European Central Bank and International Monetary Fund (also known as the “Troika”) came to the rescue of what could have been a European catastrophe, by bailing out five eurozone countries. Among them, Greece was given a €110 billion bailout loan and directed to implement austerity programs by cutting back pensions and wages for public workers. Other bailed-out countries were ordered to do the same.
The controversies of Europe’s bailout aside, policymakers made a bold move to not just rescue the eurozone, but to lay the foundation for its economic recovery.
While Europe’s ongoing bailout experiment with Greece has been rocky, there has been a silver lining. Ireland became the first eurozone country to successfully exit its bailout in December 2013. Similarly, Spain, the largest recipient of bailout funds, repaid emergency loans and exited its bailout program in January 2014. A fairly quick exit for Ireland and Spain isn’t something most analysts were predicting.
What about debt?
Excessive public debt has been and continues to be a nuisance for the eurozone. Collectively, eurozone government debt to GDP ratio increased from 90.7% at the end of 2012 to 92.6% at the end of 2013, according to Eurostat. But government debt ratios exceed 60% of GDP for 16 euro members, with the highest levels being in Greece (175.1%), Italy (132.6%), Portugal (129.0 %), Ireland (123.7%), Cyprus (111.7%) and Belgium (101.5%). Despite high debt-to-GDP levels, Europe’s sovereign yields have been falling, making debt more manageable.
The yield on 10-year government bonds in Spain and Italy hover around 2.63% to 2.75% compared to a yield of 2.59% for 10-year U.S. Treasuries. Yields on French and German 10-year bonds are 0.90% to 1.25% lower versus U.S. debt. Greece’s 10-year yield has slid from 11.59% last year to under 7%.
Mario Draghi, president of the ECB, may very well turn out to be Europe’s version of Ben Bernanke. In 2012, he saved Europe from oblivion and has shrunk government bond spreads between Europe’s strong and weak countries.
In early June, Draghi unveiled his latest stimulus package by reducing the ECB’s short-term lending rate to banks from 0.25% to 0.15%. The ECB also introduced €400 billion ($543.96 billion) in cheap long-term loans to spur more private lending and to help banks to shore up their balance sheets. The loan program is expected to begin in the fall.
Perhaps Draghi’s boldest move yet is his decision to require banks that keep excess deposits and reserves to pay the ECB a penalty of 0.1%. And if they don’t comply, they could run the risk of even higher penalties.
Forced lending along with pushing down borrowing rates, could help to weaken the euro versus the U.S. dollar and thereby inject momentum into European exports. Of course, lower rates aren’t without risk. Belt loosening may cause Europe’s politicians to decelerate or stall unpopular but necessary economic reforms.
Despite the many unknowns of whether Draghi’s stimulus plans will fully succeed, the ECB’s accommodative stance is a positive step for Europe’s economy.
It’s very clear the ECB is by no means an innovator when it comes to creative monetary policy. Really, it’s aping recent moves by other global central banks like the Bank of Japan and the Federal Reserve.
“Back in April, I suggested that the ECB would ultimately agree to create euro-dollars electronically for the purpose of purchasing bonds and depreciating the euro-zone currency,” said Gary Gordon, CFP at Pacific Park Financial, Ladera Ranch, Calif. “Many commented that Germany would never agree to such actions. The probability of a QE-type intervention however is increasing.”
Draghi, similar to his central bank counterparts, has indicated that he’s willing to take even more aggressive steps to make sure Europe doesn’t slide into a deflationary spiral. While he hasn’t announced outright purchases of private assets, there’s always the possibility for this type of strategy in the future. How would European markets react? For sure, the foundation has been laid for a U.S.-style market for private asset-backed securities in order to make asset purchases more feasible.
Pessimists in Europe’s rebound story have plenty of counterarguments about why the eurozone is still broke. Cheap money, for one, isn’t Europe’s main problem. The region is still constrained by high taxes, inefficient labor markets and a regulatory bureaucracy that inhibits innovation.
Single country ETFs linked to stocks in key European countries like France and Germany have performed better than weaker eurozone members like Spain and Italy, but still markedly less versus the U.S. market.
The S&P 500 has gained more than 150% since the 2009 market bottom, while the iShares MSCI Germany ETF (EWG) has risen 128% and the iShares MSCI France ETF (EWQ) has gained around 88%. The Vanguard European Stock ETF (VGK), which owns a collection of equities from different eurozone countries, gained just 106% over the same timeframe.
The ECB is implementing QE-styled monetary policies that should accelerate its economic recovery and thereby lift stock prices. Similar efforts by the Federal Reserve and Bank of Japan have pushed stocks higher.
While the underperformance of Europe’s equity market versus the U.S. may cause some hesitation, it could turn out to be a gift for contrarian investors.