Falling stock prices and currencies are a response to seemingly nonstop bad news from Europe and the U.K. Theresa May’s resignation as U.K. prime minister is the latest chapter of the Brexit saga, and the once unthinkable prospect of a “no-deal” Brexit could become a reality in October. Frustration with centrist politicians was apparent in European Parliamentary elections, though many voters outside the U.K. supported pro-European parties. Italy woes were back in the headlines with the European Commission threatening fines as a punishment for Italy’s failure to rein in debt.
With Italy on the brink of recession and Germany’s slowdown reflected in rising unemployment and the lowest manufacturing PMI since 2012, investors have a lot of reasons to be bearish about economic growth. The counterargument from bullish investors is that Europe and the U.K. have relatively cheap valuations relative to the U.S. In addition, Chinese stimulus may boost growth for export-sensitive European and U.K. companies. There are important lessons to be drawn from both sides of the debate about the investment outlook for Europe and the U.K. Abandoning the region may be an unwise investment strategy, but investing indiscriminately may be equally unwise.
Potential of a ‘No-Deal’ Brexit
The specter of an economically disruptive “no-deal” Brexit is considered more likely with Boris Johnson the early leader in the campaign to become the next prime minister. Johnson and other candidates for prime minister may find being in power more challenging than being “backbenchers” criticizing May’s attempts to negotiate an orderly departure from the European Union. According to one former U.K. government official, in renegotiating 100,000 pages of European Union laws, “everything is negotiable, from financial services to fish and nothing is agreed until everything is agreed.” The risk of a no-deal Brexit may be overstated, as the House of Commons is likely to block such an exit. Market volatility associated with speculation about the potential for a no-deal Brexit or the prospects of socialist Jeremy Corbyn becoming prime Mminister may create buying opportunities for high-quality U.K. assets.
European Valuations and Structural Challenges
European valuations are cheap relative to the U.S. Unfortunately, headline valuations mask fundamental differences between Europe and the U.S. European indexes are much more heavily concentrated in financial services than major U.S. indexes, while U.S. indexes have a greater concentration in faster-growing technology stocks. On a sector-neutral basis, the valuation disparity between the U.S. and Europe is less dramatic. The valuation disparity between Europe and the U.S. may also be attributable to a risk premium associated with the structural challenges facing the euro area.
In the words of a speaker at the CFA Institute Annual Conference, “Europe is a “1 ½ legged stool.” Monetary policy is forced to do much of the heavy lifting, compensating for insufficient labor mobility, the lack of meaningful fiscal stabilizers and a financial system lacking a common deposit insurance program or a robust mechanism to resolve solvency issues.
For insight into the euro area’s structural challenges, all roads lead to Italy. Italy struggled to generate 1% GDP growth in the years following the global financial crisis and today is teetering on the brink of recession. The Italian economy is struggling for reasons that include competition from Chinese exports, lagging productivity growth and high youth unemployment. The technology revolution seemingly left Italy behind, in part because of the dominance of family-run small and midsize companies.
According to TS Lombard’s Shweta Singh, “A key risk not just to Italy but to the euro area as a whole, comes from the intricate links between Italian banks and sovereign debt. Italian lenders’ public debt holdings as a proportion of GDP has been increasing and remains one of the highest in the euro area.”
What happens in Italy won’t stay in Italy in the next crisis. French, Spanish and Dutch banks have significant exposure to Italy, with ripple effects that extend to the U.S. and U.K. Germany is also vulnerable to an Italian crisis, given substantial vulnerability tied to imbalances in the Target2 cross-border payment system. Italy’s problems dwarf the challenges associated with Greece. In a way, that might be good news. The systemic nature of Italy’s challenges creates motivation to address the shortcomings of the “1 ½ legged stool.”
Reasons to Invest in Europe and the U.K.
Despite cyclical and structural challenges for European and U.K. stocks, there are compelling reasons to remain invested in the region. A rebound in global growth and avoidance of worst-case scenarios for Brexit and trade would be catalysts for a rebound in European and U.K. stocks. The slowdown in China last year was a major factor in Europe’s economic woes; Chinese stimulus efforts could jump-start economic growth in much of the export-sensitive region. Germany would benefit from a rebound in Chinese auto demand, as about half of German car sales are to China. A rebound in German consumer spending would help the rest of Europe recover, reducing imbalances within Europe and with the rest of the world.
From a longer-term perspective, Europe and the U.K. should be foundational elements in a comprehensive investment portfolio. U.S. companies used to dominate lists of the largest and “best” companies in the world. Today, many of the most successful companies in the world are located outside the U.S. A sampling of the most prominent companies domiciled in Europe and the U.K. includes automakers BMW and Daimler, insurance titans Allianz, Munich Re and Zurich Insurance Group, technology companies Arm Holdings, ASM Lithography and SAP, consumer giants Unilever, Nestle, H&M and Zara. Some of the world’s largest energy and pharmaceutical companies are also domiciled in Europe and the U.K., including BP, Royal Dutch, Eni, GlaxoSmithKline, Sanofi and Novartis.
The challenges facing Europe and the U.K. will not disappear overnight. The most likely scenario is for a push-pull process in which periods of extreme pessimism alternate with periods of relative optimism. In such an environment, investment selectivity and the patience to remain calm in response to extremes in market sentiment may be the key to successful investment results.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.