Invest in Germany Now? May 3, 2010, Bill Witherell, Chief Global Economist
With Greeceâ??s fiscal problems causing contagion in the eurobond market and threatening the stability of the entire eurozone, it may appear to be a strange time to be looking for investment opportunities in this region. Indeed, investors have become extremely bearish on eurozone equities, driving valuations to close a 30-year low. Last week the euro touched a 12-month low against the US dollar of $1.3112, before recovering somewhat by weekend. Yet over the past month, according to State Street Global Markets, investment flows into Europe ex UK by the institutional investors tracked by that institution have picked up sharply. These investors are selectively buying into Europe in the more internationally competitive northern eurozone economies, which also are not suffering heavy overloads of public debt. At the same time, institutional investors have participated in the selling of Greece, Portugal, and Spain. We too see attractive buying opportunities in the midst of this crisis, particularly in Germany, but also the Netherlands and Austria.
A comparison of valuations yields several reasons to consider these three northern eurozone markets. We use the iShares MSCI country ETFs to get exposure to these national equity markets. The estimated P/E ratios for 2010 are the following: Germany (EWG): 13.6, Netherlands (EWN): 13.2, and Austria (EWO): 13.9. Outside the eurozone some comparable figures are US S&P 500 (SPY): 15.1, Canada (EWC): 15.6, Australia (EWA): 16.3, Japan (EWJ): 19.1, and Sweden (EWD): 18.2. While the UK (EWU) at 10.5 looks even more attractive on a valuation basis, current political and hence future policy uncertainties, along with the slow arrival of the economic recovery, are reasons we are remaining underweight with respect to British equities.
Relative valuations alone do not give a good indication of the timing of changes in equity prices. Reported profits are often an important driving force. We expect an improvement in the relative profitability of European firms, which have tended in past recoveries to grow faster than those of US firms. The manufacturing sector plays a more important role in the eurozone economy than in the US economy, which is more consumption-based. This makes the eurozone economy more cyclical and more affected by export growth.
Recent data indicate that recovery from the global recession is taking hold in Germany and its northern neighbors. The latest survey of confidence of European companies and households indicates confidence is the highest since March 2008. The latest German manufacturing orders (Feb.) were up 24.5% over a year ago, confirming a strong upward trend driven by exports. It is note worthy that last week many of Germanyâ??s largest firms, including Siemans AG and Volkswagen AG, reported better than expected profits for the first quarter.
It is the prospects for future export growth, together with the starting point of relatively low valuations, which lead to our bullish view of the German equity market. Years of wage restraint together with impressive structural reforms have made Germany into an export powerhouse. Over the past 15 years unit labor costs have come down some 17% relative to the other advanced economies that make up the OECD. Now German exporters also have the advantage of a weak euro, a situation that may well continue for an extended period. Germany is particularly well positioned to take advantage of Chinaâ??s strong demand for capital goods. More generally, German firms have wisely been focusing on the rapidly expanding economies of Asia.
While some political uncertainty surrounds the coming elections, we are more impressed by the facts that Germany does not have a significant debt problem, it had no housing bubble, and there is no need for consumers to deleverage, as savings are high. The German economy is not without problems. In particular, the financial sector, which accounts for 20.1% of the German ETF, EWG, is in need of consolidation. But overall, the German economy, the largest in the eurozone, should also register the strongest economic growth in the zone over the next 12 months, closely followed by the Netherlands.
The French equity market has fallen behind the German market this year. For example, in the month of April the MSCI index for the French market was down 5.06% as compared with a 1.74% decline for Germany, a 0.37% decline for the Netherlands, and a 0.34% increase for Austria. These are absolute returns in US dollars and were affected by the weak euro. The relative performance remains the same. In local currency (euro) terms, the decline in France was 3.38%, compared with only -0.01% for Germany.
Of course, France does not deserve to be grouped with the weaker â??Club Medâ? countries. But there are some important differences between France and Germany. French banks hold some $75 billion of exposure to Greece, an important 31% share of the $189 billion held by European banks. The share held by German banks is 19%. International investorsâ?? views on this issue may ease following the weekend agreement on a massive $160 billion three-year package for Greece. Yet there remain the longer-term facts that France started much later than Germany to carry out market-friendly economic reforms and has a good distance to travel if it is to catch up with Germany in the international competitiveness race. We applaud the efforts of the Sarkozy government to reduce the heavy regulatory overload that burdened medium- and small-enterprise development. However, the broad thrust of reforming the French economy to make it more flexible has encountered political headwinds that are significantly braking the earlier promising momentum. Unless this situation changes, we would be reluctant to overweight French equities.
For a more in-depth analysis of the European equity markets in a longer term perspective, see the new book by David Kotok and Vincenzo Sciarretta, Invest in Europe Now.
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