As our clients and readers of our newsletters know, we’ve been relatively big proponents of investing internationally — both in Europe and in “emerging markets” over the last 18 to 24 months. We have taken this stance largely as a result of our central discipline and guiding belief — that assets tend to revert to their mean values over time, all else being equal. Following this logic then, inexpensive areas of the market tend to go up in value, while overheated asset classes (think “bubbles”) tend to eventually come back to earth. However, it should be quickly noted that valuation alone tells us nothing about the timing of these events, unfortunately.
Still, European and emerging market investments — both stocks and bonds — easily fit into these categories when compared to the U.S., so we have been following our investment discipline and overweighting these areas. As Warren Buffett taught us long ago: “We don’t have to be smarter than the rest; we have to be more disciplined than the rest.”
But still, Europe? Over this period of time, we have found that it’s been much easier for folks to understand the reasoning behind the opportunities in emerging markets (mainly higher growth rates and better demographics), whereas the opportunities in Europe get a lot of very skeptical looks.
It’s easy to understand why. Over the last eight years, Europe has had two recessions and an absolutely anemic growth rate. They seem to roll from one crisis to another — from the Greece debt debacle to fear of the European Union completely imploding. And, of course, we can’t forget about the Brexit vote that came down last June, which seemed at the time to be just one more straw on the back of the whimpering European camel.
So why in the world do we think there are opportunities in Europe?
Well, apparently we aren’t the only ones who see sunnier skies descending on Western European landscapes. Ruchir Sharma, the chief global strategist at Morgan Stanley, recently wrote an opinion piece for the Wall Street Journal entitled “The Economic Winds Are at Europe’s Back.” In it, he details some reasons to think that the Old World is actually not “doomed to [a] permanent crisis,” as he put it. Since some of his reasons happen to be our own, we thought this might be a good opportunity to share his thoughts. On the other hand, we want to stress that we are not trying to say that Europe is somehow going to become the bastion of economic progress in the coming years. Far from it, there are still many long-term impediments to robust growth, and if it were not for the discount price tag attached attractively to European investments, we wouldn’t even be tempted to look in their direction.
Fears of a Populist Revolt are Overblown
First, it was Brexit, then it was Trump. The world has been shocked twice by populist votes against the “establishment,” and fear has risen that there is a much deeper movement afoot. While much ink has been spilled predicting a rash of right-wing fascist uprisings erupting across Europe, the political power of these groups has largely been kept in check.
Yes, right-wing populism is on the rise. Yet in every major country holding elections this year—including the Netherlands, France and Germany—populists are reaching the limits of their appeal. Their parties still lack the critical mass necessary to obtain governing majorities.
This is by design. Most postwar European constitutions created multiparty systems, in part to block extremists. In the Netherlands, the far-right Dutch Freedom Party, led by Geert Wilders, could win a plurality of seats in Parliament. But mainstream parties will probably block it from forming or even joining a government. A similar fate awaits Ms. Le Pen in France: The April 23 presidential race will go to a May 7 runoff, and polls show her losing regardless of which mainstream contender she faces.
Of course, you could argue that no one saw Brexit or Trump coming either, but as Sharma points out, “even they performed better in surveys than Ms. Le Pen.” But still, even if somehow she manages to come out on top, extracting France from the EU (“Frexit”) would require even tougher legislative elections in the summer. Meanwhile, over in Germany, the populists barely register a blip on the radar.
Welfare Reforms are Trimming the Bloated European State
It has long been our position that governments don’t create jobs, businesses do. The highest and best economic use of the state is simply to create an atmosphere that encourages private enterprise. From that standpoint, Europe’s bloated welfare state has long held back economic activity on the continent, but that has slowly been changing.
Crises are also forcing European politicians to reform their welfare states. Largely unnoticed, many countries have started to whittle back the cushy government jobs and generous benefits that for decades had defined the Continent’s increasingly uncompetitive way of life. Sweden and Finland trimmed their welfare states in the early 1990s, and Germany adopted labor-market reforms in the early 2000s. The crises that erupted in 2010 created new urgency, as Spain and Portugal cut spending in the face of their exploding debt costs.
While many of these reforms were painful at the time, it seems that they have had an effect.
There is evidence that the European welfare state has peaked. Government spending in the 28 EU nations hit a high in 2009 at near 50% of gross domestic product and has since fallen to 46%. Germany led with a steep drop, followed closely by Spain and Italy. The eurozone countries now run a collective budget deficit of 1.6% of GDP and have government debt totaling 106% of GDP. Compare that with America’s deficit of 3.3% of GDP and debt totaling 104% of GDP.
But what about the “basket case” countries of southern Europe? Surely their economic malaise is incorrigible?
The nations of southern Europe are often seen as islands of fierce resistance to reform, but that stereotype is fraying. Spain led the latest charge, cutting government spending and cleaning up its state savings banks, which were at the center of its bad-loan problem in 2010. Even Italy, a country traditionally so slow to change that it can feel like an open-air museum, has cut spending to put its primary government budget in surplus.
Europe’s Economy is No Longer Sputtering
Beyond all the politics, the bigger picture that the European economy is no longer in neutral. In fact, last year Western Europe had a similar growth rate as The United States. Now that may not seem like much, but when you’re coming from a near-zero level of growth up to 1.5-2.0%, it is actually quite a significant move.
Europe’s economy is no longer sputtering. Initial figures suggest that last year, for the first time since the global financial crisis ended, Western Europe grew at a slightly faster pace than America. Economic growth of 1.7% might sound lousy, but keep in mind that Europe’s potential is severely restrained by a shrinking working-age population in countries like Italy and Germany.
Unemployment in the eurozone as a whole has been falling by nearly a percentage point a year since 2013. It finally dipped below 10% in August. Pent-up demand is being released. After the eurozone crisis began in 2010, Europeans put off purchases of just about everything. Car sales and residential investment had been running at two-thirds the pace seen last decade, but they are already beginning to bounce back.
One of the biggest detriments to economic growth is an anemic banking system, and Europe’s has been moaning on its sickbed. Finally, though, the banks have started to heal.
The banks at the center of the Greek crisis look much healthier. In the past five years, European banks have reduced their debts significantly and rebuilt capital reserves. Lately they have started to increase lending, which has helped spur the European economy.
All of this has led to more optimism on the part of economists and investors. In fact, projections of growth have been revised upward “more significantly for Europe than for the U.S.” On top of that, Europe may even be poised to actually reduce some of its debilitating tax rates.
To be clear, none of these reasons lead us to see Europe as the world’s next economic leader. The euro zone still has significant weaknesses in many areas, including immigration, the banking system, currency controls, and tax revenue sharing between countries; and for these and other reasons, no one is calling for a 4-5% GDP growth rate anytime soon. So, we are not “pounding the table” at this opportunity, and certainly, there are many ways it can run back off the rails. But the dark clouds seem to have lifted at least for the moment, and due to their current valuations, our discipline calls us to examine more closely. Maybe Europe is poised for at least a cyclical upturn, and not predestined to a perpetual crisis.