Europe represents the largest part of the developed world’s equity markets outside the United States.  An analysis of opportunities in Europe requires a perspective on economic performance that is in some ways like our own, and in other ways very different.  On the one hand, Europe offers lower multiples and higher yield than U.S. equities, but growth has been stagnant for a long time.

Much of the issue surrounding European prospects involves deep-rooted structural issues intertwined with a set of often-conflicted macroeconomic policies.  The combination of all of this has served to consistently depress growth below the growth rate of the United States.  The current cycle is no different.  Today, the United States’ economy is enjoying a steady expansion of economic activity, while the overall European economy has yet to grow back to pre-recession levels.  Similarly, the unemployment rate in the United States is down to 5.5% from 10% during the recession, while Europe’s unemployment rate remains near 11.5%.

It is also clear to us that Europe’s economic troubles predate their financial crisis and were not initiated by the crisis.  Aging population, low productivity rates, and declining capital investment were all problems that predated the European financial crisis, and remain part of the European story today.  Europe’s labor force has grown by less than 0.75% annually over the past decade.  Productivity is growing at only 0.25% per year.  Investment in capital has been expanding at just 0.1% annually across the Euro zone over the past decade.  These problems appear to us structural in nature and are not easily fixed by monetary or fiscal policy.  Until these issues are fixed, we should not assume that European growth rates will equal those of the United States.    European Growth Trends

10-year trend Growth Measure United States Europe
Labor Force 0.8% 0.8%
Productivity 1.0% 0.25%
Capital 1.0% 0.1%
GDP 1.6% 0.75%

We believe Europe’s structural challenges are at the root of the issues being faced today.  The figures just cited on productivity, employment, etc., are a recipe for real growth of 1% or less.  Not only does such a low growth rate detract from return potential, but also it sows the seeds for social division and fiscal unsustainability as debt rises faster than Gross Domestic Product (GDP).

If growth is about to improve in the near term, the improvement is likely the result of a more competitive currency.  According to an analysis from the Organization for Economic Cooperation and Development (OECD), Europe’s currency has been overvalued by 20% or more for most of the past decade.  This is no longer the case by the OECD’s measurement.  Over the past six months, the Euro is 20% lower in relation to the U.S. dollar and 10% lower versus the Japanese Yen, reducing overvaluation to near 0%.  The decline in the Euro should give the European economy at least a temporary boost.  To wit, New York Federal Reserve President Bill Dudley recently expressed his optimism that Europe might experience a “strong rebound” this year.  On this point, he is probably right.  Forward-looking European multiples remain lower given high expected earnings growth.

Valuation measure S&P 500 index Euro STOX index
Price-to-Earnings (NTM) 17.2x 16.4x
Dividend Yield 2.2% 3.4%

We do not believe that a currency revaluation alone will correct Europe’s troubles, but a chronically overvalued currency certainly doesn’t help either.  Moving growth above the 1% trend may require sound fiscal policies, more flexibility in labor markets, a smaller amount of government involvement in the private sector, encouragement of competition in private markets, and sound tax policy.  These are the kinds of reforms that may lift sustainable growth, attract capital, expand opportunity for both labor and capital, and promote political stability.

We continue to monitor developments in Europe’s economy and the currency.  Recent developments suggest that the near-term risk-reward mix for Europe could be improving, but more work is needed to address the bigger issues.  Our expected long-run return for European stocks is near 4.5%.