Why Europe Still Matters

By Mike Lawrence |  Jan 09, 2014

Representing almost a fifth of world GDP, the European Union is starting to stabilize after a series of very public setbacks. Is it time to take a closer look?

"Going global" has never been more important when it comes to investing. But in recent years, even as many investors have looked overseas for growth, one key area of the world has continued to cause turmoil in the markets. Since 2010, Europe’s economic woes—from a banking meltdown in Cyprus to dispiriting unemployment figures out of Italy and Spain—have caused many to wonder if the eurozone can continue to hold together. But a wider crisis does not appear to have materialized, and now the continent is starting to show some genuine signs of resilience, according to BofA Merrill Lynch Global Research.

Consider what happened in Cyprus this March, when policymakers announced plans to appropriate a percentage of private deposits. The situation rattled bank depositors and set off waves of alarming headlines. "In this instance, market volatility actually stayed relatively low," says John Bilton, European investment strategist for BofA Merrill Lynch Global Research. "Cyprus didn't kick off a chain reaction. That's a good indication that investors are behaving rationally and markets are repairing themselves."

The fact is that Europe remains an integral part of the world economy. The 17 nations of the eurozone still account for nearly 14% of the world's gross domestic product (GDP). If you include the 10 other European Union countries that have not adopted the euro, you have an economic powerhouse representing almost a fifth of global GDP, according to business-research association The Conference Board. And as this beleaguered continent begins to repair itself, new investment opportunities may already be emerging.

A Key Trading Partner With the U.S.

The European Union's ties to the U.S. have always been close. They remain each other’s most important markets, generating some $5.3 trillion in commercial sales each year, according to a 2013 study by the Center for Transatlantic Relations. Eurozone banks, meanwhile, own more than $1 trillion in U.S. assets, and as of 2011 European-owned companies operating in the U.S. accounted for some 3.5 million jobs. And while China is the U.S. government’s largest creditor, Europe ranked a close third in November 2012, holding 20% of all U.S. Treasury securities—compared with 21.2% for China and 20.7% for Japan. While in recent years turmoil in Europe has added to volatility in the U.S. markets, a strengthening U.S. economy may very well help bring stability to Europe.

Repairing Credibility

Ever since the eurozone debt crisis flared up in 2010, the confused actions of European policymakers have not done much to add clarity or a sense of unity, says Michael Hartnett, chief investment strategist for BofA Merrill Lynch Global Research. That has compounded fears of a eurozone breakup. "Policy credibility is hard to measure, but it matters enormously," Hartnett says. "One reason European assets trade more cheaply than other assets is that the credibility of policymakers is so low."

However, many are starting to see signs of improvement on that front. European Central Bank (ECB) President Mario Draghi last year announced that the bank would do "whatever it takes to preserve the euro," and in September 2012 the ECB announced that it would buy the sovereign debt of member countries as needed. "The ECB is now seen as providing the sort of protections that the Federal Reserve offers in the U.S.," says Laurence Boone, head of Developed Europe Economics at BofA Merrill Lynch Global Research. "That has made Europeans more relaxed about the fate of the eurozone. These days, people are more concerned about economic growth than about splitting up."

Expectations of Growth…Eventually

Growth does remain an issue. After a rough start to 2013, the European Commission expects GDP in the eurozone to contract by 0.4% for the year before expanding by 1.2% in 2014. However, Bilton points out that stocks are a leading economic indicator, often rebounding months before an economic recovery begins. "We don’t need strong GDP growth to trigger gains in equity markets. Historically, markets tend to turn when things get less bad than they were." He adds, however, that "investors do need to recognize that European policymakers still have a lot to do."

How You Can Invest

If you're interested in gaining exposure to Europe but wary of risk, you might consider large European corporations with recognizable global brands in everything from cars to aircraft to consumer products. "Despite the bad economy, dozens of world-class companies in Europe have done well and could continue to do well," Hartnett says. But precisely because of their relative stability, those stocks are already expensive. What's more, a chief selling point for the multinationals now—their comparative lack of dependence on the European consumer—means they stand to gain less than other companies with the return of consumer confidence.

If you can handle slightly more risk, consider somewhat smaller companies in sectors—including construction, utilities and telecommunications—that sell directly to European markets, Bilton suggests. "Even as the economy shows signs of stabilization, values of those stocks remain so low that their potential to outperform is quite high," he says.

One unexpected area of potential amid the continent's financial woes is the banking sector—specifically, large European banks. The top seven European banks control 79% of the total market capitalization in this sector, and they remain attractively priced compared with major U.S. banks, Bilton says. There has been concern, however, about the lack of resolve to shut down bad banks, particularly in southern Europe. Bilton points out that these have tended to be smaller, less well-capitalized institutions. By contrast, the ones he recommends as possible investments represent the top echelon of well-run, stable banks that are essential to European growth and stability.

Europe's built-in disparities—between the strong countries and the weak ones, between optimism and pessimism—seem likely to continue to perplex analysts and strategists as they take stock of the continent's near- and long-term outlooks. But the fact remains that the continent has too many built-in advantages to be ignored, and as it starts to show signs of recovery, potential opportunities could develop quickly. "Right now, things appear to be getting incrementally better," Bilton says. Considering just how important Europe is to the U.S. and the rest of the global economy, that qualifies as good news.


SOURCE: Unless otherwise indicated, statistics in these stories come from BofA Merrill Lynch Global Research.

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