Don’t Worry, Euro-kay
July 14, 2011 – 11:09 pm 
The financial pages now have a 1940s quality to them: Most of the headlines are coming out of Europe. But despite all the negative economic news, things might not be quite as bad as they seem.
Rolling fiscal crises have rocked Europe sporadically since early 2010. Greece, Ireland and Portugal have required rescuing. Greece is up for a second bailout, and Portugal and Ireland aren’t far behind. All but a cloistered few believe Greece will soon default on its debt, which could add another, nastier leg to the euro-zone fiscal woes.
For all the , Ireland, Portugal and Greece are economic minnows. As long as the euro-zone crises remained contained within this trio, the eurocrats could fumble their way toward some solution at some point.
Alas, in the past week, Italy, a non-minnow, emerged as a fresh euro-zone problem spot. Italy has the euro zone’s second highest debt load at 119% of gross domestic product, according to investment bank Jefferies & Co. (Greece leads the pack with total debt at 142% of gross domestic product.) Its banking sector is heavily exposed to Italian sovereign debt and the political situation seems messier than usual. Prime Minister Silvio Berlusconi and his finance minister, Giulio Tremonti, are squabbling even as the government tries to pass tough new austerity measures.
Europe looks like a mess. But sometimes the headlines scream louder than reality. Taking a closer look at the euro-zone situation, investors might find some opportunity.
Some obvious caveats: In an era when the U.S. is closing in on a possible debt default, nothing is as safe or sure as it seems. Could the euro experiment simply fail? Unthinkable two years ago, it is a debating point today. Also, Europe has a lot of problems beyond fiscal woes at the periphery. The banking sector is undercapitalized and economic growth is uneven across the European Union. So things could certainly get worse.
But let’s try and push back against the darkness and see if there’s a way to construct a cup-half-full view of Europe.
First, market indicators paint a more nuanced picture. The euro itself has proven remarkably resilient. In the initial phases of the crisis in 2010, the euro traded as low as $1.19. Today? It is up around $1.40. The common currency has certainly had a volatile few weeks and is off its recent highs of $1.49 reached in early May. But it remains up about 5% this year against the dollar.
Yes, the euro’s relative strength could say more about the dollar’s problems. But the common currency is not behaving like its demise is around the corner.
The five largest U.S.-listed exchange-traded funds investing exclusively in Europe from Lipper.
Second, core markets have held up well. Germany’s export-driven economy is doing well, and its fiscal situation is strong. The Xetra DAX has performed about as well as the S&P 500 this year. France’s CAC-40 is off 1.4%. Not great, but nothing like the 22% decline Greece has suffered.
Third, stock-market valuations are relatively attractive, and investor optimism is low. In a fashion similar to the U.S., European companies have seen profit gains outpace rather moribund domestic economic activity. Part of this is that capital is cheap (low interest rates) and growth in other markets, notably China, is strong.
“In terms of delivering economic profit, [European companies] are having their best year in 20; in terms of being rewarded for that in valuations, it’s one of their worst in 20,” says HSBC in a recent research report. “Investors are implicitly expecting the spread to collapse. The corporate sector does not have to perform very well to deliver positive surprises given this outlook. This is a key part of our thinking because it means that it is possible to be optimistic about equities without being particularly optimistic about economic prospects.”
HSBC is overweight Germany and the U.K. and likes the value of telecoms and pharmaceutical and energy companies. It also says companies with exposure to China are good bets — even though investors have grown pessimistic with that strategy, according to its research. It recommends an overweight position in materials and consumer durables.
Fourth, China has said several times it will buy euro-zone bonds. While China’s economy is doing well, it is almost certainly worried that its two biggest export markets — the European Union and the U.S. — are ailing. It would not like to see some catastrophic euro-zone implosion and would likely take steps, in its self-interest, to prevent such a scenario.
Fifth, Greece will default. This may sound like a bad thing, but it may not be. With ratings agencies seeing the various “voluntary” restructurings as defaults, politicians may feel emboldened to force a straight default. Once that is organized and comes to pass, the sun should rise the next day. In which case, similar exercises would quickly occur in Portugal and Ireland.
This scenario, of course, is not now fully knowable. Before Lehman Bros., few predicted the conflagration that followed its demise. Still, at a certain point the eurocrats will understand that lending more money to a debt-addled country is not a solution. Stiffer medicine will be required. And its administration could mark the turning point in the euro-zone debt crisis.
