So much angst has been generated in Europe in the past few weeks that it is worth noting that European companies are recovering strongly – particularly in Germany but also in much of northern Europe and parts of the southern Europe too. This creates a new proposition for the investment community: buying shares in European companies could be a potentially more profitable investment – and certainly a safer one – than buying European sovereign debt.
The argument goes like this. European companies, including those in the UK, are benefiting from a global recovery, led by emerging economies but gradually broadening into something more truly worldwide. So profits will continue to rise. The companies that will do best are those that are strong exporters to Asia, but after a while the growth will come through to other parts of the business community too.
Rising earnings will be reflected in rising dividends, which will support a further rise in share prices. Contrast this with the prospects for sovereign debt. If you buy the debt of the credit-worthy countries, obviously Germany but also a few others, you run an interest rate risk but also maybe a currency risk, for no one knows what will happen to the euro. If, on the other hand, you buy the distressed debt of Greece, Ireland and the other weaker eurozone members, you have the solvency risk coupled with the currency risk.
There is, for all bond markets, a further issue. Maybe, just maybe, we are seeing a 30-year turning point in long-term yields. Interest rates on long-term government debt have been falling since the beginning of the 1980s as inflation has gradually been brought under control.
No one can know what will happen to inflation over the next generation but given the uncertainties, not to mention the huge pressure on governments to try to inflate their way out of their debt obligations, it is at least plausible that we might be starting another 30-year cycle – this time of rising long-term interest rates.
Contrast this with what is happening in the business community. Here in Britain the purchasing managers' index, a measure of the optimism or pessimism of businesses about output, orders and employment, has just reached a 16-year high. The mood of German business is remarkably strong too. As you can see from the first graph, the Ifo index, which measures this, is the highest it has been for a couple of decades. This bodes well for the economy, for as you can see the index is a lead indicator of what happens to growth; the two have been plotted together by Capital Economics. Just this week the EU raised its latest forecast for German growth this year to 3.7 per cent. Wow!
So what might this mean for shares? The Euro Stoxx 600 index gives a fix on the share price movements of 600 companies in the large, medium and smaller sectors in 18 European countries, including two non-EU members: Norway and Switzerland. The second graph shows what happened to the index in the recovery from the 2003 dip and then plots alongside it what has happened in the present cycle from its trough in March last year.
Goldman Sachs extrapolates from this graph, suggesting that the index will rise by 26 per cent in the next 12 months. If that is right, this will be a huge opportunity, and it is certainly a proposition that should be taken seriously. The team at Goldman was brave in calling a turn in the markets, and projecting a strong and sustained rise in share prices, back in those dark days of early 2009.
Its justification for doing so lies largely in the outlook for global growth and hence for profits. Goldman's argument is based on an expectation of 25 per cent earnings growth next year and another 18 per cent in 2012, both of which are well above the consensus. It recommends companies that are exporting to Asia, rather than those that are dependent on home markets; companies that sell to the core of Europe rather than to the fringe; companies with the potential to increase their dividends rather than present high-yielding ones; and it suggests that companies with big pension deficits should be avoided in the next few months.
Naturally there are risks to all this. One such risk, the threat of a double-dip, has receded, they think. But other risks have risen, including the whole sovereign debt business, rising bond yields, tightening fiscal policy and higher commodity prices. That sounds right and it is a real question whether you can have a strong equity bull market at the same time as there is a bond bear market. But there are always risks, and share prices represent changing perceptions of the balance of risk. Looking at the bottom graph you can see what an extraordinary opportunity there was to get into the market back in March 2009. But for many people that's not how it felt at the time.
Goldman discusses some other structural issues. One is who will be buyers and sellers of equities? The bank points out that allocation to equities in European funds is now quite low compared with 2006-07, and is actually below the long-term average, whereas the allocation to bonds is above the average. Pension funds and other institutional investors are no longer sellers of equities and might become buyers. Finally, companies themselves have built up large cash balances that could be deployed to help fund mergers and acquisitions. In that sense they are potential buyers of equities too.
I suppose behind all this is a bigger point. We all know that this will be a two-speed recovery, with the highly indebted developed world growing more slowly than the less-indebted emerging economies. There is no ducking that. This perception has led to a surge in emerging equities, leading to suggestions that emerging equities might have become a bubble waiting to be popped. But the other way to profit from this rebalanced global growth is to not to invest directly in the emerging world but to invest in Western companies that sell to it, particularly since the latter are, by historical standards, priced quite cheaply relative to their earnings.
Investors would, by doing this, avoid much of the potential turmoil that may occur in emerging financial markets but still benefit from their economic growth. Sort of makes sense, doesn't it?
That leads to a further point. How is it that Europe can create such successful companies while managing to run economies in such a way that average unemployment now exceeds 10 per cent in the eurozone, government debt in EU states has been downgraded to junk, and the bond markets have gyrated as wildly as they have in the past few days? Fortunately it will be these companies, large and small, that will create the jobs to dig us out of all this.Reuse content