Why the Dark Clouds Over Europe?
By Rebecca Thomas
THE ECONOMIC AXIOM that an American sneeze gives the rest of the world a cold
may need some updating.
The American economy first achoo-ed last year, and has been pretty achy since
December. But the European economy, thus far, has fended off our nasty germs in impressive fashion. ``Growth [in Europe] is
slowing, but not nearly to the extent that it is in the U.S,'' says First Union Capital Markets global economist Jay Bryson. ``The
R-word is being bandied about over here, but not over there.''
Stuart Schweitzer, global investment strategist at J.P. Morgan Fleming Asset Management, agrees. ``Europe does not share U.S.
imbalances nor excesses,'' he wrote in a March 2 note to clients.
So, as nasty as things seem to be here at home, all the relative good news about Europe should have U.S. investors leaping
across the pond, right? Not quite. Despite Europe's relatively healthy economy, its stocks have fallen just about in lockstep
with their American counterparts in recent months. For example, after rising 1.5% Monday, Bloomberg's European 500 index
still sits 5% lower year-to-date. Similarly, the S&P 500 index rose 1% Monday, but remains down 5% on the year.
In fact, a gloomier view of Europe's prospects is getting a lot of play on Wall Street this week. First came word on Monday of
the European Central Bank's decision not to lower its benchmark interest rate, which went over about as well as Alan
Greenspan's recent reluctance to dole out more immediate rate cuts in the U.S.
And then there was Merrill Lynch's surprising slap at the Continent. The firm made a major adjustment to its global equity
allocation, downgrading Europe to Neutral from Overweight and upgrading North America from Neutral to Overweight. Why
the sweeping rebalancing? For one thing, Merrill sees downside risk to European corporate earnings projections this year.
Although a consensus of analysts expects full-year earnings growth of 9% in the euro-zone, Merrill's pan-European equity
strategist Michael Hartnett thinks anything north of 5% growth ``will be hard to achieve'' in a slowing economy. For another,
the recent boom in cross-Atlantic mergers leaves European corporations more exposed than ever to the collapse in U.S.
profitability. In addition, the Federal Reserve will have probably cut rates twice more before the European Central Bank even
begins easing its own money supply. ``By the time the ECB eases [once], the Fed may have eased by [two percentage] points,''
says Hartnett.
In the view of a lot of economists and investment strategists, though, the sudden non-, no-, nein- and neen-saying about
Europe is largely unwarranted. True, they say, Europe isn't immune to a hard landing of the U.S. economy. But it's nowhere
near as vulnerable to a slowdown as, say, Canada or Mexico would be. That's because only a small fraction of European gross
domestic product — about 2.5% — results from direct trade with the U.S. ``That's pretty small potatoes,'' says Bryson.
Credit Suisse First Boston's London-based European economist Crystal Aranda-Hassel estimates that European growth slows
by 0.4% for every 1% decline in the rate of U.S. GDP. But some trade-related weakness can be avoided so long as domestic
demand remains strong, she says. And there's reason to believe it will. European consumer and business sentiment remain near
record highs, while unemployment is falling, albeit from lofty levels. And because Europeans hold far fewer stocks than U.S.
investors, they're less liable to feel that negative wealth effect Nasdaq fans are suffering from right now.
And if the ECB seems to be a little slow in easing rates right now, its tightfistedness has had a muted effect. Although interest
rates climbed in the euro-zone last year, the weak euro partially dampened their impact, says Aranda-Hassel. More important,
she says, Europe has witnessed its biggest loosening in fiscal policy in a decade, with eight out of 12 countries implementing
substantial tax cuts that are already beginning to have a stimulative effect.
The result: Assuming consumer spending remains healthy, the European economy, as measured by GDP, should grow at around
a 2.5% pace this year — down only slightly from the approximate 3% pace recorded last year. In the U.S., by contrast, GDP
growth is forecast to slow dramatically, from 5% in 2000 to less than 2% this year.
That's why no one was really surprised when the ECB decided against a rate cut. Indeed, inflation remains a concern in the
euro-zone, even if it has dropped off the radar screen here at home. Although consumer price inflation has decelerated over the
past few months — and will continue to moderate if the euro appreciates further against the dollar, weakening the price of
imports — it remains above the ECB's implicit target of 2%. Still, economists expect the central bank to begin cutting Europe's
benchmark interest rate by May if growth shows the first sign of wavering.
So why the disconnect between Europe's solid economic fundamentals and its disappointing market performance? It's got
something to do with that old economic axiom we mentioned earlier. Simply put, the fear that a U.S. contagion will inevitably
spread to Europe has sent investors packing, laments Schweitzer. And while the strategist still has a ``preference'' for European
stocks, he's concerned about the recent high correlation between U.S and European equities.
Still, James Seddon, manager at T. Rowe Price European Stock fund and T. Rowe International Stock fund, thinks there's ``a lot
underpinning the European market.'' Although global economic growth remains uncertain, European companies are
implementing structural reforms and improving returns on capital and investment, he explains. And because Europeans believe
they're still not up to snuff on technology, they're still spending on productivity-enhancing equipment — something U.S. firms
have cut back on drastically.
So while Seddon cautions selectivity when picking stocks in an uncertain environment, he's building up positions in some
onetime favorite tech names with reasonable valuations. He remains ``slightly overweight'' in telecom-equipment companies
Nokia (NYSE:NOK - news) and Ericsson (NASDAQ:ERICY - news) and also recommends leaders in mobile telephony such as
Vodofone (NYSE:VOD - news) and Telecom Italia (NYSE:IT - news). Favorites outside technology include French TV company
TF1, advertising firm WPP Group (NASDAQ:WPPGY - news) and Scandinavian banking conglomerate Nordea.
That's not exactly a whirlwind tour of European equities, we realize — but it might make for a nice little jaunt if you're looking
to get away from the States for a while |
