It seems like just months ago we were watching scenes of protest and social unrest in cities like Athens and Rome. Many advisors and clients have vivid memories of the violent swings the market bore in the summer of 2011 as economies in Ireland, Italy, and Greece were on the verge of bankruptcy.
With the re-election of German Chancellor Angel Merkel last fall, our views of Europe have become more positive. She is a stabilizing force, leading the strongest economy in that region. She also has the momentum moving towards greater oversight in how financial markets in Europe are regulated, a great need for progress to continue. This optimism is grounded in the following observations over the past months.
1) The Economic Backdrop is Improving
The leading indicators and raw data such as housing, consumer sentiment, and spending, all show gradual recovery. Manufacturing data suggests a bottom occurred in early to mid-2013 and there is a clear uptrend. Unit labor costs are also dropping which is likely to show improved data in coming months. The pace will likely remain slow according to Markit’s monthly survey of manufacturing and services. At 0.7%, the inflation rate is below the ECB’s goal of 2%.
2) Real Reforms Across the Continent
Gradually, countries in the European Union are showing greater fiscal responsibility. Countries like Ireland and Italy have put wage cuts in place and modified pension benefits. So far it appears that these reforms are occurring without adversely affecting the currency.
3) Valuations are Attractive
Markets tend to be leading indicators, so some of the anticipated recovery has been priced in. The PE ratio for the European market is below 14, this is lower than during the financial crisis of 2008-2009.
We are watching the European equity markets closely but they remain a bright spot in our view. Earnings growth should accelerate due to the delayed effects from the synchronized efforts of the Fed and ECB. Earnings are at reasonable levels and we expect surprises on the upside. Risks clearly remain as tensions exist in the Ukraine, but our view is that growth will continue to occur despite potential uncertainty.
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