Strong Growth Prospects for Europe as Recession Ends

April 2014
Viewpoints
Strong Growth Prospects for
Europe as Recession Ends
CIO Equity Europe Neil Dwane says there are several reasons to be optimistic about European equities:
the recession is ending, the euro is strong and many high-quality companies in the euro zone have
been overlooked by investors.
Key Takeaways
Neil Dwane
CIO Equity Europe
◼◼ Europe’s
recession is finally ending; better access to credit means improving growth prospects.
◼◼ Europe’s
central banks remain clearly committed to accommodative policies.
◼◼ Investors
have missed out on structurally sound, high-quality companies in Europe.
◼◼ While
first-quarter earnings in European markets were disappointing, investors should remain optimistic about
growth.
Our Outlook: Continued Financial Repression
Means Risk Assets Must Be Considered
In keeping with our long-term investment theme, we believe
that financial repression will continue with low or negative
real rates in many markets. However, economic growth
will remain relatively weak around the world. As a result,
developed-market central banks are likely to be behind the
curve, maintaining accommodative monetary policies longer
than the markets expect, and will tolerate higher levels of
inflation. In this slow-growth, low-yield climate, there may
be a risk associated with not allocating a portion of long-term
assets to risk assets, as money in cash will be repressed,
which will erode the savings power of investments.
Current State of Journey Toward
“United States of Europe”
In this environment of continued financial repression,
Europe’s policymakers promise both that they have the
situation under control and will be able to generate
growth. But in the three-year period through the end of
2013, economic growth slipped through their fingers.
The job of ramping up growth will prove difficult because
of continued deleveraging and levels of corporate and
consumer confidence that remain fragile.
To achieve their political and economic goals,
policymakers have put Europe on a path to creating the
“United States of Europe.” Many of the three key pillars
that we have previously mentioned are necessary for this
voyage are being slowly put into place:
◼◼ Europe
needs a banking union. We will soon see a
roadmap for how the European Central Bank (ECB)
and politicians may agree on how banks are to be
supervised and regulated. Obviously, we don’t expect
a pan-European deposit insurance or resolution
scheme in early 2014, since the stronger countries have
no interest in bailing out bad banks from the previous
cycle. Over time, though, we believe politics will resolve
these issues.
◼◼ Fiscal
integration is critical for the EU. It was important
to the future of the EU that Germany’s Chancellor
Angela Merkel was re-elected in 2013, because she is
looking for more, not less, Europe. She wants to
continued
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encourage France, Spain and Italy to become more integrated into
her vision for Europe, with more assignment of joint liabilities, but
she will not issue “get-out-of-jail-free” cards by handing out money
to the Greeks, Portuguese or Irish. Austerity driven out of Germany
will thus remain key for the EU, and the Germans expect this to be a
long-term journey, requiring both commitment and persistence.
◼◼ The
lender of last resort must be put into place. If the ECB
perceives the euro to be under threat, the ECB charter allows it to
defend the euro as a currency. ECB President Mario Draghi thus has
all the ammunition he needs to defend the European Union if
another financial crisis occurs in the next few years. As a result, the
euro and its architecture are becoming more transparent.
Recovery in Europe Is Proceeding Slowly but Surely
Europe’s economic recession is gradually ending, though we don’t
see a rapid return to growth. Europe, over the last 10-20 years,
has been content with 2%–3% nominal growth compared with the
5%–6% the American economy has been used to. Importantly, during
2012, the “all it will take to protect the Euro” comments from the
ECB have significantly improved the tone and tenor of the prospects
emerging in International Monetary Fund forecasts. Europe was
going through a credit crunch, and by backstopping the European
credit market, and allowing access to credit, the growth forecast has
improved. This recovery is still fragile, but it is gaining momentum
and in terms of sentiment it has helped international and domestic
investors as we see payoff from the austerity of the few last years.
Draghi to Favor a Stronger Euro
Since 2007, many central banks—both in Europe and the US—
have implemented aggressive easing policies; the UK, for example,
increased its amount of pound sterling issuance fivefold. Yet in Europe,
the ECB’s balance sheet may begin declining. The reason: After
efforts in 2012 to keep the European banking system liquid, health is
gradually returning to that sector and loans are being repayed. This
is a key reason why the euro remains a strong currency even as the
euro zone remains weak. We think Draghi and the ECB will continue
to stand behind a stronger euro, because, despite causing pain for
weaker peripheral countries, it’s forcing necessary restructuring and
competitiveness in much of Europe, including Germany.
Mixed Progress in Europe’s Troubled South
Italy is finally beginning to turn the corner economically. We now
have a genuinely constructive government there, and labor-market
and other reforms are being pushed through. The important thing to
remember is that in the north of Italy, there are companies that are as
productive and profitable as any found in Germany. Furthermore, the
more light that is shined on Italy’s “dark” (non-taxed) economy, the
easier it will be for the government to raise revenues to reinvest in the
rest of the country’s economy.
Greece’s gross domestic product in the last five years has fallen nearly
40%, and it’s no surprise the equity market is cheap with a price-to-
earnings ratio (P/E) of 5. This means that, over the next 10-12 years,
investors have the potential to earn an attractive return. Yet many
investors are still overlooking the scale of serious restructuring in this
country. We remain very constructive on Greece and are selectively
constructive on other peripheral countries.
Corporate Europe Is in Good Health
Many high-quality companies in the euro zone have been overlooked
by investors, who by and large have not realized that these companies
don’t need a lot of economic growth, don’t need a rising tide and are
structurally very strong. Combined with a general lack of an equity
orientation in Europe, the result is that many of these companies
remain undervalued and have missed the global rally of the last four
years. Yet there are three compelling reasons for investors to take a
new look at European equities today.
1. Attractive Income Potential from Dividend-Paying European Equities
Dividend payouts in Europe are stable and solid relative to otherequity
asset markets. As a result, we believe it makes sense for incomefocused investors around the world to start focusing on European
equities—particularly fixed-income investors who have been taking
what may be outsized risks to get the income they need. Income investing in the equities space is different. By investing in high-quality
companies that pay dividends, equity investors don’t have to take a lot
of risk other than that of simply being in equities themselves.
2. European Markets Are Not Artificially Inflated
In recent years, US corporations issued record levels of bonds and
pushed equity markets to new highs. Europe has not done this yet,
though there is a potential for it to do so. Of course, during this
time, US equities outperformed European equities, but it is important to note that the largest buyer last year of US equities was corporations; they are essentially selling to themselves. That makes
US companies more leveraged, from our perspective, which puts
European corporations in a stronger position in 2014 and beyond.
3. Europe’s Recent Underperformance and Current Strength
Points to Strong Upside Potential
The past two years has shown a very aggressive re-rating of equity
markets, but not because of earnings growth. Clearly, we need to
see an upward earnings trend in the US and particularly in Europe,
which had fairly disappointing first-quarter numbers. Still, we
remain optimistic that European equities will manage to turn the
corner and continue to offer investors attractive investment opportunities, particularly given Europe’s 40% underperformance against
US equities in recent years. Market-watchers who are concerned
that the “great rotation” has not yet happened should realize
that many investors were already quite long equities in certain
regions—but not in Japan and Europe, where asset allocation to
equities has historically been very low. As a result, we may yet see a
great rotation, but perhaps not in America.
Conclusion: Bright Prospects for Europe
Prospects for global economic growth remain muted, with financial repression continuing to force central banks into an accommodative
stance. This is keeping rates artificially low, forcing investors further out on the risk-reward spectrum. At the same time, our outlook for
Europe remains positive. We believe that the recession in Europe is ending and that we are in the early stages of a genuine, albeit gradual,
recovery. Continued solidification of the euro, increased access to credit and an abundance of overlooked, quality companies
are combining to suggest that Europe’s recovery will be both real and sustainable.
This viewpoint contains the current views and opinions of Allianz Global Investors, which are subject to change at any time without notice. The materials on this viewpoint
are being provided for informational purposes only and should not be considered investment advice or recommendations of any particular security, strategy or investment
product. Dividend-paying stocks are not guaranteed to continue to pay dividends. Foreign markets may be more volatile, less liquid, less transparent and
subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. Statements concerning
financial market trends are based on current market conditions, which will fluctuate. If presented, references to specific securities and issuers are for illustrative
purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have
certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation. Past performance is not indicative of future
results. Allianz Global Investors is a global asset management business that operates under the marketing name Allianz Global Investors through affiliated entities worldwide,
including Allianz Global Investors U.S. LLC and its subsidiary NFJ Investment Group LLC, each an SEC registered investment adviser. No part of this material may be reproduced
in any form, or referred to in any other publication, without express written permission.
©2014 Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019-7585, us.allianzgi.com
AGI-2014-03-19-9208 | VP-018-0314-I
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