Continued divergence favours Europe’s more fiscally fit
Euro-zone economies and markets are continuing to reverse the long period of convergence that took place in the years before the credit crisis. As noted in our April Investment Perspectives, we expect this unwinding process to last for the foreseeable future, leading to significant further divergence between the performance of stocks and bonds in those countries with stronger fiscal positions and those burdened with heavy debts.
As plans for the euro-zone solidified in the early 1990s, Europe’s financial markets began a decade-long convergence. For example, the spread between 10-year German and Portuguese government bond yields, which was 4% in 1993, had disappeared completely by 2004, two years after the introduction of euro notes and coins. However, from the start of this year doubts about the ability of some peripheral euro-zone countries to pay back their debts have reversed this process. Countries hit by rising bond yields have been under intense pressure to cut debt and have seen sharp reductions in GDP growth forecasts (see below).
The gaps between key economic indicators within Europe have widened substantially since the start of the year, as austerity measures have begun to be implemented. Again, we expect this trend to continue, as these fiscal consolidation measures need to be sustained over a long period of time if governments are to regain their ability to pay back their debts. Large differences in the rate of growth for various countries’ government and consumer spending will continue to fuel divergence in GDP growth and unemployment rates (see chart below) within Europe.
Investment implications
We believe country solvency will remain in the headlines, and therefore it is vital for investors to have clear country views when considering investment in government bonds. Given our expectation for continued divergence, we prefer those countries with less need for fiscal austerity. On this basis we also see the German, Swiss and the Scandinavian equity markets as the most attractive. In terms of the ratio of prices to forecasted earnings relative to historical averages since 1990, Germany (10.5 vs. 16.6), Norway (9.9 vs. 11.8) and Switzerland (11.9 vs. 14.9) all look attractive.
While Sweden (13.6 vs. 16.1), Denmark (14.9 vs. 15.9) and Finland (12.9 vs. 25.2) all trade below their long-term average valuations, they are not cheap compared to the rest of Europe. However, their economies should benefit from above-average GDP growth, as seen in the table above, and we therefore believe their valuation is justified.
As noted in recent publications, we also have a preference for assets with attractive yields, and history shows that equities with high dividend yields have performed particularly well in periods of disinflation. The Scandinavian countries and Switzerland have recently shown good dividend-growth momentum, while in Germany dividends appear to be bottoming out.
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