William Riegel, Head of Equity Investments
David Brown, Head of TIAA General Account
The European market environment is plagued with considerable uncertainty, given the eurozone debt crisis and the threat of one or more countries withdrawing from the euro. Set against this backdrop, however, has been the stability and booming export growth found in Germany, which is one of the eurozone’s strongest economies and responsible for generating about 25% of the region’s output.
In the near term, we expect that Germany will continue to provide favorable investment opportunities, as long as the eurozone is preserved and demand for the country’s exports continues. In other European countries, we see attractive opportunities in sovereign and corporate debt that has been beaten down by the regional volatility. But given this volatility, and the potential for a breakup of the eurozone, investors need to remain cautious and closely monitor their exposure to the region.
Germany’s fiscal stance
Throughout the eurozone’s sovereign debt crisis, Germany has pressed for strict conditions on the release of bailout funds, saying they should be linked to greater fiscal discipline among the recipient countries. While some countries have advocated stimulating the economies of troubled countries through increased government spending, Germany’s Chancellor, Angela Merkel, has rejected that position. “Growth through structural reforms is sensible, important and necessary,” she said on May 10. “Growth on credit would just push us right back to the beginning of the crisis, and that is why we should not and will not do it.”1 Germany has been more flexible with regard to domestic inflation. The country’s finance minister has said an inflation rate “in a corridor between 2% and 3%” would be “tolerable.”2
Germany’s focus on austerity and structural reform reflects its own experience with economic reform over the past 10 years. In 2002, after years of slow growth and high unemployment, the country began implementing comprehensive changes to its labor market. These reforms made the labor market more flexible and made it easier (and less costly) for employers to hire and fire workers. Today, Germany’s unit labor costs are lower than the eurozone average.3 The success of Germany’s structural reforms has reinforced the government’s belief that other countries should follow the same path.
Germany’s structural reforms also allowed the country to weather the impact of the 2008 financial crisis much better than many other developed economies. Although the country’s economy contracted by 3% in 2009, there was only a 0.5% increase in unemployment. Among the other 33 developed countries belonging to the Organization for Economic Cooperation and Development (OECD), the jobless rate rose, on average, three percentage points.4
The flexibility and competitiveness of the German economy, coupled with its fiscal discipline, has also enabled the country to avoid the worst of the eurozone’s sovereign debt crisis. The unemployment rate is just 5.4%, according to Eurostat,5 and the export sector remains strong. Exports to China doubled from 2007-2011,6 and exports to non-European Union (EU) countries rose 115% from March 2011 to March 2012.7 While the economy contracted by 0.2% in fourth quarter of 2011, it expanded 0.5% in the first quarter of 2012.
Challenges facing the German economy
Germany’s near-term expansion will depend on its ability to maintain strong export growth. Such growth is linked to higher output in China, economic stability in India (where the first quarter expansion was slower than in any quarter since 2003) and economic recovery in the U.S.
Among the long-term economic challenges facing Germany, one is to increase domestic demand, which could be achieved through deregulation of professional services and implementation of a research and development tax credit focused on fostering innovation. Another challenge is to reduce taxes on labor, which are significantly higher than the OECD average.8 Lower taxes on labor would help to bring more people into the workforce and spur hiring.
The investment outlook for Germany
In the meantime, we believe the health of the German economy creates a number of attractive investment opportunities, though the outlook will be affected by economic and political developments across Europe. We see a very high probability that the eurozone will be preserved and remain mostly stable, in which case we expect German exporters will prosper, especially automotive companies and capital goods manufacturers. A stable eurozone could also lead to a favorable environment for housing and consumption in Germany. In fixed income, we see opportunities to invest in a few large, Germany-based global companies with well-diversified revenue streams and similar credit quality to U.S. investment-grade corporate bonds. Institutional-quality commercial real estate and certain infrastructure-related categories can offer relative value as well.
Beyond German borders
Elsewhere in Europe, we see potential value in selective purchases of existing bonds that are trading at a decent discount. This includes certain sovereign positions as well as some corporate bonds of large global companies that have well-diversified revenue streams outside of their home country, but are tainted by being domiciled in the eurozone.
Europe’s equity markets, like Germany’s, will be affected by economic and political developments in the region. We see a one-in-three chance of northern European countries agreeing to subsidize their southern partners, in which case we would expect to see strong performance by Spanish and Italian equities. On the other hand, if the European Central Bank pursues a U.S.-style quantitative easing, which we think is now unlikely, European bank shares would benefit. But if the eurozone breaks up, which we believe is also a very low probability, consumer staples such as utilities and pharmaceuticals would be most insulated, while Germany’s export sector would be vulnerable, since the new deutsche mark would spike upward in value and make exports more expensive.
Many observers, ourselves included, believe that over time, Europe will need to move toward greater fiscal union to preserve its current monetary and trade arrangements. That process may well be painful and incremental, as many within Europe are reluctant to relinquish political sovereignty. However, the cost of an EU breakup, even if it is partial, is very high. We believe that reality will eventually force Europe to more fully embrace closer fiscal ties.
But it remains to be seen whether that integration will be achieved. For investors, the range of possible scenarios provides a potent reminder of the need for caution when investing in the European market. With the region out of favor, investors can uncover potential rewards — but often involving significant risk.
1 Reuters, May 10, 2012: http://af.reuters.com/article/worldNews/idAFBRE8490G020120510
2 Financial Times, May 11, 2012: http://www.ft.com/intl/cms/s/0/49e9e708-9abe-11e1-94d7-00144feabdc0.html#axzz1wNz5wEH2
3 Wall Street Journal, May 21, 2012: http://online.wsj.com/article/SB10001424052702304791704577416430370096006.html
4 "OECD Economic Surveys: Germany," February 2012
6 Financial Times, April 20, 2012: http://www.ft.com/intl/cms/s/0/dff3976a-8a08-11e1-87f0-00144feab49a.html#axzz1wNz5wEH2
7 New York Times, May 11, 2012: http://www.nytimes.com/2012/05/12/business/economy/outside-europe-german-trade-surplus-soars-off-the-charts.html
8 "OECD Economic Surveys: Germany," February 2012
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