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How do you define Europe? A hard question, but answering it provides clues to the recent surge of interest in investing in the continent.

Late last month, European market capitalisation grew to exceed the US, Thomson Datastream says. The following week brought the merger of the NYSE Group with Euronext, the pan-European stock exchange. The chief flag-carrier for American capitalism had been desperate to establish a European beachhead. This week saw the pound move above $2. The dollar is almost at an historic low against the euro.

The main stock indices for continental Europe have far outperformed the US so far this year. While the US has been beset by jitters about subprime lending, data has shown Europe’s economy growing faster than thought.

This goes far beyond the furore about the impact of Sarbanes-Oxley legislation in the US. Rather, the current interest in Europe looks like belated realisation by the world’s investors, mainly based in the US, that Europe has its act together. But maybe the realisation has come too late for foreign investors to profit.

The definition of Europe turns out to be important. The eurozone now exists as an obvious bloc within Europe. Donald Rumsfeld famously divided the continent into “Old Europe” – the big nations of western Europe – and a “New Europe” that includes the emerging nations of central and eastern Europe.

The Thomson Datastream version of “Europe” goes further by including Turkey and Russia. “Europe” thus gains two wide sweeps of territory that geographers place in Asia. As Turkey and Russia would be the fifth- and eighth-largest economies in Europe respectively, these are important inclusions.

The countries of the old Soviet bloc plainly have far greater growth prospects than those of “Old Europe”.

A Citigroup analysis of International Monetary Fund data shows emerging Europe’s economy is one-third the size of developed Europe’s, but both regions have a population of about 400m.

The gap will narrow – indeed, it has already narrowed. Since 2000, according to Citigroup, emerging Europe’s economy has grown at 15 per cent per year – double that of developed Europe.

But investing in emerging European stocks may not be the best way to benefit. The corporate sector is small, there are few experienced executives, and the countries, except for Poland and Russia, are not big. So the best way to invest in New Europe may be to buy the stocks of Old Europe. European multinationals are well-placed to buy up companies in eastern Europe, and they can easily set up operations there.

The motor industry offers intriguing comparisons with the US a decade ago, in the wake of the North American Free Trade Agreement. That saw the growth of a huge auto components industry on the south bank of the Rio Grande. Now, Clive McDonnell, chief European equity strategist at Standard & Poor’s, points out that German manufacturers are avoiding high labour costs at home by relocating to the east, notably to Slovakia, which is close to producing 100 cars for every individual.

Add the influx of cheap labour from the east, joining the flow of workers from Turkey, and parallels with the US and Mexico grow closer. They allow the companies of “Old Europe” to improve their profit margins.

Ian Harnett of Absolute Strategy Research in London points out that the average return on equity for quoted European companies is now above that of the US – something unimaginable in the mid-1990s, when US profit margins were 50 per cent greater.

For years, European “bulls”, confronted by anaemic corporate performance, pointed instead to the chances of restructuring. That has at last happened.

Should Europe be re-rated? US companies still trade at a premium to European counterparts, in terms of price/earnings multiples – implying they are seen as a better long-term growth bet. Is this still the case?

Nick Nelson, European equity strategist at UBS, suggests Europe can close that gap this year. He points out the US appears to be in a mid-cycle slowdown (while Europe is still growing); European companies could gear up more and there are few reasons to fear earnings disappointment from them; acquisitions, fuelled by cheap debt, are affecting ever more companies in Europe; and large caps, on both sides of the Atlantic, are nearly the only sector of world equity markets not to have been awarded a higher multiple already. He adds there is little evidence of excessive speculation in flow of funds data.

This is a strong case, but there are also reasons for caution. First, the exchange rate. A strong euro does not help Europe’s competitiveness. Harnett points out exports made up 50 per cent of German GDP by the end of last year; testament to the way it has globalised, but also reason to worry at the strength of the euro.

Examine the macroeconomic condition of eastern Europe and there are more concerns. Its population is shrinking. The region’s countries are running fiscal and current account deficits and have benefited from an influx of liquidity. These are disquieting parallels with the Asian tigers on before their crisis in 1997.

The greater integration with New Europe may not benefit Old Europe, at least in the short term, as much as might first appear. john.authers@ft.com

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