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Home in on Europe

Europe has been castigated unfairly as the indicators are very positive, says Matthew Leeman Co-manager,SG Europe fund.

Europe-bashing is all the rage these days. You cannot pick up a paper or turn on the TV without being confronted by a barrage of news items delighting in the plight of our European neighbours: eurozone unemployment levels of 9 per cent, hopelessly inefficient economies, lacklustre economic growth, spiralling budget deficits, a dodgy currency.

The reluctance of most major European countries to support the US and the UK in Iraq has increased the vigour with which Europe is castigated. Small wonder, then, that European equities have little appeal to UK investors.

But UK consumers are increasingly buying European goods – everything from clothes to cars, holidays to houses. Our demand for things European is not limited to consumer items or even property as surveys claim that more than half of us want to leave the UK altogether, with many identifying Europe as their final destination.

But suspicion of Europe remains, partially because of the euro and the ECB, even though these symbols of Europeanism are changing. The euro was introduced without a hitch and, despite a recession in parts of Europe, there has been little friction between founder members.

In fact, the euro has had positive effects. Budget deficits have been reined in and before you even mention the stability pact, look at the US deficit. Member states have been forced to rebalance their welfare systems and reform their labour markets. These tasks are incomplete but are undeniably works in progress. State monopolies are facing ever greater competition while the Danish “no” to the euro and the refusal of the French to open their energy markets are doomed, as is the refusal of the UK to adopt the euro.

However, as long as the unemployment rate in Europe remains above the US rate, European labour market law and institutions will be judged inefficient. True, Germany, at $33, has hourly labour costs in manufacturing which are among the world’s highest. The eurozone’s are $20 and the US is $22. Per hour worked, however, productivity in Germany is the same as in the US. The fact that German manufacturing productivity is below that of the US is largely explained by the difference in hours worked.

Germans do not work as long (only 35 hours per week) and have more holidays. In fact, within the OECD, only people in Holland and Norway work fewer hours while the Czechs, Poles and Greeks top the table.

Those who refuse to believe reform is taking place had better look again. EU enlargement has helped corporate Germany.

Having tried the carrot approach in union appeasement for years, companies such as Siemens and Daimler have finally turned to the stick – in the form of Germany’s long and convenient border with Poland and the Czech Republic, where costs are as low as $3 per hour.

Moving production over the border has resulted in a re-negotiation of labour contracts and increased flexibility. The threat of accelerating this process has resulted in the abolition of the 35-hour week at Siemens handset unit, where hours have been increased to 40 with no extra compensation. Such changes are not limited to Germany.

Even the ECB is gaining credibility. It is a common perception that the ECB is nothing more that the Bundesbank in disguise but this is untrue. According to the Maastricht Treaty, the ECB cannot be influenced by the community or member states’ governments.

This independence is the key to maintaining currency stability, since it prevents the monetisation of public debt and the financing of budget deficits with money creation.

US investors think the ECB has been inept at handling financial markets, failing to stimulate domestic demand, but the ECB’s prediction of slow but steady recovery for this year is proving to be correct.

With the pace of eurozone recovery accelerating, the stage is set for the ECB to enhance its reputation further by maintaining price stability and ensuring that euroland economies remain prosperous.

Moreover, foreign investor apathy towards European stocks is unwarranted since Europe is home to some of the world’s finest companies.

BMW and Porsche are the most profitable car makers globally while UBS is arguably the finest investment bank in existence, with a private banking franchise that is the envy of its rivals.

Players such as LVMH, Hermes and Richemont lead the luxury goods market.

Even in the technology sector, SAP dominates its American counterparts.

The list goes on but is not only confined to the blue-chips. The argument that whatever Europe has to offer can be bought elsewhere better and cheaper is false.
In addition, Europe provides diversity. Compare it with the UK market, where five banks, two oil companies and two pharmaceutical companies comprise more than half the index.
Although the arguments in favour of Europe are founded on long-term trends, there are several reasons why the timing now is opportune.

The doomsters are writing off the current economic recovery before it has begun, but their pessimism is unfounded. Forecasts for GDP growth for the eurozone are rising. More important, 2005 GDP growth is set to accelerate in the eurozone, in sharp contrast to Japan and the US.
Add to this the restructuring that has been taking place in recent years and the outcome is a powerful driver of bottom-line earnings, providing double-digit advances this year and next.

Consumption is another positive. The consumer has been in the doldrums but this could be about to change.
Given that GDP growth is set to exceed the 1.8 per cent required to stabilise unemployment, consumer confidence should rise and so should consumption.

Finally, valuations are extremely supportive for European markets.

Long-term trends underpinning European equities are also unquestionably positive. The dismantling of old state structures, the shift of the pension burden on to the individual, the reform process in the social and labour systems – these are not new topics but they are not going to disappear either.

The pace of change may be frustratingly slow at times but failure to acknowledge that change is taking place is just wrong.

Much of the criticism levelled at Europe is outdated and unjustified. It may not be fashionable to claim it, but European equities offer great potential.


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