Concerns in Europe can Lead to Opportunity

Diversified investment portfolios should include an allocation to international assets. The goal is to improve the portfolio’s long-term, “risk-adjusted” returns, or, put more simply, to avoid putting all your eggs in one basket. However, economic and market cycles can and will create differing levels of risk over short periods of time, and questions will always emerge on how to best navigate this constantly evolving environment. Poor economic performance in Europe over the last few months gives clear rise to such questions.

From a macroeconomic perspective, the outlook for the European economy as a whole has weakened considerably from the beginning of the year. GDP growth has unexpectedly stalled in Germany, a country long considered the continent’s financial engine. For the past few months, forward-looking economic indicators like Business and Consumer confidence have been trending lower not only in Germany, but also in France and Italy. The geopolitical environment has created an additional headwind, particularly with the conflict in Ukraine hanging over Europe for most of the year.

The European Central Bank (ECB) has stopped just short of putting in place the type of quantitative easing program (QE) implemented in the U.S. However, the ECB still has initiated some extraordinary monetary stimulus. Rather than employing the same or similar monetary stimulus as the U.S., the U.K. and Japan, the ECB and European leaders first concentrated on fiscal policies aimed at balancing budgets. With inflation and economic growth data continuing to be weaker than expected, the ECB and European leaders have moved away from policies that emphasized more stimulative policies. Europe is changing its approach in order to avoid replicating the kind of deflationary cycle that has plagued Japan’s economy for the last 20 years.

The ECB’s increasingly accommodative stance illustrates the diverging economic paths of the U.S. and Europe. The different approaches taken by the Federal Reserve and the ECB helped push the Euro to a two-year low against the dollar last week. The exchange rate is at a level not seen since the European Sovereign Debt Crisis was in the headlines in 2012.

However, despite this dark landscape, there are a few glimmers of sunlight. Spain is beginning to improve its external competitiveness as growth in exports expanded to 8.1% earlier in the year. In addition, the Spanish banking system continues to recover from its near collapse in 2008. Ireland’s economic performance also continues to provide positive surprises; Irish GDP for the second quarter was reported at 7.7% earlier this month.

Markets (and investors) do not like uncertainty. When future prospects become unclear and volatility rises, investors who are uncomfortable in this type of environment often increase their cash holdings. The tendency of some market participants to “panic” in the face of uncertainty also creates short-term market inefficiencies.  Such inefficiencies can create opportunities for those who are able to employ a disciplined, long-term approach to identify attractive investment opportunities at reasonable prices.