Angela Merkel has won again in Germany. She now embarks on her third term as chancellor. Although some ambiguity still surrounds the nature of the country's new government, investors can take comfort that Berlin, under Merkel, should continue its support for Europe.
Germany would likely have remained a buttress, even if less openly supportive parties had done better in the vote. The country simply has too large an economic and financial stake in the European Union and the common currency, the euro, to do anything else. This stake, more than any political ideals, promises to keep the EU together.
Germany's stake in EU survival also relieves investor fears of EU dissolution, member defaults and bankruptcies. The Continent's financial crisis will go on and still carry enough risk to argue against a portfolio overweight in European stocks. But due to German interests, the situation appears contained enough to reward active stock picking in the region.
Since Europe's crisis broke in 2010, investors have been dogged by a phalanx of worst-case scenarios: that economic strains will overwhelm the Continent's economic and financial resources, ending in a dissolution of the common currency; that possible expulsions of some Eurozone members and the departures of others will result in defaults or, at the very least, the restructuring of existing debts; that the resulting severe losses among financial firms will cause bankruptcies and deepen the recession; and that this chain reaction will extend west across the Atlantic, reigniting the recession in the United States. If such fears were realized, investors would do well to abandon risk assets and hold only insured deposits and the best quality sovereign debt, despite low yields.
Fortunately, these fears are unlikely to come to fruition. The Europeans have shown a remarkable political will to hold their union and their common currency together. The European Central Bank has a powerful interest in preserving the euro as the currency for the widest area. Apart from a commitment to the European experiment, a shrunken Eurozone would diminish the ECB's influence, and were the euro to fail, there would be no need for a ECB. Self-preservation instincts will foster ECB efforts to keep the EU afloat.
By far the Continent's most powerful political-economic player, Germany has many reasons to hold the Eurozone intact, meaning that Berlin will likely marshal its economic and financial resources to this purpose. Berlin knows that any expulsion or departure from the euro area immediately threatens German finance. It will back Europe's peripheral nations, or it will have to rescue its banks.
German banks and other financial institutions recently revealed that they hold some 400 billion in Spanish, Greek, Portuguese and Irish obligations alone, and much more in Italian government debt. This exposure amounts to about 270% of the German banking system's Tier 1 capital and 17% of Germany's gross domestic product. Left unrelieved, such losses would surely curtail the flow of credit in Germany's economy and just as surely tip it into recession.
Reinforcing this powerful motivation is German industry's new love of the euro. Had the common currency not existed, the torrent of funds currently flowing into Germany would long ago have pushed the deutsche mark up far enough to erase any German pricing advantages in global markets. But because the euro encompasses weaker economies, it has not risen as high as a German deutsche mark would have. German producers know that the common currency has saved them.
Because Germany joined the euro when the deutsche mark was cheap relative to German economic fundamentals, the common currency has enshrined a competitive pricing edge for German producers across the entire zone, especially compared with producers in Europe's peripheral nations, which joined the euro when their respective currencies were dear. International Monetary Fund data indicates that the euro initially gave German producers a 6% pricing advantage over their Greek, Spanish, and Irish competitors. But because the advantage encouraged greater German industry and investment and discouraged it in the disadvantaged periphery, these advantages have expanded.
Since Berlin cannot avoid paying one way or another, it is easier, politically and financially, to marshal Europe to support the peripheral nations than for Berlin to use tax money to bolster the country's banks. In opting for bailouts, Berlin wants assurances that its money will go to ease the debt situation and not to feed additional profligacy. It also wants to ensure that France, the Netherlands and other, stronger members of the zone carry some of the burden.
Although lurches are always possible, investors can assume that the future will be less dire than feared. Investors won't need to be extremely risk averse, but Europe's ongoing crisis argues against an aggressive investment strategy. Although equity valuations look far more attractive than in the United States, as do credit spreads, the risks in Europe are greater.
In making an allocation decision, U.S. equities and credit-sensitive bonds retain the edge on their European equivalents. But Europe is home to a number of world-class firms. Markets have priced the stocks of these companies down with the general risks in Europe, but they offer a great opportunity to pick up quality cheaply. The U.S. market may be the best place to settle an overweight allocation among developed economies, but Europe offers the best selective opportunities.
Milton Ezrati is senior economist and market strategist for Lord, Abbett & Co. and
an affiliate of the Center for the Study of Human Capital and Economic Growth at
the State University of New York at Buffalo. He writes frequently on economics
and finance. His new book, Thirty Tomorrows, linking globalization to aging
demographics, is from Thomas Donne Books of St. Martin's Press.
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