Positive economic news has been coming out of Europe lately, but it is still no plain sailing, Charlotte Moore finds

Despite the re-emergence of political turmoil in Europe, with the recent threat of a collapse in the Italian government, there does at last appear to be light at the end of the tunnel: there has been a raft of consistently positive economic data emerging from the region.

The first confirmation of the improvement was the eurozone coming out of recession, when second quarter GDP growth was positive, after six quarters of contraction.

Schroders European economist Azad Zangana says: “The economic growth has been led by the core European markets with the big export markets, such as Germany. But the news is also more positive from the peripheral European countries with either the pace of contraction slowing or some countries starting to expand again.”

The improvement in the outlook for the peripheral European economies is welcome after the harshness of austerity measures and reform programmes. But, while these have been hard pills to swallow, deflating prices, benefits and labour costs has had economic benefits.

Momentum Global Investment Management investment director Glyn Owen says: “Competitiveness in the peripheral European economies has started to improve. Current account positions are now moving in the right direction.”

“It’s vital to remember that in peripheral Europe it was never just about too much debt, it was also about competitiveness. While Germany had kept a tight lid on labour costs, it ballooned out of control in other countries, particularly in Southern Europe,” he adds.

Not only has economic growth improved throughout Europe but there are positive signs about the future. L&G Investment Management European economist Hetal Mehta says: “Importantly we have seen a big improvement in sentiment indicators, which have all been pointing upwards for the last few months.”

In particular, the purchasing managers’ index, which is considered a leading indicator, has been positive for the last few months. Other forward indicators have also been improving – the number of car registrations is no longer falling. “That indicates that there is finally a stabilisation in consumer spending,” adds Mehta.

And while unemployment is rising, the pace of growth has slowed. “We should reach the peak level of unemployment relatively soon,” says Mehta.

While the outlook for Europe has improved, it would be foolhardy to be complacent and believe that it will now be plain sailing - as the surprise decision of Silvio Berlusconi to withdraw his five PDL party ministers and consequence of that uncertainty neatly illustrates.

Zangana says: “There are still a number of outstanding issues that still need to be dealt with. We’re far from the end of sovereign debt crisis.”

For example, Portugal probably needs another bailout later this year. Greece also needs another round of government debt restructuring. “Unlike in the past, most of Greece’s debt is now in the hands of official institutions, which includes other European banks as well as the ECB. That will be contentious,” adds Zangana.

One area in Europe that particularly needs to be improved is the banking sector. ING Investment Management senior economist Willem Verhagen says: “An important drag on the European economy is that even though access to credit has improved marginally, there is still a lot of work to be done.”

The European banking system is under-capitalised and needs to be deleveraged much further. “The formation of a true banking union is absolutely vital if we are going to see sustained economic growth in Europe,” says Verhagen.

While there are still major issues that need to be resolved within Europe, and the economic recovery will be far from smooth, the more positive newsflow has shifted investor sentiment. Zangana says: “From an investor’s perspective, the very large tail risk – that a country would exit the euro and the currency would collapse – has largely been removed.”

Mehta concurs: “Policy makers, particularly central banks, have changed their stance to become a lender of last resort which has removed a large degree of the uncertainty.”

Verhagen also agrees: “The introduction of the OMT as a backstop for sovereigns has calmed down the situation even though this is a temporary, not a permanent, solution.”

Improving investor sentiment has resulted in an increase in European equity ownership. A recent fund manager survey carried out by Bank of America Merrill Lynch said that the allocation in European equities had reached levels last seen in May 2007.

The turning point came 12 months ago when Mario Draghi made his OMT speech. Since then European equities have performed well: the FTSEurofirst 300 Index has risen by 14.5 per cent.

While it’s usually a good idea in investing to blindly follow the market, pension schemes that have had low or no allocations to European equities should now consider changing that position.

Owen says: “While investors would not be buying at the bottom of the market, valuations are still relatively low and profitability has been pretty steady across Europe. While the risks mean that the region should continue to trade at discount to the US economy, there is still room for Europe to outperform.”

Mercer Global Fiduciary Management head of asset allo-cation Rupert Watson agrees: “Many investors have stayed clear of the unknown for a long time because of the fear of the unknown. Now that has been removed, now is a good time to look at investing in European equities. I think that European equities will perform very well.”

Zangana says: “Now is as good a time as in the last two years to return to European stock markets. But you need an active manager to pick the best stocks and keep a lid on risk.”

A thorough understanding of the risks associated with a particular company or sector is vital. For example, the Spanish government will remove the price caps on energy to encourage competition that will hurt the earnings of existing energy companies.

“Many investors held these stocks because they thought they were defensive stocks but they were actually vulnerable to government intervention,” says Zangana.

Analysts along with fund managers and economists can provide this kind of insight which can make the difference between investment success and failure.

An improving economic outlook in Europe has implications for pension schemes other than how they should allocate their assets.

For European defined benefit schemes, particularly in the UK and the Netherlands, the interest-rate environment has a major impact on the health of schemes.

Interest rates are used to value the liabilities of the pension scheme – the lower the interest rate, the higher the value of the liabilities. Pension schemes have seen the value of the balloon in the current low-interest rate environment.

If the European economy improves then central banks will once again revert to more normal macroeconomic policy and interest rates will rise. That will be a godsend to European pension schemes as the value of their liabilities will fall.

Unfortunately interest rates are unlikely to rise over the short term. Watson says: “It’s difficult to see the ECB raising interest rates for another four years.”

While European pension schemes will have to wait longer for an improvement in interest rates to lower the value of their liabilities, now is the time to be more positive about the economic outlook for the region and look more closely at European equity allocations.

Written by Charlotte Moore, a freelance journalist

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