Can Europe's markets climb through the slump?

AP News
Posted: Jan 13, 2013 12:24 PM

NEW YORK (AP) — The big worry a year ago was that Greece would collapse under its debts, upend Europe's markets and set off a global financial crisis. But the world's most dangerous bond market turned out to be one of the world's best bets last year: Greece's government bonds soared 97 percent as the debt crisis eased. Across Europe, many of the region's stock markets outpaced those in the U.S.

"It has been a great investment opportunity, because a year ago at this time Europe was a big mess," said Geoffrey Pazzanese, who manages an international stock fund at Federated Investors.

The worst is likely over, most investors say. And that's where any agreement ends.

A lot appears to be going right in Europe's financial markets. Greece is no longer a threat, banks are looking stronger, and government borrowing costs are down. Yet Europe's economy remains in a slump. The 17 countries that share the euro currency recently slid into their second recession in three years, and the European Union's statistical agency reported Tuesday that the unemployment rate had reached a new high of 11.8 percent.

Either the pain will pass and markets will continue surging ahead, investors say, or it's going to be a painful slog for many more years to come.

"It looks like the Greek meltdown scenario is off the table," Pazzanese says. "I'm just not sure Europe is back from the dead yet."

Greece and the European debt crisis no longer topped Wall Street's list of worries by the end of the summer. Traders turned their attention to the danger that a package of budget cuts could push the U.S. into a slump in 2013. The turning point came in September when the European Central Bank pledged to stand behind the hardest hit countries and protect the euro currency. Mario Draghi, the head of the ECB, said the bank would buy the bonds of struggling governments once they sought rescue loans and agreed to the terms.

"Thanks to the ECB, people now expect that if you buy a government bond you'll get paid back in full on time and in the right currency," says David Kelly, chief global strategist at J.P. Morgan's money-management group. Before the central bank hatched the plan, bond buyers weren't entirely sure if their Greek bonds would be paid back in euros or in newly printed Greek drachmas.

Since then, Government borrowing costs in Greece, Italy and other struggling countries have dropped from dangerously high levels. European finance ministers have given Greece another two-year financial lifeline, and made strides toward shoring up the continent's banking system. In December, the rating agency Standard & Poor's gave Greece a better credit rating.

All these signs of progress propelled stock markets up. The Athens market surged 32 percent for the year, Italy's 8 percent. Germany's DAX index reached a five-year high this month. Hedge funds and other big money managers from around the world have started warming up to the region, putting billions into European stock funds for all but one of the past eight weeks, according to fund tracker EPFR.

Even after those recent gains, stock markets across Europe still appear cheap by standard measures. The typical company trades at less than 12 times its earnings over the next year and 6 times its cash flow. For U.S. companies, the same averages are 13 and 8.

To Kelly, there's a good reason European companies sell for a discount: The economic crisis is far from over. Europe's financial markets may look stable but the region's overall economy is shrinking. It's likely to keep shrinking, Kelly says, as long as European officials demand struggling countries cut spending on government services in exchange for aid.

"Austerity to fix a debt crisis doesn't work," Kelly says. "It only makes things worse. There's no evidence Europe's leaders really understand that."

So why do so many of Wall Street's investment strategists believe that European markets will keep climbing? Bank of America predicts Europe's economy will recover later this year and push stock markets up more than 10 percent. Morgan Stanley's London-based investment team says European stocks could rise as much as 13 percent and now favor Europe over the U.S.

One reason is that companies can thrive even when people at home curb their spending. Adidas and Bayer, for instance, lean more on customers in China and other countries with faster-growing economies than on customers in Bonn and Berlin. So analysts expect that as China picks up speed and the U.S. economy recovers, their sales will increase even if Europe remains stuck in a recession.

"China and other emerging markets are doing better," says Federated's Pazzanese. "That's great news to German and Italian exporters."

Another reason is that financial markets often heal before the underlying economy, says Martin Jansen, lead manager for international equities at ING Investment Management. Investors are supposed to be forward looking, if a little trigger happy. They ditch assets if the future suddenly looks bleak and buy them back again on signs, or hope, that things will eventually get better.

"Stability is one thing," Jansen says. "Getting back to normal is another."