We are cautious about euro zone growth prospects in 2005 and 2006: we are estimating GDP growth in the 1.5% to 2% region. Inflation is set to remain low, and may actually fall in the course of 2005.
BC: Is that GDP growth outlook tempered by the fact there were signals towards a rate hike in Europe?
AS: We believe the European Central Bank will remain on hold for the remainder of the year: the more recent language of the ECB seems not as hawkish as it was in the autumn of 2004. Within our company, we have recently discussed the possibility of a rate cut by the ECB, as growth remains below trend and inflation falls. However, we decided against predicting monetary easing by the ECB this year. The ECB has been critical of the U.S. Fed’s policy of extremely low interest rates, believing they fuel bubbles in asset markets. Already the ECB is worried about house prices in some areas, and they believe there is enough liquidity in the system to finance decent economic growth.
In recent weeks the euro has weakened against the dollar and also against some Asian currencies; however, on balance over the last 12 months, the euro has appreciated. We consider these recent developments as temporary and believe that the ECB does not want to contribute to further appreciation of the euro.
BC: Do you believe Europe is a more attractive investment than the U.S. at present?
AS: We believe the macro risks are higher in the U.S. However, European export dependency is still pretty high, so when the U.S. gets it Europe will be affected as well. We still think there’s more potential in Europe when confidence recovers. We’ve worried a lot about trade imbalances: the only way really to sort them out is by changing growth dynamics, meaning much lower growth in the U.S. and stronger growth abroad. In that case, I think there’s something to be said for euro zone assets: even though the short-term dynamics support the dollar, if you don’t sort out the savings shortfall and the huge current account deficit, it will continue to be pressured.
BC: Certainly, any recovery for the U.S. dollar hasn’t been seen as underway yet, especially not versus the euro.
AS: The problem is the biggest deficit for the U.S. is with Asia. If China and Japan stopped buying all these Treasuries, yields would rise and put a lid on U.S. consumer spending. That’s one way to solve it, but it’s not the painless way that the U.S. policymakers would like to see. Of course, you can’t say don’t invest in equities at all just because of these imbalances, but I think it does justify a very cautious kind of stance. It’s really a case for a well-diversified portfolio.
BC: Initially, when the euro was first floated, it was too weak for some of the stronger economies and their currencies, but too strong for some of the weaker ones. Is there more harmonization now?
AS: The euro has been strengthening now for about two years. Export growth is still quite strong, although the reaction upon strengthening of the euro is that exporters have had to cut their prices, so there’s a lot of price pressure on them. The question, of course, is how long can they do that? We’re now at a point where many are saying they’d rather lose market share than cut prices any more, because it’s becoming too costly. However, that sector is still pretty strong.
BC: What about your country’s economy?
AS: At the introduction of the euro, interest rates in the Netherlands were actually on the low side for our economy, because we were already overheating. In the end [because interest rates were not standardized across the 12 euro zone countries], adjustments had to be made in the real economy, with the result being we haven’t grown for three or four years. We’ve become too expensive: we had low interest rates, we had tax cuts, and we had a weak euro all at the same time, and then all these things reversed all at the same time, so we had a recession. Not too much can be done.
BC: So, the Netherlands has yet to recover from monetary union?
AS: Yes, we’re still struggling. We’re one of the very low-growth countries now—not even 1%—so we’re stagnating, whereas in the ‘90s we were always at the forefront of the European league. We were a very fast grower, and we had all these positive things at once: positive stock market, great housing market, wages were strong, exports were strong—we were firing on all cylinders. Now we’re stagnating, and we have to make adjustments in the economy; in a way, because leverage is so high, we’ve borrowed growth from the future, and there’s not so much potential anymore. So, companies are restructuring, and wage growth is minimal.
BC: Who do you expect to lead and lag the euro zone economies in the short term? How about in the long term?
AS: Actually we don’t really monitor the euro zone anymore on a country-by-country basis, but rather look at the aggregate data. Currently, Germany and Italy have the most problems: Germany is still struggling with high labour costs and an inflexible labour force. The biggest problems are in the East, where wages have been raised to levels comparable with the West but where productivity is lower and unemployment is high. Nevertheless, German companies have heavily restructured and are very competitive. In Italy, businesses were used to a devaluating currency and [now] struggle to cope with the strong euro; because of inflexibilities in the financial system, they do not really benefit from the much lower rates. The Netherlands is also in the slow growth camp, but the government and corporations are restructuring.
As for leaders, France and Spain are relatively fast growers. More successful measures have been taken to make their labour markets more flexible, and also the housing market is strong in both countries.
BC: Are there sectors in the euro zone countries that are hot due to monetary union? Exports were mentioned— is that a function of the common currency?
AS: The euro zone has several strong sectors, including energy, healthcare, consumer goods, and financials. The telecom sector has been through a very rough period, but generates a lot of cash at the moment. Still, there does not seem to be a direct impact of the monetary union. Because regulation will be harmonized, there are challenges for the utility sector and the financial sector, which can possibly spur a new wave of consolidation, but these are very long-term processes.
BC: What’s your outlook for foreign investment in Europe?
AS: Despite the outlook for moderate growth, we have a preference for European assets. On the fixed income side, it is an effective way to diversify or limit dollar exposure. We believe the dollar will remain under pressure, therefore we believe the risk to bond positions is smaller in Europe. Within equities, generally the correlation between Europe and the U.S. is high, about 85%. Still, we like the higher dividend yield of European equities: Europe tends to be more a cyclical play than the U.S., which can be beneficial at this stage of the cycle. Leading indicators stabilized late last year and Europe would benefit more from a gradual improvement. Due to the imbalances, we also believe the ultimate macro risk is higher in the U.S.
James Lewis is a contributing editor of BENEFITS CANADA.
james.lewis@bencan-cir.rogers.com
