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Europe at a Crossroads The Outlook and Opportunities iShares Market Perspectives | November 2012

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Europe may have turned the corner and investors have turned more bullish on Europe. Recents months have witnessed a significant inflow into European equities.

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Page 1: Market perspectives in Europe

Europe at a CrossroadsThe Outlook and Opportunities

iShares Market Perspectives | November 2012

Page 2: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 2 ]

Russ Koesterich, Managing Director, iShares Chief Investment Strategist

Recent actions by the European Central Bank (ECB),

coupled with positive news out of Germany and the

Netherlands, suggest that Europe may have turned the

corner. Investors have turned more bullish on Europe,

and in recent weeks we’ve witnessed significant inflows

into European equities. However, while we believe that

the ECB has significantly mitigated the tail risks, there

is still much work to be done to address Europe’s

structural imbalances.

The good news is that, in the aggregate, Europe is solvent. In addition, by lowering bond

yields the ECB has bought politicians time. They must now use this respite to address

the structural flaws that hamper growth and leave the banking system at risk. While

Europe’s politicians have shown some resolve in addressing these issues, they will need

to act with a greater degree of urgency. We still believe the odds favor further

integration. The question is, can Europe’s political class move fast enough to satisfy

financial markets and address economic realities?

In assessing the outlook for Europe, we see three main areas requiring further reform.

First, Europe needs to move closer to some form of fiscal union to match the existing

monetary union. Second, banks need to be recapitalized and regulation synchronized.

Finally, the southern part of the continent needs to address structural rigidities in the

labor markets, which have hampered growth for more than a decade.

While all of these reforms are economically viable, and should ultimately improve

Europe’s long-term growth potential, they will be politically difficult. Politicians face

entrenched interests that will seek to slow or block reform. We would further expect some

reluctance on the part of politicians themselves. In one form or another, fiscal union will

entail some loss of sovereignty for all of the nations in the European Union (EU). While the

political desire for a more integrated Europe may be sufficient to overcome the inertia, it

will still take several more years to address all the outstanding issues.

Given this dynamic, we would remain generally underweight European stocks, but

would be buyers of northern European equities. In particular, we like German, Dutch,

and Norwegian stocks, all of which appear undervalued relative to the fundamentals.

Should we see further evidence of structural reforms, cheap valuations would suggest a

more aggressive stance in Italy and Spain as well.

Executive Summary

Page 3: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 3 ]

Solvent But Structurally FlawedOh, London is a man’s town, there’s power in the air; And Paris is a woman’s town, with flowers in her hair; And it’s sweet to dream in Venice, and it’s great to study Rome; But when it comes to living, there is no place like home.”

—Henry van Dyke

Over the past several years, any investor outside of Europe has done well to stay closer to home. Since January 2010, European equities have fallen by roughly 16%, while global equities have advanced 10% and stocks in the United States have gained more than 25%.

However, with the European Central Bank’s recent announce-ment of more aggressive monetary policy, and a positive ruling regarding the European Stability Mechanism (ESM) from the German Constitutional Court, investors are getting more sanguine regarding Europe. In the third quarter through late September, $5.9 billion flowed into European developed market equity exchange traded products (ETPs). By comparison, the second quarter witnessed a $0.3 billion outflow. Year-to-date, $5 billion has flowed into European ETPs, of which September accounted for more than $3 billion of those flows.

For investors who believe that Europe has avoided a crisis, the attraction of European equities is not hard to understand: they are trading at a big discount, both to their history and to other countries. After underperforming global equity markets for the past several years, European equities are particularly cheap compared to the rest of the world. Stocks in the United States trade at approximately 2x book value. By comparison, European equities are currently trading at a bit more than 1x book value.

In addition, actions by the ECB have removed some of the near-term tail risk associated with European equities, while the risks associated with the United States, in the form of the fiscal cliff, have risen. Many investors who have been underweight Europe for several years are asking if this is the time to move back into European markets. This leaves the question, what does Europe need to do to address its remaining problems, and how should investors position themselves in the interim?

In examining the long-term case for Europe, it is worth starting with the issue that has been plaguing Europe since early 2010—European sovereign debt. Much of the debate surround-ing the longevity of the euro has centered on the European debt burden and its sustainability.

On this topic, investors can take some relief. European sovereign debt has risen dramatically in recent years—along with much of the developed world—but the aggregate burden appears manageable. Currently, the eurozone has an overall debt-to-GDP

ratio of roughly 85% (see Figure 1). While this is up significantly from the 2008 trough of 60%, it compares favorably with the United States, where gross debt-to-GDP is nearly 100%, and Japan. For investors who want to fixate on countries with unsustainable debt burdens, Japan is in a class by itself: the country’s debt-to-GDP ratio is more than 225%.

That said, although overall European debt levels look manageable, the euro-wide statistics mask significant differences by country. Not surprisingly, Greece is in the worst position. Despite several rescue packages and write-downs, Greek debt-to-GDP still stands at more than 150% (see Figure 2), a level that most economists would argue is unsustainable, even for a normal economy. For Greece, which has been contracting by 5% to 7% a year since the start of the crisis, it is difficult to envision a scenario under which

Deb

t-to

-GD

P

1/96 1/98 1/00 1/04 1/061/02 1/08 1/10

50%

55%

60%

65%

70%

75%

80%

85%

Figure 1: European Debt-to-GDP Ratio (1996 to Present)

Source: Bloomberg as of 8/31/12.

Greece 160.6

Italy 123.5

Ireland 116.1

Portugal 113.9

Belgium 100.5

Euro area 91.8

France 90.5

UK 91.2

Germany 82.2

Austria 74.2

Spain 80.9

Netherlands 70.1

Finland 50.5

Denmark 40.9

Sweden 35.6

0 25 50 75 100 125 150 175Government Gross Debt as a Percentage of GDP

2012 Forecast 10 Year Average

Figure 2: Debt to GDP Ratios

Source: http://graphics.thomsonreuters.com/F/09/EUROZONE_REPORT2.html (accessed August 31, 2012)

Page 4: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 4 ]

this debt will be paid in full. This suggests that ultimately Greece will need an additional write-down or will have to at least partially default. But whether or not a Greek default, coupled with an exit from the euro, represents an existential threat to the euro largely depends on the state of the European banking system at that time (which we’ll cover in the next section).

Beyond Greece, other parts of the periphery also look vulnerable, albeit to a lesser extent. Thanks to the bailout of its banking system, Irish debt stands at 116% of GDP. In southern Europe, both Italy and Portugal have debt burdens in excess of 100% of GDP (in the case of Italy, this may not be quite as dangerous as it

seems, as the country is running a primary surplus and, like Japan, tends to fund most of its deficit domestically).

Outside of Ireland and southern Europe, debt levels appear more reasonable. For most of northern Europe, debt levels are at or below 80% of GDP. While it is true that even in northern Europe debt levels are above their 10-year average, this is equally true for countries outside of Europe.

Looking beyond sovereign debt, the picture changes somewhat, but not the overall impression. Europe in the aggregate still appears quite solvent. The accompanying table (Figure 3) charts

United States Japan United

Kingdom Canada Euro Area Belgium France Germany Greece Ireland Italy Portugal Spain

General government debt 1

Gross 107 238 88 85 90 99 89 79 153 113 123 112 79

Net 84 135 84 35 70 84 83 54 n.a. 103 102 111 67

Primary balance -6.1 -8.9 -5.3 -3.1 -0.5 0.5 -2.2 1 -1 -4.4 3 0.1 -3.6

Household debt 2

Gross 88 74 99 89 70 53 63 59 70 120 51 105 89

Net 4 -226 -236 -178 -151 -123 -191 -127 -118 -48 -68 -171 -124 -72

Nonfinancial corporate debt

Gross 3,5 87 143 118 53 138 178 152 63 75 244 112 154 196

Debt divided by equity (%) 82 184 86 45 106 53 85 107 264 84 139 144 149

Financial institutions

Gross debt 87 177 742 60 142 124 169 97 33 691 97 63 109

Leverage of domestic banks 6 11 23 22 18 23 27 24 28 15 24 19 16 20

Bank claims on public sector 3 7 79 8 18 n.a. 23 17 21 29 27 32 19 26

External liabilities

Gross 3,7 146 66 717 93 191 403 255 219 207 1717 142 286 221

Net 3,7 16 -52 11 11 14 -64 9 -33 97 93 23 107 93

Government debt held abroad 8 30 19 25 17 25 57 56 48 87 66 49 62 28

Figure 3: Indebtness and Leverage in Selected Advanced Economies

Source: Global Financial Stability Report, “The Quest for Lasting Stability,” IMF, April 2012.

1 WEO debt projections 20122 Gross debt minus financial assets that are debt instruments3 Most recent data divided by WEO projection for 2012 GDP4 Calculated with flow of funds data on financial assets and liabilities5 Includes intercompany loans and trade credit, which can differ significantly across countries6 Ratio of tangible assets to tangible common equity7 Calculated from assets and liabilities reported in each country’s international investment

position; includes data on International Financial Services Centers8 Most recent data from JEDH divided by WEO projection for 2012 GDP: JEDH and WEO debt

data are incompatible when one set is at market value and the other is nominal.

Page 5: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 5 ]

sovereign debt, but also household debt, corporate debt, debt of financial institutions, and external debt (the portion held by international creditors). A cursory examination suggests that several of the southern European countries do indeed have an overstretched consumer, as does the United States. However, on the whole euro-area countries have gross consumer debt that compares favorably with other developed countries. Gross household debt in the euro area is 70%, compared to 88% in the United States and nearly 100% in the United Kingdom.

Where Europe does appear vulnerable is its banking system. Ireland was a cautionary tale of what happens when a country’s banks grow too large compared to the overall economy. Ireland was a particularly acute case, but the problem is endemic throughout much of Europe. Overall European financial debt is 142% of GDP, double the level of Canada or the United States. This highlights that a critical area for near-term reform is the banking sector. In particular, Europe will need to both recapital-ize and better regulate its banks.

Moving from debt to deficits, the picture looks similar. Europe’s fiscal position deteriorated sharply in the aftermath of the financial crisis, but Europe’s aggregate deficit is improving and is also considerably lower than in the United States (see Figure 4).

Again, the euro-wide numbers mask significant differences. Not surprisingly, Greece is still the problem child of Europe. Although Ireland’s recent deficit was nominally higher, this is a function of its banking commitment rather than a structural problem, as is the case in Greece. Following Ireland and Greece, Spain is the biggest risk. Not only is its deficit large, at roughly 8% of GDP, but as most investors are aware, the country’s size makes a full-scale bailout much more expensive and daunting than for the other peripheral countries. The hope is that if Spain can deliver on its commitment—which would entail a fiscal deficit of 4.5%

in 2013—this will alleviate some of the pressure on Spanish bonds. But for now, the jury is still out on whether Spain can deliver on this target given continuing economic deterioration and growing popular resistance to further austerity.

Outside of Greece and Spain, most European countries, having already undergone significant fiscal contractions, have brought their deficits to below 6% of GDP. While Europe is still in the midst of a recession, further short-term improvements may be difficult to come by and arguably counterproductive. But from a structural standpoint, most of Europe has made significant progress in starting to address their fiscal problems.

Closer Union Requires Less SovereigntyWhile Europe is slowly climbing back toward a more sustainable fiscal path, bond investors are not known for their patience—US Treasury investors aside. The continuing challenges facing Spain and Portugal suggest that unless the ECB is willing to fund these countries indefinitely, bond yields may start to rise again. In order to avoid this scenario, and sever the dependence on monetary policy, Europe needs to move toward a tighter fiscal union, ideally one that involves some form of pooling of sovereign obligations. There are many versions this arrangement can take, but all need to fulfill two conditions: a mechanism to ensure balanced budgets over an economic cycle and some arrangement for the pooling of at least a portion of European sovereign liabilities.

Defi

cit-

to-G

DP

‘97 ‘99 ‘01 ‘05 ‘07 ‘09 ‘11‘03-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

Figure 4: EU-27 Deficit-to-GDP (1997 to Present)

Source: Bloomberg, as of 8/31/12.

Spain

Slovenia

Slovakia

Portugal

Netherlands

Luxembourg

Italy

Ireland

Greece

Germany

France

Finland

Eurozone

Estonia

Cyprus

Belgium

Austria

-14% -12% -10% -8% -6% -4% -2% 0% 2%

Fiscal Deficit as a Percentage of GDP

Figure 5: Eurozone Country Surplus/Deficit

Source: Bloomberg, as of 8/31/12.

Page 6: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 6 ]

Ultimately, for an effective monetary union, fiscal arrangements will need to be designed to share fiscal risk before a crisis erupts, not after. Without some form of risk sharing, countries will continue to face very different financing conditions and remain prone to having liquidity crises turn into solvency concerns.1

There are various ways to accomplish these two goals. Mecha-nisms to share risk vary from access to common bond issuance to a full-fledged fiscal union with a large federal budget, but they all have one thing in common: the surrender of a considerable degree of national fiscal autonomy. In order to facilitate this type of change, a further strengthening of the role of the euro-area institutions will be essential. The most direct mechanism for pooling liabilities would be the issuance of euro-wide bonds. Euro bonds would provide the following benefits: risk sharing, greater resilience to external shocks, breaking the so-called “banking-sovereign feedback loop” (in which a nation borrows to recapital-ize its banks, pushing up yields and making it more difficult to fund the banks) and providing a liquidity premium (by trading in a unified sovereign bond market, euro bonds would deliver a substantial liquidity gain, theoretically lowering borrowing costs).2

While the term euro bonds has gained in popularity, there are various forms this solution can take. At its most complete, full euro bonds would entail that all euro-area sovereign financing be raised through common bonds. Partial euro bonds would convert national debt up to a certain share of GDP, the rest would be issued nationally. Another potential approach is the “pooling proposal.” Under this approach, sovereign bonds would continue to be issued separately, leaving sovereigns subject to market discipline. In addition to the regular sovereign bonds, a synthetic security would be created with a safe tranche and a risky tranche. The safe tranche would help delink sovereign and banking risks.3

While economically logical, euro bonds still face significant political obstacles. At its core, the concept entails countries with less sovereign debt—Germany, Finland, Austria, the Nether-lands—assuming now or in the future the liabilities of other countries. Politicians in the north have become less viscerally opposed to the idea, but it is clear that the concept will only work if the creditors can extract significant and binding constraints on the budgets of the more profligate countries.4

Some proposals that address the political economy dimension are those of the German Council of Economic Experts, or “Wise men,” (2011) and of Christian Hellwig and Thomas Philippon (2011). Both proposals preserve the political status quo and are compatible with the current EU Treaty’s no-bailout provisions. The proposal of the German Council aims to reduce debt overhang by

granting joint guarantees for debt above 60% of GDP. The approach would have certain similarities to bonds issued by the European Financial Stability Facility (EFSF), but financing would be an instrument available to all countries outside any crisis context. To ensure sufficient creditworthiness, some additional collateral would be provided by issuing countries.

The path toward closer fiscal integration needs to be based on an explicit bargain: northerners agree to some form of joint liabilities in return for credible guard rails on spending and budgets of all eurozone members. Given the implied loss of sovereignty it will likely be a slow, tortuous path getting there. In addition to all of the challenges inherent in this effort, we are beginning to see separat-ist movements and tensions in countries such as Spain, which will only exacerbate the difficulties. However, we believe that most of the governments will ultimately acquiesce to this deal.

One Currency, Multiple RegulatorsMoving toward a fiscal union is a necessary condition for the euro’s long-term survival, but it is not the most pressing problem. Thanks to the ECB’s Outright Monetary Transaction (OMT) operation—under which the ECB agrees to buy unlimited short-term sovereign debt in return for a formal request for aid and conditionality—European politicians can proceed at a more measured pace on fiscal union. Although the market’s patience is not infinite, assuming there are signs of progress, ultimately implementation can probably take place over the next 18 to 36 months.

Unfortunately, the banking system is unlikely to have that luxury. European banks have also benefited from the largess—in the form of the long-term refinancing operation (LTRO)—of the ECB, but they remain vulnerable. The risk to the European banking system is more acute and needs to be addressed in a much more compressed time frame.

The good news is that the banks do not face the same liquidity squeeze of a year ago. The ECB’s decision last December to provide unlimited collateralized loans for up to three years afforded much-needed relief to the banks. As a result, short-term funding costs have fallen. There are also signs that bank funding conditions are easing, with debt issuance on the rise. But market conditions are still far from normal, with indicators of bank credit risk persisting at high levels and with many institutions still heavily reliant on central bank liquidity support.5 In other words, whatever improvement we’ve seen in bank liquidity can be attributed almost entirely to the ECB. To the extent the LTRO will eventually expire, banks will need a more permanent solution.

Of particular concern is what would happen in the event of an imminent and disorderly Greek exit. As discussed previously, while the other peripheral countries face ongoing challenges, Greece’s large debt burden and ever-shrinking economy put it in

1 Global Financial Stability Report, “The Quest for Lasting Stability,” IMF, April 2012, page 22.2 Ibid, page 56.3 Ibid, page 57.4 Ibid, page 58. 5 Ibid, page 28.

Page 7: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 7 ]

a class by itself. Greece’s long-term viability as a member of the euro remains in question. As long as that is the case, the risk of contagion is a very real threat.

If Greece were to leave the euro, Europeans would rationally question which country was next. This raises the risk that depositors in southern European countries would begin pulling their funds from any bank domiciled in a country perceived as being at risk. While the ECB could theoretically step in to help plug the loss of retail funds, the central bank might find it difficult to stem the panic. In other words, as long as a euro in a Spanish or Italian bank is worth less than a euro in a German or Finnish bank, Europe is still vulnerable to an old-fashioned bank run. Should Greece leave the euro in the near term, the contagion risk is most acute through the banking channel.

In order to remove these threats, there are several changes that are needed, both for banks and their regulators. To start, banks must replenish their capital without simply delevering, their preferred approach to date. In addition, Europe must move much faster toward a common regulatory structure and some euro-wide mechanism to provide a basic level of deposit insurance.

On recapitalization, while European banks no longer have a liquidity problem, they still have a solvency problem. The ECB must pay continued attention to funding needs of the banks, but additional loss-absorbing capital is also needed, in line with European Banking Authority (EBA) requirements.6

Although institutions in the United States have reduced their leverage and reliance on wholesale funding, EU banks remain more reliant on wholesale funding, as opposed to retail deposits. Furthermore, though it is true that bank leverage has been reduced, levels remain elevated. In the eurozone, bank loan-to-deposit ratios are down from a peak of nearly 140% in 2008 to around 125% today. This still compares unfavorably with the

United States, at roughly 75%. The situation has left the European banking system more exposed to structural and cyclical deleveraging pressure.7 As the ECB has been willing to dramatically alter the nature of its balance sheet, banks have been assured a source of liquidity—mostly through the LTRO operation (see Figure 6). The ECB’s intervention has mitigated much of the liquidity risk surrounding the European banking system, but bank capital levels remain too low.

Lender of Last Resort?There is now little doubt that the United States took a more effective approach in its stress tests and bank recapitalization than did its European counterparts. While estimates vary, the European banking system still needs several hundred billion of new capital to stabilize the banking system. If an even worse recession is to be avoided, banks will need to improve their capital adequacy through new equity rather than simply deleveraging, which would only exacerbate an already painful European recession.

In assessing next steps, Europe could probably do worse than emulating the US approach. This would mean setting a new target for raising additional capital, and having the various EU countries, or the ESM if necessary, act as a backstop if the banks were unable to raise the additional capital through private investors. The European governments could pledge to purchase equity in the major banks at a price discounted to today’s market. This would effectively set a floor under the price, and hopefully give private investors the confidence to invest. Furthermore, any ECB bond purchase plan for a given country could be made contingent on that country committing to the bank recapitalization plan.8

In addition to recapitalizing the banks, Europe needs to integrate its banking regulations and establish some form of euro-wide deposit insurance. While there is broad agreement that the ECB will be the supranational regulator, there are lingering questions regarding which banks will be impacted. To date, the discussion is proceeding at an agonizingly slow pace.

Before Europe can put its financial system on firmer footing, there are a number of issues that still require resolution. First, there is considerable debate as to the timeline for establishing ECB-wide supervision. France and Italy are pressing for speedy implementation to get to burden sharing, but Germany seems to be dragging its heels. The current timeline has the ECB taking over supervision of the 17 systemically important financial institutions (SIFIs) in Europe in July 2013 and all banks in January 2014.

ECB

Bal

ance

She

et (B

illio

ns E

uros

)

1/99 1/01 1/05 1/071/03 1/09 1/11500

1000

1500

2000

2500

3000

3500

Figure 6: European Central Bank Balance Sheet (1999 to Present)

Source: Bloomberg, as of 8/31/12.

6 Ibid, page 21.7 Ibid, page 38.8 Philipp Hildebrand and Lee Sachs, “The Eurozone should fix its banks in the US way,”

Financial Times, September 25, 2012.

Page 8: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 8 ]

Figure 7 illustrates the extent of the challenge for southern European countries. As the figure illustrates, unit labor costs in southern Europe have been rising at a much faster rate than in the north of the continent. As a result, much of southern Europe has lost its competitiveness with the northern part, particularly Germany. One relatively painless way to address this would be for Germany to allow its unit labor costs to rise faster. To the extent that southern Europe could hold its wage growth flat, this would allow for a gradual adjustment. Unfortunately, as of today, inflation rates are actually higher in the south than in Germany. Given Germany’s historical aversion to inflation, faster wage growth may prove a tough sell.

Fortunately, southern Europe can also improve its competitive-ness through addressing structural impediments to growth. When looking at what ails southern Europe, Italy provides a very telling example. In some ways, Italy distinguishes itself from Spain and other peripheral countries. While debt levels are high, its deficit is low and the country is actually running a primary—before interest—surplus. Also, Italy enjoys a high level of national savings and hosts several world-class companies.

Nevertheless, while segments of the Italian economy function quite well, overall Italy has many of the same structural flaws as the rest of southern Europe. Italian growth has averaged less than 0.5% in the last decade, while total factor productivity growth was negative.9

Weak growth can be attributed to a number of factors: regulatory rigidities, labor market rigidities, and weak public services. While the new Italian technocratic government has implemented a number of necessary and important structural reforms, much remains to be done. The existing reforms cover key structural

Beyond timing, there are also lingering issues regarding how the European institutions will provide supervision. The current proposal has the ECB Governing Council, which currently sets interest rate policy, ultimately responsible for supervision. This raises awkward questions as to the ECB’s independence (would the ECB wind down banks that it has previously given loans to and therefore would record losses on?).

There is also the question of allocating responsibilities between those members of the EU that are in the euro versus those that are not. The 10 non-eurozone countries, most vocally the United Kingdom and Sweden, are worried about the ECB’s supervisory influence and the EBA’s powers to overrule national regulators. Even if non-euro EU states were to join the supervisory regime, rules currently prohibit them from voting on ECB decisions.

Lastly, there is the matter of how to assess contributions for the bank resolution fund and deposit guarantees; this is likely to become a political hot potato. One can only imagine trying to sell to German voters their liability for Greek deposits. One recent example of the furor this may cause was outrage in Finnish papers months ago over just a suggestion of this. It is not hard to under-stand why this proposal, while necessary, will be so contentious. Eurozone bank deposits amount to some €15 trillion, of which €5.5 trillion are in Spain, Italy, Portugal and Ireland.

In summary, this all suggests that the process will remain politically contentious. We would expect continued headlines over northern European opposition to burden sharing over the coming weeks and months, dampening stock market hopes for a speedy resolution.

Structural Reforms: Growing Out of the Debt Requires GrowthAssuming the European Union can move toward closer fiscal and banking integration, there is still a final hurdle that needs to be addressed—growth. We said at the outset that the European Union is solvent, at least communally. Aggregate sovereign debt of 85% is high, but manageable. Other countries have ap-proached similar levels—Canada in the early 1990s was a notable example—and have successfully repaired their financ-es. But doing so will require not only a less fragile banking system and the pooling of resources, but also faster growth. If the European Union can improve its secular growth rate, this will help make the debt burden more manageable in the same manner that faster income growth will alleviate the debt burden on US consumers.

However, achieving faster growth will require addressing several labor market and other rigidities that have thus far resisted all attempts at reform. In particular, southern Europe will need to regain its competitiveness and rein in its labor costs (see Figure 7).

Uni

t Lab

our C

ost I

ndex

(reb

ased

to 1

00)

2000 2002 2006 20082004 2010 2012

90

100

110

120

130

140

150

Greece Italy Portugal SpainIreland France Germany

Figure 7: Eurozone Unit Labor Costs

Source: http://graphics.thomsonreuters.com/F/09/EUROZONE_REPORT2.html (accessed September 5, 2012).

9 IMF Country Report No. 12/168, “Italy: Selected Issues,” July 2012, page 5.

Page 9: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 9 ]

bottlenecks in the product and labor markets, but the govern-ment has yet to address the sources of labor market rigidities. Future reforms should aim to lower labor adjustment costs, introduce more flexibility, increase participation—especially among women—and improve activation policies.10

In addition to labor market rigidities, one of the main obstacles to growth is the public sector, which is grossly inefficient and too often an impediment to private sector initiative. Important areas for public sector reform include liberalization in the areas where the central government is a major stakeholder, liberalization and increasing competition in local services, and regional differentia-tion and more flexibility in public sector employment and wages. If done correctly, the impact of public sector reform could be sizeable. By adopting Organisation for Economic Co-operation and Development (OECD) best practices, Italy could raise real GDP by 5.75% after five years and by 10.5% in the long run.11 Given the size of the Italian debt burden, a growth differential of this magnitude could be a game changer for Italy, as well as other southern European countries.

Another challenge throughout much of Europe is low labor force participation. While this is also a growing issue in the United States where labor force participation is at a 31-year low, the problem is even worse in much of Europe. For a 15- to 24-year-old Italian, the chance of being in education is about 60% and being employed is slightly more than 20%.12 For a 40- to 64-year-old, the chance of being employed is only 60% (mainly driven by low female employment) and being inactive about 35% (almost 50% if a woman).13

While the issue is long standing and does not lend itself to a quick solution, there are potential fixes. One would be to employ a method that has been extremely effective in Germany—pro-moting apprenticeships. A second critical step would be to seek to reduce the costs of individual dismissal by limiting compulsory reinstatement in case of dismissal for economic reasons.14

All of these reforms will face some degree of resistance from entrenched interests. Nevertheless, if southern Europe is to manage its debt burden, that burden needs to be reduced relative to national income. That will only happen if income grows faster, which is in turn dependent on removing the numerous barriers to growth.

In the Meantime, Avoid the SouthThanks in large part to the Herculean efforts and the unlimited balance sheet of the ECB, Europe has thus far avoided a crisis. The implementation of the OMT was a major step forward in reducing the systemic risks emanating from Europe. A further boost for eurozone equities was provided in early September by the German Constitutional Court ratifying the ESM. This buys time for the reforms described above.

Given our belief that the euro will survive, but only after a prolonged transition toward a fiscal union, we still prefer equities in the more stable north, especially Germany. We remain under-weight Spain and Italy, which we think are cheap for a reason.

In arriving at these views, our methodology takes into account not only the valuation, but the fundamental and macroeconomic factors that should drive the valuation, specifically economic growth, profitability, solvency and sentiment.

On these metrics, few European countries have a particularly strong growth outlook. The only real exceptions are the Nordic countries—Sweden and Norway—which have, thus far, man-aged to dodge the worst effects of the European recession. Outside of the Nordics, the only real question is how bad the outlook is and how much of that is already reflected in the price.

Near-Term View

p/b growthprofit-ability

risk sentiment

Norway overweight + + +

Germany overweight – +

Netherlands overweight + –

France neutral + – –

United Kingdom neutral – +

Sweden neutral – + + +

Italy underweight + – – –

Switzerland underweight – – +

Spain underweight + – – –

Figure 8: Near-Term Outlooks and the Factors Behind Them

Source: BlackRock MPS Group and Bloomberg, 9/25/12.

“Given our belief that the euro will survive, but only after a prolonged transition toward a fiscal union, we still prefer equities in the more stable north, especially Germany. We remain underweight Spain and Italy, which we think are cheap for a reason.”

10 Ibid, page 6.11 Ibid.12 Ibid, page 12.13 Ibid, page 13.14 Ibid, page 12.

Page 10: Market perspectives in Europe

i S H A R E S M A R K E T P E R S P E C T I V E S [ 10 ]

Germany provides a good illustration. While we believe German growth will continue to fall, this appears fully reflected in the price of German stocks. In assessing the near-term outlook for Germany, one indicator that has historically proved useful is the IFO Survey, a German business sentiment measure. This measure has turned sharply lower in recent months, falling from a high of 109.7 in April to 101.4 today (see Figure 9). However, while the drop confirms the slowdown we’ve seen in German GDP, readings at this level are still close to the long-term average. This suggests that while the German economy may stall or even suffer a mild contraction, as of now it looks to be a shallow one.

While German economic numbers are not yet signaling a severe recession, stocks prices are. German equities are trading well below their historical valuations. Today, large-cap German stocks can be had for roughly 10x forward earnings and 1.3x book value. In the past, German stocks have traded at approximately 1.7x book value, which makes the current valuation a 25% discount to the long-term average.

It is true that given the prospects for weaker-than-normal growth, valuations should be lower, but the current discount appears exaggerated. With the IFO at this level, you would expect German equities to be trading at roughly 1.6x book value, rather than 1.3x. Obviously there are other factors driving the discount, not the least is the lingering sovereign debt and banking crisis. However, if the ECB has succeeded in mitigating this risk, it seems that valuations at this level may offer an opportunity. The same holds true for other northern European countries as well.

ConclusionIf you open up that Pandora’s Box, you never know what Trojan horses will jump out. –Ernest Bevin, warning on the consequences of setting up the Council of Europe

Mixed metaphor aside, the above quote has proved a prophetic warning. Europe is now confronting the implications of its initial foray, more than 60 years ago, toward closer union.

Despite Herculean and unconventional efforts by the ECB, Europe’s long-term future remains very much in the balance. The acronym soup—SMP, LTRO, OMT—emanating from the ECB has helped prevent panic and dramatically lowered the risk of a liquidity crisis, but it cannot solve the underlying structural problems that face Europe.

Those problems emanate from two sources: the incomplete nature of the European enterprise and structural rigidities that hamper growth. On the former, Europe must come together on some mechanism to, at least partially, pool sovereign obligations. The monetary union needs to be complemented by some form of fiscal union. In addition, the fragmented nature of the European banking system ensures that Europe’s banks will remain its Achilles’ heel. In order to address this, Europe must agree to a realistic—note the emphasis—recapitalization plan, rules for common banking regulation, and a euro-wide deposit insurance scheme.

Longer term, Europe must simply grow faster. Given elevated debt levels and deteriorating demographics, most of the developed world faces a similar challenge. But most of southern Europe is further hampered by rigid labor markets and cosseted professions that prevent competition and suffocate growth. This needs to be addressed.

Given the nature of these reforms, they will require a concerted effort by politicians. Europe needs both institutional and structural reform, which in many instances will necessitate a loss of sovereign-ty, a hard sell to countries that have been in existence for centuries. While there are economic solutions to Europe’s challenges, the political changes will be slow, and investors are likely to be periodi-cally frustrated along the way.

That said, we do believe there is still a reasonable chance that Europe will manage this transition. It is helpful to remember that the motivation for the EU was never driven purely by economics, but had its impetus in politics. European politicians recognized the factors that led to the catastrophe of two world wars. To their credit, the EU institutions have brought the continent closer. Hopefully, the political motivation will drive the further economic reforms that Europe desperately needs.

However, even under a best-case scenario, these changes will take time. Given that Europe is likely to remain in a state of chronic stress for a prolonged period, we would prefer to gain our European exposure primarily in northern Europe, as these countries appear cheaper relative to their economic prospects. We would remain underweight Europe, but maintain positions in Germany, the Netherlands and Norway. As for taking on a more aggressive position, particularly in southern Europe, that needs to wait for evidence of either faster growth or a lower risk premium; both rest in the hands of the politicians.

IFO

Sen

tim

ent S

urve

y

3/95 7/98 3/04 7/0711/01 11/10

80

85

90

95

100

105

110

115

120

Figure 9: IFO Pan German Business Climate Survey (1995 to Present)

Source: Bloomberg, as of 9/26/12.

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