Over the last business cycle, the Euro-zone performed better than the US in those areas that drive the return on capital, notably productivity. Although Euro-zone GDP growth is likely to remain far lower than US growth, Euro-zone asset returns are likely to be as high, if not higher, than in the US.
This is the startling conclusion of a piece of prize-winning research by Kevin Daly, a research economist at Goldman Sachs. Daly has analysed the economic performance of Euroland and the US and finds the apparent superiority of the US’s economic performance is not borne out by the data when it is analysed over a full economic cycle. He concludes that the Euro-zone’ s GDP performance has been inferior to the US’s chiefly because it had a slower growing labour force that works shorter hours.
The Euro-zone’s productivity has actually been higher than the US , he says. Daly calculates that the Euro-zone’s productivity per hour growth, in the 10 years to 2003, was 1.8% a year, 0.2% above the US productivity rate of 1.6% a year over the same period.
This has implications for the financial markets in general and Euro-zone equities in particular. It means that a slower Euro-zone GDP driven by weaker labour force growth should result in a lower return on Euroland assets. This is because economic models show the rate of return is dictated by productivity growth rather than labour force growth.
This has been borne by the Euro-zone’s experience over the past 10 years. While the US economy has outgrown the Euro-zone by 10%, the total return on Euro- zone equities, including dividends, has kept pace with the US .
Daly says that the US economy will continue to grow faster than the Euro-zone economy over the next 10 years because growth in the labour supply will substantially outstrip that of the Euro-zone. But as long as faster growth in the US is driven by demographics alone – an expanding labour force – the Euro-zone is unlikely to produce lower returns than the US. In other words, the Euro-zone and US equity markets will continue to move in tandem.
Even the concern about the impact on Euro-zone equities of the weakening of the dollar against the euro may have been overdone. Michael Schubert and Christopher Weil, senior economists at Commerzbank, suggest that worries that the Euro-zone recovery will be ‘torpedoed’ by the weakness of the dollar seem exaggerated. “The tendency for the media and the financial markets to focus on the euro-dollar exchange rate has blown up the euro’s gains out of all proportion. It is the external value of the euro that is the decisive factor for price competitiveness in the euro area,” they say.
Schubert and Weil point out that from June 2002 to January 2004 the euro rose 30% against the dollar. However the weighted effective exchange rate versus the currencies of 38 trading partners rose by just under 17% in the same period.
They add that the dent in companies’ price competitiveness is only one side of the coin. Purchasing power within the Euro-zone has risen, as imports are cheaper.
As a result, many Euro-zone companies are in better shape than they have been for some time. Corporate restructuring remains a key driver of Eurozone equities, according to Fraser Chalmers, head of European equities at Standard Life Investments in Edinburgh.
“After three years of deteriorating equity prices and declining business and investor sentiment, some of Europe’s worst basket-case companies have managed to turn themselves around. Aggressive cost cutting, debt reduction initiatives, disposals of non-core assets and serious management shake-ups have resulted in many leaner European businesses,” he says. Chalmers identifies Deutsche Telekom, France Telecom, Zurich Financial Services and Deutsche Bank as some of Europe’s most notable successes.
“Vivendi Universal’s new management hasn’t put a foot wrong since it was installed and the company is perhaps one of Europe’s best examples of restructuring,” he says. “The company came close to bankruptcy in 2002, when it posted the largest one-year loss in French history. However, since the installation of new CEO Jean-René Fourtou, the company is a changed beast and he is now beginning to convince investors of his worth.”
The effect of this, says Chalmers, has been to draw retail investors back into the Euro-zone equities markets, where they have become net buyers for the first time since the second quarter of 2002. FEFSI figures show that collective investment equity funds attracted more than E13bn in the second quarter of 2003, compared with an outflow of E9bn in the previous quarter.
Although equity price increases slowed in the third quarter of 2003, European equity funds gained E25bn in net new money between July and September – the highest quarterly result since the second quarter of 2001.
However, Europe still has some way to go to match the appetite of US retail investors. In the 10 months to the end of October 2003, US equity mu-tual funds attracted $105bn
(E82bn), while funds in Continental Europe attracted only $19.3bn in the same period.
Chalmers says SLI’s strategy within Euro-zone equities is to maintain its bias towards pro-economic growth, anti-defensive stocks but with a less extreme tilt than previously.
“We have captured the persistent relative strength in technology sectors like software, IT hardware and consumer electronics. We have recently added to some non-cyclical consumer stocks, in the food and pharmaceuticals sectors, given their recent underperformance relative to cyclical and technology sectors.
“We remain heavy in banks. Within the banking sector, there has been an increase in the flow of corporate deals and several leading European banks have intimated that future expansion plans within Europe are high priority.”

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