Positive buzz about Europe is hard to defend - FT.

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MARKETS INSIGHT March 18, 2015 5:52 am

Positive buzz about Europe is hard to defend

Stephanie Flanders

‘Outperformance’ of EU shares due to weak euro and strong dollar

©EPA

A nd so the tide of market opinion turns. At the start of the year it was difficult to sell many
investors on a European recovery story. There was so little confidence in anything other
than the US; the fear was that America was going to be the only game in town, with potentially
destabilising consequences for the US and the world.

Now, though, the positive buzz is all about Europe, and the angst is targeted at the US.

Good news from the real economy has sent European markets up,
despite inflation falling firmly into negative territory. So far in 2015 the main European stock
index (Euro Stoxx 600) has risen more than 15 per cent. By contrast the S&P 500 has not really
risen at all.

That is not due to any alarming twist in the domestic recovery story. Though the data have
disappointed more often than not since January, the main US indicators still look good —
especially the jobs market. Looking ahead, cheap oil and the strong dollar should also put
money in the pockets of US consumers and boost consumption.

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Positive buzz about Europe is hard to defend - FT.com 22/03/2015 10:32

Yet the news from Wall Street is decidedly mixed. Profit margins have been falling, and the
latest corporate earnings season was a rude reminder to investors that the profits of big US
companies are much more dependent on foreign sales than the broader economy is.

In the last three months of 2014, companies in the S&P 500 that are wholly focused on the US
market saw top line sales growth of around 5 per cent year-on-year and 10 per cent growth in
earnings. More export-oriented companies saw their total sales fall 3 per cent in the same
period and profit growth in the low single-digits. The earnings of US multinationals are likely to
take an even bigger hit in the first quarter.

You might think this shift in relative confidence is healthy. If we were worried about the US
being too much the centre of the action, surely we should be less worried after two months of
European outperformance?

Perhaps. It is certainly true that Europe’s economy has surprised on the upside in recent
months, with a surge in activity in Germany and even signs of improvement in France and Italy.
The European Central Bank took much too long to start a full-scale quantitative easing
programme, but if there was a good time to come late to the QE party the ECB seems to have
chosen it.

Credit growth has been positive since the start of

the year and the fall in the oil price was starting to
boost consumers, long before the formal start of
QE. We saw at his latest press conference that ECB
President Mario Draghi is more than happy to take
the credit for any upturn in economic activity that
results.

So yes, there is some basis for this wave of

European optimism. But that optimism can hardly
be said to extend to the currency. Quite the
opposite. Investors are assuming the ECB will
continue to welcome a weaker currency and
European leaders will continue to pin most of their
recovery hopes on demand from abroad. Dig a little deeper into Europe’s “outperformance”
since the start of the year and this uncomfortable reality comes through clearly.

That near 16 per cent return on European equities since January 1 is measured in euros: in
dollar terms, the rise is less than 2 per cent. Similarly, it is only dollar-based investors who have
seen a flat or negative return on the S&P 500 so far this year. If your base currency is euros,
your return from US equities this year has been just shy of 13 per cent.

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Positive buzz about Europe is hard to defend - FT.com 22/03/2015 10:32

In other words, taking currency into account, Europe’s “outperformance” since the start of 2015
almost completely disappears. It is all about the euro and the dollar.

That European focus on currency weakening and exports is not healthy in a world in which the
eurozone is already running a current account surplus of more than 2 per cent of GDP, and
Germany’s is now among the highest in the world. But the further fall in the euro in recent
weeks suggests investors are willing to go along with this dodgy economic logic — just as long as
the ECB does.

The good news is that for the time being the US recovery looks strong enough to shrug off any
negative hit from the soaraway dollar. We have to hope so, given how important US growth is to
continued recovery in Europe, Japan and beyond. But investors who measure their returns in
dollars may find the world’s reliance on the US more difficult to swallow.

Stephanie Flanders is chief market strategist for Europe at JPMorgan Asset Management

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