Investors Look to Europe

The European Union has been working toward economic cooperation and integration since shortly after World War II. A significant step in establishing the European Monetary Union occurred in February 1971 when the Werner Report was published. The report’s three-step proposal for achieving the EMU included a permanent fixing of exchange rates, a single monetary authority and monetary policy, and a new European Economic Community fiscal policy.

In May 1998, there were 11 countries qualified to participate in the EMU: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Missing were the United Kingdom, Sweden and Denmark, all of which declined to join for political reasons.

Jan. 1, 1999, marked the introduction of the euro, the single currency of the European Union. Credit transactions can be conducted in euros, but there is no physical currency. Paper money and coins will be introduced by Jan. 1, 2002. January 1999 also signified the beginning of the EMU and the start of European Central Bank responsibility for monetary policy.

Recent developments

As of Aug. 26, one euro would buy only 1.045 U.S. dollars. As a result, U.S. investors now have an opportunity to participate in European markets at a discounted rate since U.S. dollars are stronger than they were in January. Listed below are several of the reasons that Europe is attractive for investment.

Falling interest rates: To become a member of the European Monetary Union, countries had to meet strict criteria established by the Maastricht agreement. One is the stipulation that long-term interest rates for each country must remain within a range determined by the interest rates of other countries in the EMU. This is causing a convergence of interest rates among the EMU countries, helped by the efforts of the ECB to lower rates.

Corporate mergers and restructurings: More corporate mergers and restructurings are expected as companies rush to compete in the new economic environment. Restructurings and consolidations should make European companies more profitable, increasing return on equity, which should positively affect share prices.

Single currency: Companies will be able to purchase materials from many suppliers in Europe with the same currency and without trade restrictions and costly hedging programs. This increased fluidity of goods is expected to stimulate sales growth and allow companies to enjoy economies of scale.

Exchange rate risk: The removal of exchange rate risk within the EMU should increase investment between countries by reducing investors’ reluctance to buy and sell stock in foreign companies, thereby allowing capital to flow smoothly throughout the EMU.

Risks

The creation of the EMU, while potentially lucrative, contains several risks. The main concern for EMU participants is the erosion of sovereignty. Historically, there have been many monetary unions, but without political union, most have failed. During prosperous periods, fiscal cooperation should be relatively easy to achieve. However, a downturn in the European economy or a major crisis could strain the alliance.

Economic growth is expected to improve next year, as are corporate earnings. European companies are restructuring and reducing their costs in order to be more competitive in the new European economy. Productivity improvements, similar to those that propelled earnings growth incorporate America in the early ’90s, should support earnings growth in excess of economic growth in Europe.

The decline in interest rates in Europe is expected to support the shift of assets from deposit-type, interest-bearing instruments into equities. We saw a similar asset allocation shift by U.S. investors in the 1990s. As interest rates on fixed-income investments decline, assets flow toward growth investments.

European equity markets have under-performed the U.S. stock market, in dollar terms, since 1994. Although European equity markets are up about 2.5 percent, on average, in local currencies year-to-date, due to the strength in the dollar relative to the euro, U.S. investors can still purchase European equities at 1998 levels.

The European stock market is not perfectly correlated with the U.S. stock market. As a result, U.S. investors can benefit by allocating some of their assets to European investments. For an equivalent level of equity exposure, risk is reduced.

Elaine M. Longer is a certified financial adviser and president of Longer Investments Inc., in Fayetteville.

David V. Tuzzolino, a research analyst, contributed to this article.