October 23, 2013

Europe has not completely regained its economic strength, but it is finally emerging from recession. Financial market performance has improved, while some periphery countries still have significant hurdles to overcome. In a recent interview, Dean Tenerelli and Ken Orchard discuss the European economy, the debt crisis, and the outlook for the future. Tenerelli has managed the European Stock Fund since 2005, and Orchard is a European fixed income portfolio manager and a key analyst covering the eurozone debt crisis.

Recovery From Eurozone Debt Crisis

Periphery countries have moved from significant current account deficits at the end of 2012 to surpluses by the midpoint of this year, so they are no longer dependent on large capital inflows. However, there are still some concerns, so the crisis is not completely over. Orchard points out that the banking sector is still shrinking, and loan growth is negative. However, economic indicators are suggesting 2013 GDP growth of 0.5% to 1.0%, which is a major improvement.

Elevated Unemployment Creates Some Risk to Recovery

Several European countries continue to have high unemployment rates, particularly among youth. Orchard believes that some of the statistics are artificially high, though, as many young workers are working in some form or another. However, the concern cannot be completely dismissed.

In the short term, social unrest as the unemployed grow increasingly impatient could stifle the progress of structural reforms. Economic buffers provided by large governments have become an expected way of life in many European countries, but remaining globally competitive is increasingly important. That has driven attempts at pension and labor market reforms. Tenerelli believes that there will always be an aspect of the social state that persists, but it is modernizing and shifting. In the long term, young people persisting in jobs in an informal economy may hurt economic strength, as they will not acquire the necessary skills to be globally competitive.

Debate Over the Pace of Austerity Measures

The proper pace of fiscal austerity has been the source of debate across the eurozone in recent years. The "hard camp," those who believe in rapid austerity and tighter monetary policy, won out at first, which was a major contributor to Europe's plunge into recession in 2011 and 2012. Orchard says that the "soft camp" has taken over the debate in the last six months, encouraging easier monetary policy and slower austerity.

Part of the softening was due to Germany easing its stance on stimulus earlier in the year. Chancellor Angela Merkel was facing reelection, which she has since convincingly won, and had also seen that early austerity measures caused extensive backlash and recession. However, Orchard believes that the last six months probably have been too soft in terms of austerity measures. Balancing the two will remain a factor in the European outlook for some time.

European Outlook: Deeper Integration

Orchard believes that any risk of a eurozone breakup has passed. That has alleviated some investors' concerns. At the same time, investors are losing confidence in emerging markets, where growth is slowing. As a result, European markets have improved quickly. But Tenerelli notes that many European markets are still relatively cheap and could be strong for the next few years.

Orchard anticipates a more integrated Europe moving forward. The region went through an awkward phase of having a common currency but few shared institutions. It may take up to 10 years, but eurozone countries are likely to grow closer politically and economically.

The European Stock Fund is subject to the risks of stock investing, including market risk. It is also subject to currency risk and political risk, and its geographic focus involves higher risk than a more geographically diverse international fund because of its focus on a specific region.

The views are as of October 7, 2013, and may have changed since that time. This information is provided for informational purposes only and is not intended to reflect a current or past recommendation or investment advice of any kind. Opinions and commentary do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.