TAKE NOTE COVER STORY

Opportunities in Europe

The eurozone recession has deepened, as austerity measures take their toll. Paying off government and consumer debt will take many years. But a number of high-quality companies have proven adept at navigating the economic minefields, creating promising investment opportunities.

The adoption in 1999 of a common currency in Europe was a watershed. After World War II, European countries had moved steadily toward greater political and economic integration in an effort to increase their global stature and influence. Supporters believed that a single currency encompassing much of Europe would help companies compete with those in the U.S. and emerging markets, and would bring further economic security at home. But a debt crisis that began to unfold in Greece in 2009 and has spread through much of Europe in the past several years has challenged that vision and even prompted some observers to question the sustainability of the euro itself.

Despite the doubts, the eurozone, which includes 17 of Europe's 27 countries, remains a major economic force. Its combined gross domestic product (GDP) slightly trails that of the U.S. But, unlike in the U.S., the source of economic growth in the eurozone is more concentrated, with more than 76% of the region's total GDP generated by just four countries—Germany, France, Italy, and Spain.1 This number illustrates why political leaders and investors alike are concerned about the illness that has infected Europe.

DEBT CHALLENGES
Many eurozone countries are out of alignment, as they suffer from mounting debts and low levels of growth. Spending cuts and higher taxes have helped to meet stringent deficit targets mandated by the European Union (EU). But the measures—property-tax hikes in Italy, lower unemployment benefits, and sales-tax increases in Spain, among them—may fall short.

The Eurozone by the Numbers

An increasing number of European economies have slipped into recession recently. The EU economy contracted by 0.1% in the third quarter of 2012, marking the second straight quarter of declines, on an annualized basis, according to Eurostat, the EU's statistical office. But the number belies the depth of the problems in key countries, including Italy and Spain, which declined more than the eurozone average. Even some of the healthier countries that escaped a technical recession are weakening. Germany, which expanded 0.2%, has slowed in recent quarters.

Central Bank Action. As the eurozone debt crisis has worsened, the European Central Bank (ECB) has assumed a greater role in helping countries avoid defaulting on their debts, primarily by buying bonds of the affected countries. In September, the ECB said it would be willing to buy short-term government debt in order to keep borrowing costs down—a controversial move because the ECB would require even more stringent deficit measures from recipients in return for the relief. Some observers oppose the deal because, while such an agreement would funnel desperately needed funds to central governments, additional austerity requirements could be so draconian that voters might respond by forcing the ruling class from power.

Many leaders who have sought and received bailouts are no longer in power. These include political leaders in Portugal, Ireland, and, of course, Greece, where former Prime Minister George Papandreou oversaw painful cuts before he and his political party were banished from office. With all of this bad news, and the likelihood of challenges in the future, investors could be forgiven for asking: Why Europe?

A STRONGER EUROPE
"The bad news is that the European economy is decelerating more than people had thought or predicted," says Dean Tenerelli, portfolio manager of the T. Rowe Price European Stock Fund (PRESX), which invests in growth companies in Europe and the United Kingdom. "This is happening in conjunction with the global slowdown as well, which includes Brazil and China."

"[Countries in Europe are] liberalizing their economies, cutting costs, and raising revenues. This is painful medicine. But it will work, in my view. We think that when they get through this crisis, they'll be debt-free."

—Dean Tenerelli, portfolio manager, T. Rowe Price European Stock Fund

Tenerelli believes that austerity measures across Europe could produce worse economic conditions in the near term. "It's important to keep in mind that getting out of the debt spiral many of these countries find themselves in will be difficult," he says. "Debt downgrades increase borrowing costs, which in the end affects growth rates. So you have this negative cycle, and it takes a good long while to reverse that trend."

Japan

But Tenerelli is optimistic that the difficult steps taken by European leaders will eventually revive dormant consumer spending and propel economic growth. He notes, for example, that many countries are slowly reducing their government deficit-to-GDP ratios. In 2011, the eurozone deficit-to-GDP figures improved from 2009 and 2010 levels. "They're following the right recipe," Tenerelli says. "They're liberalizing their economies, cutting costs, and raising revenues. This is painful medicine. But it will work, in my view. We think that when they get through this crisis, they'll be debt-free."


PHOTOGRAPHS FROM GETTY IMAGES
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