The European sovereign debt crisis is back in the headlines as debt-laden countries struggle under stark austerity programs. Recent concerns regarding a Greek default have revived contagion fears, market volatility and questions about whether the Eurozone can survive the ongoing turmoil.

Below, Capital Group Private Client Services global equity portfolio manager Gerald Du Manoir puts the situation into context. He discusses how we got here, explains why he believes the Eurozone is likely to remain intact and reveals why the current climate offers some compelling opportunities for long-term investors.

The underlying problem

Whenever concerns about European sovereign debt surface, the real fear is that financial weakness in Greece and some of the other peripheral Eurozone countries will spur a wide-scale liquidity crisis similar to the collapse of Lehman Brothers in 2008. However, I don’t think this is realistic. Central banks have learned a lot from the Lehman incident, and European countries have a strong political will to keep the Eurozone intact. The monetary union stemmed from European countries wanting a way to integrate their economies, facilitate the transportation of goods and people throughout Europe, and make it easier for companies to do business with one another.

The problem is that once a common currency is formed, unless there is also a common fiscal policy, imbalances are created within the countries themselves. The disparity started about 10 to 12 years ago when the European Commission transfer payments, which were designed to equalize the purchasing power and social protections of people across the European Union, ended. These payments began in 1992, when Europe was expanded to include several southern countries and massive payments were transferred from the north to assist in the development of the south. When the transfer payments stopped, many countries maintained fiscal policies that protected social programs, but didn’t raise revenues to meet various social needs. As a result, many of these countries essentially borrowed money to fund the programs.

Cracks began to show after the collapse of Lehman Brothers, because borrowing at the sovereign level suddenly became much more difficult. Certain countries were faced with a completely different borrowing pattern that included paying much higher interest rates.

In 2010 the first real European crisis emerged when Eurozone countries confronted the reality of repayment. That is what led to the Greek crisis. Meanwhile, several other countries began falling behind on their repayments including, Italy, Portugal and Spain.

The Greek situation is the most severe, will be the hardest to solve and will probably carry the largest write-off requirements. Problems in Spain and Portugal are less dire and will likely be worked through at a gradual pace. Italy’s situation is nowhere near those of the other three countries. Italy has a very high savings rate, and Italian households are in very good shape. The Italian government under Mario Monti has already started restructuring its social policies. The government has also been reforming its labor force to reduce liabilities, and is overhauling its very arcane tax code.

Options for Greece

If Greece left the euro, the country would reintroduce the drachma, which would probably instantly lose about half of its value. Holders of Greek debt would be hit by a double whammy of substantial write-downs (equal to 30% to 40%) and currency devaluation (of roughly 50%). Essentially, they would see the value of their holdings drop by 80%.

If total Greek debt exposure is roughly 220 billion to 230 billion euros, the cost of Greece leaving the monetary union would be about 180 billion euros. When the current Greek debt-reduction plan ends in December, I expect there will instead be a write-down of about 80 billion euros on Greek debt, simply because it’s much cheaper than forcing Greece out of the Eurozone.

I do believe the Eurozone will remain intact. Germany, despite the hard line it has been taking on struggling European economies, benefits from the monetary union. If Germans did not have the euro, the deutschmark would be a very expensive currency reflective of a healthy economy with a high savings rate. Germany’s current economic success reflects solid exports from industry, which would be dramatically penalized by a stronger currency. In fact, if Germany didn’t have the euro, it would be in trouble economically, facing a situation similar to Japan’s.

Opportunities amid uncertainty

One of the worst misconceptions I’ve seen is the belief that European companies must be bad investments because their governments are enacting austerity programs. There is no doubt that European banks are exposed to the sovereign debt crisis. There will be substantial balance-sheet issues stemming from write-downs on sovereign debt and the need to reduce exposure to some of the struggling countries.

However, other sectors offer opportunities to tap into growth outside of European markets, and many companies based in the Eurozone are currently trading at unprecedented valuations. The average price-to-earnings ratio on the European market is about 9, which means there’s a tremendous risk premium attached to European equities. It’s like saying that an investor isn’t expecting to recoup the value of his or her investments for another nine or 10 years. Even assuming a worst-case scenario in which there is no earnings growth in 2012 (something that I think is pretty unlikely), the current price-to-earnings ratio really doesn’t make a lot of sense. 

The reality is, most European companies have excellent balance sheets and at least some exposure to continued growth markets outside Europe.

It’s important to remember that investing is about identifying two things: attractive fundamentals and the right entry (price) point. In Europe we are seeing some very compelling starting points right now. The fundamentals aren’t in great shape, but they will get better. This is an ideal situation for long-term investors because there are ample opportunities to buy strong companies at attractive prices and the fundamentals will improve as Europe works through the current crisis.

At Capital Group Private Client Services, portfolio managers are cautious when it comes to our investments in European companies. We analyze the downside risks as closely as the upside potential. After identifying an attractive company based on various valuation metrics (such as price-to-earnings, price-to-book or dividend yields), we look at whether the company’s revenues or balance sheet could be affected by a Greek default or another restructuring of Portuguese debt.

Our next step is to identify reasonable mid-cycle earnings for the company and value it on that basis. The fact that we’re long-term investors gives us an advantage over the competition, as we look through the short-term demand risk and focus three to four years out at what the company might be earning and generating in cash flows.

The way we have been handling our European equity exposure is to take advantage of bumps in the market (as we saw in the fall of 2011 or in the past six weeks) to invest in companies that hold the potential to generate significant upside revaluation once the market stabilizes. Unlike what we saw a few years ago, investors are differentiating between strong results and the market as a whole. Internal correlation for the market peaked at the end of 2011, when everything was correlated, but we’re finally seeing substantial differentiation among companies within the market. This has allowed us to do well in our continued focus on company fundamentals.

European holdings in client portfolios today comprise consumer goods companies, high-quality industrials, insurance businesses with exposure in Asia and some newer investments in technology.

Impact on the U.S. market

U.S. companies have benefited from the weakening dollar for some time, and the rest of the world has experienced a reasonable recovery since the 2008 crisis. As a result, the U.S. market has seen very strong growth, increasing its valuation premium to the rest of the world. However, events in Europe are making investors in general very nervous, sending them out of equities and into perceived safer havens.

The second reason the U.S. market has been affected by what is happening in Europe is that a significant percentage of U.S. company earnings come from outside the U.S.—namely, from Europe. Every multinational company has exposure to Europe because, in aggregate, it is the largest economy in the world. Investors are concerned that austerity measures will negatively impact the earnings growth of multinational companies. This is certainly a real risk: a weakening euro means a strengthening dollar, which results in a reduction in the repatriation of earnings—plus, there could be weaker demand as a result of austerity measures.

I think the recent case of European credit-default-swap losses at JPMorgan surprised some people because they had forgotten that U.S. banks are global, with exposure across the spectrum of credit risk. This is why we’ve been underexposed to banks, particularly those based in Europe, in client portfolios.

Nevertheless, corporate America is in good shape overall, valuations are not excessive from my perspective, and we are taking advantage of this volatility, albeit cautiously, in the U.S. as well.

Signs of progress

Although the situation in Europe is very serious and still carries a lot of risk, some significant political decisions of late could lead to a resolution in the not too distant future. The first occurred back in November 2011 when the European Central Bank introduced the long-term refinancing option (LTRO) to European banks, allowing them to borrow money at low interest rates with more time to repay the loans than in the past. It was a very big deal because it stabilized the European banking system and avoided a widespread liquidity crisis. The LTRO is ongoing (there will likely be another one this year) to continue the stabilization process.

The second was the recent announcement by the president of the Bundesbank that Germany may tolerate some inflation in order to support a long-term solution for Europe, particularly the readjustment needed to stabilize unit labor costs across Europe.

Finally, there has been a slight change of tone from European politicians as they recognize that austerity plans should be combined with some sort of stimulus to protect economic growth. For example, a long-term plan to restructure pension liabilities can coexist with monetary policies that encourage growth. If European policymakers institute a more balanced plan, then core European countries can recover at a better-than-expected pace even if there is a Greek default and a restructuring of Portuguese debt. Such a plan would improve the outlook for European companies and should ultimately lead to greater stability for the global financial markets. n

The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, reflect the views of one individual and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this paper will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with your Investment Counselor. © 2012 Capital Group Private Client Services. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.