Claims that Europe is becoming the next Japan have grown louder in recent months, after Eurozone GDP growth flat-lined in the second quarter and consumer prices increased just 0.4%, the lowest level in nearly five years. Clear parallels do exist between the current Eurozone macroeconomic environment and that which started to take shape in Japan in the mid-1990s. However, much lower starting valuations mean European equity investors seem unlikely to suffer the same “lost decades” as their Japanese equivalents.
For context, after experiencing robust levels of economic growth in the late 1980s and early 1990s, the Japanese economy began to decelerate in the mid-1990s and between 1998 and 2012 effectively flat-lined. Collapsing asset prices were largely to blame, and Japanese policymakers were relatively slow to respond. Benchmark interest rates in the mid-1990s, in hindsight, were arguably too high, and the Bank of Japan didn’t begin quantitative easing until 2001. One thing the government did do was provide enormous fiscal stimulus—government debt to GDP exploded from 80% in 1993 to 180% by 2004.
Eurozone economic growth has been weak since 2011, but balance sheets and growth dynamics differ from those seen in Japan in important ways. Debt levels for certain Eurozone countries like Italy are problematic, but at an aggregate level have been kept in check by limited fiscal stimulus in recent years. Despite a lower starting level, between 2008 and 2013 Eurozone government debt to GDP increased 25 ppts (to 95%), compared with 51 ppts (to 243%) and 32 ppts (to 104%), respectively, for the Japan and the United States over the same period. This lack of stimulus has weighed on growth, which had averaged around 2% going into the global financial crisis but has essentially been zero since 2008.
Where the Eurozone has been aggressive is on the monetary policy side. The European Central Bank (ECB) has responded to falling price levels and concerns about sovereign debt affordability with a series of rate cuts and asset purchases. The ECB’s balance sheet has doubled since the start of the global financial crisis to over €2 trillion, and recent ECB comments suggest another expansion may be imminent.
More importantly, asset valuations in Europe today are far different than Japan’s in the late 1980s. In 1989 Japanese stocks traded at over 50 times trailing earnings and nearly 5 times book value. Eurozone assets did not exhibit similar signs of exuberance before the financial crisis. At the end of 2006 Europe ex UK equities traded at around 15 times trailing earnings and 2.5 times book value; today they trade at 19 times and 1.8 times, respectively. Meanwhile, Eurozone housing has appreciated much more modestly than Japan’s did in the late 1980s, in part because tax and lending policies in Germany have reduced incentives for homeownership and its housing market actually declined from 2000 to 2007.
The Japanese asset bubble took more than two decades to deflate, weighing on asset returns and growth. Notwithstanding their stunning 54% return in 2013, the 20-year average annual compound return (AACR) for Japanese stocks through September 30 was barely positive. These low returns occurred despite earnings compounding at over 8% per year during this period—it is valuations, not earnings, that have weighed on Japanese equity returns.
European firms have suffered a significant drop in earnings given the financial crisis, but their long-term earnings capacity has been stronger. Europe ex UK earnings have compounded at nearly 6% per year for the past 20 years, driving their 7.2% 20-year AACR. The fact that Japanese companies could grow earnings at 8% despite virtually zero economic growth over the past two decades speaks to the possibility of European companies continuing to post profits amid the current economic slowdown.
This is not to say that investors should be overly sanguine about Eurozone macro prospects. Unique political dynamics increase the risk of policy error, as member states with different rates of inflation and growth have difficulty agreeing on uniform monetary and fiscal policies. The unwillingness of some Eurozone members to use fiscal stimulus and condone outright quantitative easing to lower interest rates has triggered significant market turbulence in recent years; standoffs may again prevail until market disruptions trigger consensus building. Growth in the Eurozone, like that in Japan, will also suffer from demographics. Still, while European equity returns have disappointed this year, valuations do not portend a decade (or more) of poor returns.
Wade O’Brien is a Senior Investment Director on the Cambridge Associates Global Investment Research team.
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