A case for owning euro-zone shares

IN AN episode of “Seinfeld”, a 1990s television comedy, George Costanza, a serial failure played by Jason Alexander, decides that every instinct he has is wrong. So he resolves to do the opposite. He is soon squiring a new girlfriend and is up for a dream job. “It’s all happening because I’m completely ignoring every urge towards common sense and good judgment I’ve ever had,” he says.

Success in investing often means going against the grain—and your own feelings. To do otherwise is to be swept along by the general greed and fear. Still, fear is a useful emotion. It would be unwise, for instance, to ignore the recent turmoil in Italy, where bond yields spiked in response to concerns that the country might be on the road to leaving the euro. Though the worst fears have subsided, the coalition that was eventually given the president’s blessing to form a government looks capable of causing trouble.

A natural inclination in the circumstances is to turn away from euro-zone assets—not just bonds (where the rewards are notably scanty in relation to the risks) but equities, too. Yet such instincts can betray investors. There is an argument for buying euro-zone shares precisely because their defects have now become all too clear to everyone.

Among the shortcomings is that Europe is ageing. It is the place to find businesses ripe for disruption, rather than those doing the disrupting. Its bourses are heavy with the technologies of the second industrial revolution—mass-market cars, petrochemicals and machinery—but light on the digital firms that power stockmarkets in America (see chart). Its banks, a big weight in stockmarket indices, look leaden. Deutsche Bank is a target of short-sellers. Last year’s strong GDP growth has cooled. To cap it all, there are glaring holes in the euro area’s design. There is no continent-wide deposit or unemployment insurance, for instance. A nasty recession could plausibly break the zone apart.

So there is plenty not to like. The experience of owning European stocks over the long haul has been quite horrible. The Euro Stoxx 50 of big euro-zone shares is no higher now than it was 20 years ago. Its broader sibling, which contains 300-odd companies, is well below its peak in the summer of 2000. The inclination to steer clear is quite natural. But there is a strong case for doing exactly the opposite.

For a start, euro-zone equities look cheap. The earnings yield on the Euro Stoxx 50 is 6.4%. That compares with a 4.8% earnings yield on America’s S&P 500 index and is handsome for an economy where holding cash pays less than nothing and where the safest government bonds pay a negative yield after adjusting for inflation. Patience may be required. But over time the chances that a punt on euro-zone equities pays off are good.

What is more, there is room for earnings to improve. Take banks, for instance. Bad loans and the need for more capital had been a continuing drain on their profits. But now even Italy’s big banks are in decent shape. “If at any point interest rates turn positive, you could see huge earnings upside,” says Eric Lonergan, of M&G, a fund-management group. Similarly, other firms, which still had to fork out on wages and rents during the euro zone’s depressed years, could squeeze out more profits if the economy keeps growing. In America, by contrast, there is no comparable scope for earnings to accelerate, because the economic cycle is more mature.

To be sure, the euro is a rickety construct. Countries are also currency zones and they work tolerably well because of fiscal transfers from rich to poor regions. That is absent in the euro area—hence the fear of break-up. Even so, it is far from obvious that this should be ranked higher than any number of other uncertainties.

What investors choose to worry about changes. At the beginning of 2016, for instance, China’s debt mountain was a source of terror for financial markets. Now it elicits a yawn. Few have yet mapped out the implications for markets of President Donald Trump’s foreign policy in the way they have done for a break-up of the euro. Yet it might turn out to be of greater consequence. The risks to the euro are simply more salient. And when risks are more palpable, people tend to give them too much credence.

Instinct does not always serve investors well. The political tremors in Italy are more like a scare than a rerun of the crisis of 2012. In which case there is money to be made from European equities, says Mr Lonergan. So remember George Costanza. When every urge tells you to shy away, consider doing the opposite.

This article appeared in the Finance and economics section of the print edition under the headline “The wisdom of George”