The market's schizophrenic ability to switch between sunny optimism and crisis is nowhere better illustrated than the frequent swings in sentiment when it concerns the economic health of one of the top three trading blocs in the world. The eurozone - Germany, in other words - will eventually get around to starting a banking union and a measure of fiscal control from the centre, but the important point for investors is that the return from European equities next year promises to be greater than emerging markets.
Since the start of the autumn there has been a steady round of fund managers increasing their exposure to European equities, particularly the German market. On the face of it, this strategy seems contrarian to the point of foolhardy, but what the professionals sense is that Europe is over the worst of its recession, in spite of the many complex problems the continent still faces.
The worst of the medicine
The squeeze on spending is likely to remain in countries such as Italy and Spain, but progress towards freeing up the southern economies has been far quicker than expected. The International Monetary Fund (IMF) may have a point when it says that excessive austerity has damaged the productive output of the European economy - whether there was any other way to avoid a bond buyers' strike is a moot point - but what seems to have been lost in the debate is the benefits countries will derive from a massive reorganisation of the labour market and regulatory reform, effectively re-engineering their economies towards global competition and building on the fact that southern Europeans tend to work longer hours than their northern counterparts.
The surprise is how well Italy, in particular, is coping with the process. Not only has the country adopted a deficit closing programme that was twice as fast as the UK's, but it is forecast to emerge from recession next year. Key to this was the little reported news earlier this year in June that Italy's technocratic prime minister, Mario Monti, had managed to pass a series of labour reforms that made it easier for Italian companies to hire and fire workers. A measure of how inefficient Italy had become is an estimate by the Organisation for Economic Development that the Monti reforms on their own will add about four percentage points to the country's GDP over the next four years. The reforms open Italy's traditionally closed labour markets to a younger cadre of cheaper and more productive workers. Spain has been undergoing similar shock therapy and the net result will be a big boost to productivity, which is why the markets have supported both Italian and Spanish debt and started to buy up cheap looking equities.
Fundamentally, now that Spain has requested a widely forecast €37bn (£30bn) bail-out for some of its worst-hit banks – Bankia, Catalunya Bank, NCG Banco and Banco de Valencia – and another €2.5bn to capitalise a 'bad bank' to quarantine the worst assets, most of the really tough medicine has been swallowed.
The direction of Germany's economy - which manufactures Mercedes - will be the single biggest factor in Europe's performance this year.
Deutschland still Uber Alles
The German electorate may be grumpily resigned to bailing out Greece - the last pieces of legislation were signed off last month by the Bundestag. The country's financial muscle is translating into a political activism on the European stage that is threatening to upset the cosy assumptions of the Mitterand/Kohl era. The German government is skittish for historical reasons about imposing its will on Europe, but in economic terms Germany's export-orientated industries and highly productive workforce is de facto forcing the rest of Europe to fall in behind an austerity and reform agenda. The figures are indisputable - with the same quantity of capital a French worker is 10 per cent less productive than his or her German counterpart.
The direction of Germany's economy will be the single biggest factor in Europe's performance this year. The country may be reliant on Bric economies - the Brics are set to endure their worst year in a decade as China unwinds its credit boom, India grapples with exploding costs, and Russia and Brazil cope with falling commodity prices - but its indicator of business confidence, the IFO, surprisingly turned positive earlier this month after several quarters of contraction. As a lead indicator it is a fairly accurate measure of business confidence, which has a direct impact on investment decisions. All in all, the high-beta Dax is reckoned to be the exchange to follow next year.
Know your market
So why is Europe worth investing in? Fundamentally, because it is dirt cheap. At a cyclically-adjusted price-to-earnings ratio of just 13, the MSCI Europe Index, which tracks Europe's developed equity markets, is well below the index's long-term average PE ratio of 21. That is fairly close to its all-time lows and opens up a clear opportunity to go long on Europe by using a simple tracker fund. There may have to be an element of 'muddle through' for investors as the situation in Spain could yet have political consequences, but the deeper risks within the Union seem to have been brought under control, not least by the bond-buying activities of the European Central Bank, which has helped force liquidity back into the market. The move towards a banking union in 2013 could also create opportunities, with the likes of Ireland and Portugal then able to access the market with a backstop guarantee in place.
However, there could be an element of drift if the eurozone's institutions fall short, as Goldman Sachs pointed out in its latest advice to clients: "The best opportunities to take on exposure to Europe have come either when the market believes that the system is close to collapse (as it did again in May this year) or when there is confidence that the key risks have been resolved. Neither is true right now." Nonetheless, with plans for a banking union and single supervisor for Europe's bank on the slate for next year, there is a sense that the European Union is groping its way towards a stable regulatory framework for finance, which comes in spite of its institutional failings.
The advantage the developed world has over the developing world is that its output is unlikely to outrun the economy's ability to sustain it, unlike markets where capacity constraints are a real issue past a certain level of economic growth. That means that emerging market equities, which haven't done well over the past couple of years, might do better than Europe in absolute terms, but in practice the relative outperformance will not be that great.
