A lot has been said about the risks in Europe from the possibility of further sovereign debt troubles in Greece and Spain to the prospect of very weak growth in 2013. Some economists are even calling for recessionary conditions in the Eurozone in the first half of next year. Throughout this past year, Europe has been one of the worldâ€™s greatest sources of uncertainty, risk and sluggish growth and yet many investors are surprised to find that European assets are in demand. In fact in 2012, the German DAX has been one of the best performing stock markets, rising more than 25% since January. In contrast, the FTSE is up a mere 4.75%, the S&P 500 is up only 12%, Nikkei is up 12% and the Hang Seng only 19%. Investor also piled into German bonds, driving the price of 10 years sharply higher and yields down more than 27%. While the value of the EUR/USD now is pretty much the same as where it was in the beginning of the year, the currency pair recovered strongly since July when it traded as low as 1.2042. In other words, demand for euros drove the currency up nearly 8% over the past 4 months.
So how can European assets perform this well if Europe posed such a major risk to global growth in 2012?
Reduction in Tail Risk
The answer is reduction in risk and the attractiveness of German products. Throughout the year, the European Central Bank implemented an alphabet soup worth of measures to support the Eurozone economy and to prevent European bond yields from soaring. Euro area countries also committed up to 2 trillion euros to their rescue fund and the ECB offered to buy unlimited amounts of government bonds on the secondary market and together, these steps have finally worked. Spanish 10 year bond yields are now closer to 5% than 6% and the German governmentâ€™s approval of the third bailout package for Greece removed the near term risk of a Grexit. Overall, a European tail risk event that could send the markets plunging has diminished significantly and the commitment from EU nations and the European Central Bank to do everything in their power to keep the euro intact gave global investors the confidence to pile into European assets. For foreign investors, purchases of German stocks will oftentimes involve a conversion of their own currency into euros, which helps to explain the underlying support for the currency.
German Stocks Offer Attractive P/E Ratios, High Dividend Yields
During this time, the price to earnings ratio of many German stocks including big names such as carmaker Daimler (Mercedes) and Asprin producer Bayer fell to single digits. With stocks trading at such cheap levels and dividend yields in Germany at their highest level in 50 years, global investors woke up to the golden opportunity this summer and soon after, stocks soared. While German stocks fell because of concerns in Europe, many of these big names are global companies servicing consumers around the world. The trade surplus in Germany is higher now than at the beginning of the year because German companies make high value high priced products such as BMW cars that are extremely coveted in Asia and growth in that part of the world supported the earnings of many German companies.
Looking ahead if the tail risk in the Eurozone and the U.S. continues to diminish in the New Year and this would need to involve progress on the Fiscal Cliff, European assets could outperform after having been shunned by investors around the world. In this case, EUR/USD would rally as foreign investors convert their own currencies into euros. However if the U.S. falls off the Fiscal Cliff, even low P/E and high dividend yields may not be enough to save the EUR/USD.