The $100 billion-plus bailout of Ireland, which followed the $100 billion-plus bailout of Greece, seems at first to validate the standard U.S. view of Europe - that it's a bunch of backward, socialist countries that will be washed away by the tide of history.
According to this view, one European country after another will succumb to the "Greek disease," until the continent ultimately runs out of bailout money. The conventional wisdom is that U.S. investors should just avoid the European Union (EU) in its entirety. But U.S. investors who embrace this view - and ignore the economic muscle that exists in key European market economies - will end up leaving an awful lot of money on the table.
Ireland and Greece: A Tale of Two Divergent Economies
The average public-sector deficit in the 15 countries that use the European euro currency will be 6.5% of gross domestic product (GDP) this year, The Economist magazine's team of forecasters concluded recently. That's lower than the 9% ratio for the United States, the 10.1% ratio for Great Britain, or even the 7.5% ratio for Japan.
So why would an investor who was worried about public-sector finances run away from the EU? The reality is that as you go through the 27 countries of the EU - from worst to first - the concerns about public-sector finances are concentrated in less than a third of the European continent.
Greece is a basket case - no question about it. Ireland, on the other hand, has merely been foolish about its banking and housing policies - and can actually boast an overall national economic policy that was put together in a highly intelligent manner.
Ireland's low corporate tax rate of 12.5% has generated strong inbound investments. That has developed Ireland's economy and its national skill set - while admittedly also fostering the formation of a sector of dodgy aircraft-leasing companies. It will be very unjust if Ireland is forced to jettison that excellent national economic policy to get a bailout from the EU - but tough choices must sometimes be made.
The bottom line: Greece and Ireland are on divergent paths. In the long run, I expect Ireland to recover nicely; Greece - not so much. The difficulty now is that with the markets having generated $100 billion rescue packages for each country, they'll next be hunting for new victims.
The Next Phase of the EU Contagion
In this hunt for potential EU victims, there certainly appears to be a "target-rich" environment. In my opinion, there are six economies to watch. They are:
- Portugal: It has a sensible banking system and had only a moderate housing-price bubble (for some reason the Algarve stayed more selective than Benidorm or Marbella). Unfortunately, it has a dozy Socialist government that engineered a "stimulus" in 2009 and that resorted to such ill-advised, onetime deficit-reduction strategies as stealing the telecom company's pension fund - instead of employing such proper strategies as spending cutbacks. Portugal's deficit for the first 10 months of 2010 was higher than in 2009. Spending was up 2.8%, in spite of a modest economic recovery and very low inflation. So Portugal is almost certain to get a bailout, and is fairly unlikely to recover.
- Spain: This country had a real-estate the size of Ireland or England, has a Socialist government as dozy as Portugal's, and a huge 2010 fiscal deficit of 9.7% of GDP. While the top end of its banking system (Banco Santander SA (NYSE: STD), for example) is admirable, there's a lot of dreck lower down. So at some point, I'd expect Spain to demand a bailout, too. The problem is, Spain is bigger than Portugal, Ireland and Greece put together. A bailout of around 50% of GDP, roughly the size handed out to Ireland and Greece, would total $730 billion - and drain the bailout fund of the remainder of its cash.
- Spain's plight is unfortunate, because we should also worry about Italy: Bigger than Spain, and with a government that is tottering on the brink (at which point it will be replaced by yet another dozy Socialist operation), Italy is a country whose banks are so sleepy that they've been able to avoid trouble. Its real estate market stayed within bounds and its fiscal deficit is only half of Spain's. But its public debt is far in excess of 100% of GDP. If the speculators succeed in knocking off Portugal and Spain, they will think they are on a roll and have a go at Italy - which is probably too big to bail out.
- There are two countries that pundits talk little about - Hungary (not an EU member) and Slovakia (got lucky and elected a competent government last summer). And there's a final one nobody talks about - Belgium: A mirror image of Italy, with about the same budget deficit and even more public debt, Belgium has the worst debt/GDP ratio outside Japan. What's more, it has great difficulty forming governments and may someday split in two. Its big advantage is that it happens to be where all the Eurocrats live and work, so like the District of Columbia, it will get bailed out somehow.
If Spain goes, the EU can't survive in its current form. That's a pity, as it's very convenient if you're traveling in Europe, and has been quite well run by the European Central Bank (ECB), whose policy in the last decade has been distinctly better than that of the U.S. Federal Reserve.
However, if the European Union splits, that doesn't mean that European investments become super-dangerous - far from it. Instead, those countries in Europe that are genuinely well run - think Germany, Sweden and the Netherlands, for example - become even better investments, because they will lose the responsibility for bailing out their weak siblings.
Eastern Europe, too, is mostly benefiting from having lower labor costs than its Western European brothers and sisters, fewer welfare-state problems and an education system that is just as good. The EU as a whole is recovering nicely, and these countries are currently doing best. So, oddly enough, if you want to hide from the Irish contagion, some of the best places to do so are in Europe. In particular, take a look at the:
- iShares MSCI Germany Index (NYSE: EWG), which covers Germany, currently Europe's strongest economy, an export dynamo recovering rapidly on the basis of some of the world's soundest economic policies. At $1.6 billion, with a 0.55% expense ratio, a Price/Earnings ratio of 11 and a yield of 1.4%, it should be a core holding of any portfolio, even if other investments are mostly domestic.
- iShares MSCI Sweden Index (NYSE: EWD), which invests in an EU success story. Americans tend to think of Sweden as a dozy Socialist economy, but it has actually revived itself considerably recently, after a horrid crisis in the early 1990s. The World Economic Forum has recently rated Sweden the world's second-most-competitive economy, ahead of the fourth-place U.S. economy. EWD is a $250 million fund, with a low 0.55% expense ratio; the P/E is a bit higher at 15, and the yield 2.1%.
- iShares Netherlands Investible Market Index (NYSE: EWN), which has a yield of 1.9% and a modest P/E ratio of 11. It's a smaller fund, with assets of only $171 million. But its expense ratio is only 0.55%.
- iShares MSCI Eastern Europe Index (NYSE: ESR), which is a small fund, at only $14 million, but one that still gives you access to the growth areas of Eastern Europe, where it is very difficult for U.S. investors to find direct investment plays. The fund's expense ratio is a little higher, at 0.7%, but its P/E ratio is only 10 - and the lower P/E and higher growth rates certainly looks attractive to me.