Is The European Grass Greener?

Euro stocks are not a slam dunk

With the U.S. economy entering a sharp slowdown and the euro up 14% against the dollar since late October, many Wall Streeters are putting more money into European equities while lightening up on U.S. stocks. Joseph P. Quinlan of Morgan Stanley Dean Witter warns, however, that many big-cap U.S. companies may be a better bet than their European rivals.

"The huge growth in U.S.-European linkages via direct investment," says the economist, "has changed the calculus of equity investment strategy."

The normal strategy when global economic tides are shifting is to cut back in regions that are losing steam and focus on those that are relatively strong. Like most experts, Morgan Stanley's economists believe that the slowing of the U.S. economy (they see a mild recession ahead) will have sharp repercussions abroad--especially in Mexico, Canada, and Asia, which are big exporters to the U.S.

They also agree with the consensus that any slowdown in Europe is likely to be relatively modest. Tax cuts, rising outlays for information technology, healthy consumer confidence and spending, the absence of a European "wealth effect," and lower oil prices--enhanced by the rising euro--all bode well for European economies in the coming year. Not least important, America accounts for only a few percentage points of Europe's exports.

Quinlan points out, however, that trade is no longer the main mechanism by which multinationals in the U.S. and Europe compete. Thanks to huge flows of foreign direct investment across the Atlantic over the past decade, total sales by affiliates of U.S. companies in Europe and by affiliates of European outfits in the U.S. are now four to five times the size of trade flows between the two trading partners.

The fact is that Europe and the U.S. have been each other's favorite foreign investment targets for years. As a result, the earnings of many U.S. and European companies have become increasingly sensitive to shifts in currency exchange rates and the performance of each other's economies. European companies posted over $40 billion in U.S. affiliate earnings last year, and Quinlan estimates that half of U.S. foreign-affiliate earnings of $130 billion were derived from Europe.

In sum, investors need to look beyond the relative performances of U.S. and European economies this year. As U.S. growth sags, many European multinationals will be hurt by a drop in U.S. affiliate income and a weaker dollar. And many U.S. multinationals that take a hit at home will get a welcome earnings infusion, courtesy of relatively robust European growth coupled with a stronger euro.

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