Collectively, the European Union (EU) has the largest economy in the world as measured by gross domestic product (GDP). Last year the total value of all goods and services produced within the 28-member EU totaled 14.3 trillion euros, according to the International Monetary Fund. But the European economy has been languishing, and due to its size and scope, this causes great concern for some investors. Right now investors may be asking themselves: What are the European authorities doing to restore the health of the EU? How might these problems in Europe affect businesses and their stocks based here in the United States? And finally, should I be altering my portfolio in light of the current situation?
To address the economic situation, the European Central Bank has recently started a monetary stimulus program aimed at supporting the economy. This is similar to the course of action taken by the central bank here in the United States starting in late 2008. The stimulus program should tackle a few problems, in part by bringing down the interest costs that countries in the EU are paying to their bondholders. It may also continue to weaken the euro against other major currencies, making European products and services more affordable to foreigners.
A potential consequence of lowering interest rates in Europe may be to push investors into riskier asset classes, such as stocks. This shift may occur when investors who desire the fixed return of savings accounts and bonds are forced to look elsewhere to meet their income needs. When interest rates are expected to remain low for an extended period of time, investors may choose to utilize stocks to find that income. Propping up stock prices can have a wealth effect, which can aid in the process of economic recovery.
While EU leadership works on alleviating its economic issues, investors and businesses here in the United States are feeling some pain, as well. Because Europe is one of our largest trading partners, a decline in European demand for our goods can lead to less business for and even fewer jobs at certain U.S. companies, particularly those with a strong presence in Europe. These problems are compounded by the recently strong performance of the U.S. dollar against the Euro, making our goods and services even more expensive for EU consumers to purchase.
From an investor’s standpoint, European stocks and index-tracking investments have performed poorly over the past few years relative to major U.S. indexes. For example, the iShares Europe Index has trailed the S&P 500 by 57.68% over the 5-year period ended April 3, 2015. It should be interesting to see if the monetary stimulus that just started in Europe will have the same positive outcome on stock prices in Europe as it did here in the United States. If so, recent lackluster performance may translate to opportunity in the near future.
So what, if anything, should U.S. investors do to protect themselves and potentially benefit from the situation in Europe? The answer to that question will depend on your unique investment objectives and tolerance for risk. Economic cycles are a natural part of investing, so a well diversified portfolio with a long time horizon should be able to withstand this sort of market behavior.
For investors who enjoy being proactive to some degree in their investing process, a decline in the price of European stocks may actually present an opportunity to buy additional shares at more attractive valuations by using strategies such as dollar cost averaging and portfolio rebalancing. These strategies allow investors to buy shares of stocks at various prices over time and return a portfolio to its target asset allocation after periods of market volatility.