Investors appear to be embracing Europe again. Flows into the region have increased in recent months on signs the eurozone economy is stabilizing. And as I wrote last month, I now believe that investors underweight European equities should raise their allocations to the region.
But while European growth looks better than it did a year ago and eurozone stocks are attractively valued, I’m not yet advocating that investors should overweight European equities.
Why am I only cautiously embracing the eurozone market? There are two major regional issues that remain unresolved. Here’s a look at these two, plus the signposts to watch to gauge whether the issues will be resolved anytime soon.
The job of integrating the region’s fragmented banking system remains a work in progress. All important decisions regarding this issue have been postponed until after the German federal election on September 22. While the election may produce some short-term market volatility, I believe the most likely outcome is either a continuation of the current coalition government or a return to the Grand Coalition (CDU and SPD) of Chancellor Merkel’s 1st term. Under either scenario, policy is unlikely to change significantly.
But even after the federal election, the road to a banking union will be choppy. There are many details that still need to be figured out including which banks will be included and what European-level authority will handle the resolution of troubled banks. In addition, before integration can occur, the European Central Bank (ECB) needs to conduct a banking sector asset quality review program and a stress test, both scheduled for next year.