Why We Like Europe, Particularly the Eurozone
You are at:»»Why We Like Europe, Particularly the Eurozone
Smart Beta Channel

Why We Like Europe, Particularly the Eurozone

Figure One makes the point more vividly, listing the six largest country allocations in each region (using MSCI Indexes). Notice two things – the disappearance of the UK and Switzerland as you move from Europe to the Eurozone, and the significantly higher weightings that France and Germany get, almost double their holdings in Europe.

Figure One: The Top Six Country Weights in MSCI Europe and MSCI Eurozone (as at 3/28/18)

As a firm we’re pretty positive right now on Europe. Our view is that the macro picture has been improving, and continues to do so. We’re forecasting Eurozone gross domestic product (GDP) to grow at 2.3% this year, and a still healthy 1.9% in 2019. That compares pretty favorably to the paltry 0.6% or so average growth we saw from the region in the five years preceding this. Add in a forecast for still tame, though positive, inflation of 1.5% this year and 1.7% next, tightening labor markets, positive economic sentiment and business surveys, a central bank that still appears to be very focused on providing the support of quantitative easing, and a number of key elections that have passed off relatively smoothly, and it all starts to add up to a reasonably optimistic picture. Or, at least, a very different one to five years ago, when existential risk to the euro was common talk, and Europe appeared to be lurching from one crisis to the next. However, it’s not just from a macro perspective that we are warming to Europe. We also believe that this should filter through to stock market returns and is reflected in valuations. But, before we get to that, a short digression. U.S. investors accessing Europe need to be careful about exactly what version they are getting. Put simply, there are two key regions that are predominantly tracked – whole Europe, and the Eurozone. And the difference of course is that the former will encompass the major markets throughout the entire continent of Europe, whereas the latter will focus solely on the major markets of countries that have adopted the euro as their common currency. Does the distinction really matter you might ask. Well, the answer to that is yes, it matters quite a bit. Despite a high degree of weight overlap, and a high correlation of returns, the critical difference is that whole Europe will include the UK, Switzerland, and a few of the Nordic countries. The Eurozone is restricted just to the 10 developed markets of the 19 countries that have adopted the single currency. So anyone gauging the relative merits will have to at least consider their view on the three or four largest European equity markets to decide which is right for them – broader Europe or the more focused Eurozone. Figure One makes the point more vividly, listing the six largest country allocations in each region (using MSCI Indexes). Notice two things – the disappearance of the UK and Switzerland as you move from Europe to the Eurozone, and the significantly higher weightings that France and Germany get, almost double their holdings in Europe. Figure One: The Top Six Country Weights in MSCI Europe and MSCI Eurozone (as at 3/28/18)

Germany and the UK – A Divergent View

For many of the reasons outlined above we are currently overweight Europe and the Eurozone. However, we are slightly more positive about the prospects for the narrower Eurozone than broad Europe, and the main reason for this is our calls on two of the key markets highlighted above – Germany and the UK.

We moved to an overweight position on Germany given the record levels of exports that the German economy is currently producing, coupled with a still relatively attractive valuation to the U.S. Figure Two shows this graphically, charting the average ratio of the Price-to-Book in Germany, and the Eurozone, versus the U.S. It’s clear that both are still below the longer term average.

Figure Two: The Price-to-Book Ratios of Germany and the Eurozone to the U.S. (6/13 – 12/17)

For the UK on the other hand, our relatively more conservative forecast for equity markets, while still positive, remains below that of Germany and Europe because of the continued drag that we believe Brexit, and its ancillary effects, are having on the UK economy. Our growth forecast is 1.5% this year and 1.6% next, and, with inflation running above target – mainly due to the weaker pound boosting import prices – it seems as though the Bank of England will have a tricky challenge ahead. Balancing the need for higher rates that that inflation demands, while mitigating the downside of tightening into an economy with subdued growth, flat business investment, lower exports, and a slightly worsening unemployment rate will require some very careful policymaking. And you thought central bankers had it easy!

Related: China – Bullish on a China Shop

So, the bottom line is that there are some significant differences between accessing Europe, and accessing the Eurozone. Investors should at least be aware of the key weighting differentials that each region has in terms of the big four European equity markets – the UK, Germany, France, and Switzerland. In this blog, we’ve given a few thoughts on how different views for the first two impact our broader regional; calls. To anyone who regularly follows the soccer World Cup, the message is an old one – they should both do well, but prefer Germany!

RELATED TOPICS
EuropeInvestingsmart beta
X