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Why it's Time to Reconsider European Equities

August 23rd, 2013

by Russ Koesterich

of iShares Blog

This summer, for the first time in three summers, investors did not have to contend with a eurozone financial crisis.

While the continent’s problems remain far from solved, a year after European Central Bank (ECB) President Mario Draghi pledged to do “whatever it takes” to save the euro, the eurozoneappears to be on more stable footing.

As such, many investors are asking: “Is it time to reconsider European equities?” My answer: a qualified yes. While I’m not advocating that those already overweightthe eurozoneadd more exposure to the region, I do believe that European equitiesshould no longer be excluded from portfolios. Here are three reasons why:

  1. Europe’s economy is stabilizing. After six-consecutive quarters of contraction, Europegrew a better-than-expected 0.3%in the second quarter. While still weak, the economy – particularly around the core countries –is improving.
  2. Eurozone equities are cheap relative to US stocks. Eurozone stocks currently trade for less than 1.30xbook value. This is a 25% discount to their long-term average valuation and nearly a 50% discount to the book value of US stocks. The eurozone market typically trades at a discount to the US market due to its lower profitability and larger allocation to financials, which tend to trade at lower multiples than other sectors. However, the current discount looks excessive.
  3. There’s less risk that the euro will be dissolved. A year ago investors were reasonably concerned that the single currency may not survive. But last year’s actions by the ECB, coupled with some modest reforms in peripheral European countries, significantly lowered the risk of dissolution.

To be sure, while Europe looks better than a year ago, there are stilla few important caveatsthat are keeping my “yes” answer a qualified one. First, the job of integrating Europe’s fragmented banking system remains a work in progress. Until we see further evidence of banking integration, which is unlikely until afterthe important German federal election next month, a weak and fragmented banking systemwill remain Europe’s Achilles heel.

Second, many ofthe southern European countries still need to make more progressin implementing structural reforms. Without further labor market reforms and deregulation in Greece, Portugal, Spain, Italy, and arguably France, European growth will remain anemic at best. Finally, getting these reforms through will be complicated by political instability and voter fatigue with austerity.

However, even with these risks, improving growth and cheap valuations suggest investors want some exposure to eurozone equities. Investors significantly overweight the United States and underweight Europe may now want to consider trimming some US exposure and reallocating it to international markets like the eurozone.

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