While US stocks have gotten off to an exceptionally strong start in 2013, European equities have kept pace.
This performance is likely leaving many investors wondering whether they should jump on the European bandwagon. My take: I’m less bearish on Europe now for three reasons:
- Improving fundamentals: Europe is likely to suffer through another year of sluggish growth and its political problems remain, but the overall situation on the continent has improved, with peripheral bond yields plummeting and taking much of the pressure off Spain, Italy and Portugal.
- Cheap valuations: Much of the bad news in Europe is already reflected in European stock prices. For instance, the Euro Stoxx 50 is currently trading for about 1.23x book value versus 2.2x for US large caps. Some of this discount is justified given that European companies are less profitable than American ones, but even after accounting for the profitability difference, European shares look inexpensive.
- Yield: The current dividend yield on the S&P 500 is a bit more than 2%, about half the yield for European large caps.
So where should investors go in Europe? In the past, I advocated avoiding peripheral countries such as Italy and Spain, which looked cheap for a reason. But while Spain still appears that way, I’m upgrading my view of Italian equities to neutral from underweight for two reasons:
- Current Valuations: While Italy’s growth outlook remains dire, prices of Italian shares already reflect this.
- Improving Sentiment: Despite the short-term pain inflicted on the economy by difficult reforms, the reforms have made a big difference in restoring Italy’s credibility and competitiveness. Thanks to the country’s fiscal reform and the European Central Bank’s bond buying commitment, Italy’s borrowing costs have fallen significantly over the past six months.
Elsewhere in Europe, I’m maintaining my neutral view of Germany, a market I would be looking to buy on a dip, and I continue to advocate overweighting France, a market that looks attractively valued. To access these markets, I like the iShares MSCI Italy Fund (EWI), the iShares MSCI Germany Fund (EWG) and the iShares MSCI France Fund (EWQ).
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.
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