Europe is far from out of the woods.
Bond yields in Italy and Spain are creeping higher. The region also still faces record high unemployment, a lack of growth, a fragile banking system and political dysfunction.
But while I generally remain cautious on Europe, I am starting to see some modest improvement in some of the peripheral countries — particularly in Spain. In fact, as I write in my latest Investment Directions and weekly commentary pieces, I’ve recently upgraded my view of Spanish stocks to neutral from underweight. While Spain continues to face severe growth headwinds, there are three main reasons why I’m less concerned about the market now:
1.) Improving Profitability. Following the completion of the Spanish government’s mandated cleanup of the country’s real estate sector and banks, Spanish corporate profits are expected to recover, albeit from a low base.
2.) Attractive Valuations. While the Spanish economy will likely continue to struggle this year and into next, most of the bad economic news is now priced into current valuations. This is thanks to Spanish stocks’ massive underperformance in recent years. Since I initiated my underweight call on Spain at the end of 2011, Spanish stocks have underperformed other developed markets by around 20%.
3.) Reduced Risks. Finally, the market’s risks have been reduced due to the European Central Bank’s (ECB) proposed asset purchase program, which is designed to fuel Europe’s growth.
However, Spanish stocks aren’t without their risks. One potential roadblock on the horizon for both Spanish and European stocks: An upcoming ruling from the German constitutional court on the legality of the ECB’s proposed asset purchase program.
In addition, until we see more aggressive measures from the ECB to boost lending to small- and medium-sized enterprises in Southern Europe, it’s hard to envision a quick turnaround for the region.
However, Europe has one distinct advantage to domestic equities: market watchers’ low expectations. In the current environment, even modest signs of good news can have a positive impact on European equities in general and on Spanish stocks.
iShares MSCI Spain Index Fund (EWP)
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.