Eurozone shares offer opportunities

Eurozone equities will push higher in the coming months, as worries about the region's sovereign debt crisis recede further and investors face a lack of alternatives for investment.

That's the view of several European money managers and strategists, although they also caution the debt crisis could resurface to some extent.

Much of the optimism is based on a speech rather than action. It dates back to July 2012 and the words of Mario Draghi, European Central Bank president, who said the ECB would do “whatever it takes” to preserve the euro.

“It (the eurozone crisis) has gone onto the back burner. It's nowhere near the issue that it was ever since Draghi said he would do whatever it takes,” Daniel McCormack, London-based strategist at Macquarie Group Ltd., said in a telephone interview.

Mr. McCormack said the European bull has further to run. Macquarie has highlighted German carmakers Bayerische Motoren Werke AG, Volkswagen AG and Daimler AG as among its top picks, as they benefit from increased consumer confidence and spending.

To be sure, investors buying in now have missed some of the best buying opportunities. The Euro STOXX 50 index of the biggest companies domiciled in countries using the currency has soared more than 30% since the time of Mr. Draghi's remarks.

Invesco Perpetual's European Opportunities Fund is a case in point. The fund returned 45% in the year to July, boosted by exposure to eurozone financial stocks that had suffered from the crisis. Top 10 holdings include Italy's Banca Generali SpA, which has gained more than 70% in the past year and French insurer AXA SA, up 50%.

“Despite good recent gains, we still believe Europe as a region is attractively valued, trading on cyclically depressed earnings at near trough multiples,” Jeff Taylor, head of European equities at Invesco in Henley-on-Thames, England, said in an e-mail.

“Recent economic data are pointing toward an improving macroeconomic picture — something we have believed for some time. The consensus view last year was that the eurozone would blow up and the only thing you want to own is Nestlé, but my view was the euro would survive, a view consensus opinion now seems to concur with,” he said.

Increased optimism is attracting more money mangers to equities, according to a survey of 100 fund selectors, defined as professionals who select third-party investment managers on a significant scale, compiled by London-based financial publisher Citywire for Invesco.

More selectors, 44%, plan to increase their exposure to European equities over the next 12 months than to any other asset class.

The poll, conducted in late August, found the eurozone crisis was worrying investors less.

Of course, other factors also are in play. The quantitative easing programs of central banks, notably the U.S. Federal Reserve, and the threat of withdrawal or tapering of those efforts, continue to help drive the ebb and flow of the financial markets. In the short term, political tensions such as the possibility of a military strike on Syria, also will play a part.

Then there's the politics of the eurozone crisis itself. German Chancellor Angela Merkel was under a certain amount of pressure to convince German voters that their taxes will no longer be used as blank checks to bail out the eurozone's most troubled economies. But after her re-election Sept. 22 it may be a different story, as Ms. Merkel has to be pragmatic to keep the euro together, especially if Greece needs further help.

But the crisis is a longer-term phenomenon, and has been a major driver of equity and bond markets for several years. Markets on both sides of the Atlantic have watched developments eagerly.

When the crisis was at its worst, share prices of banks and publicly traded money managers were among those to suffer most. As it became clear that countries like Greece could not service their debt and might need a bailout, the value of their sovereign bonds plummeted. The obvious casualties were the major holders of Greek debt, such as Greek banks.

Up to a point, however, investors felt a crisis in peripheral countries could be contained.

But Italy was a different matter. When sovereign bond yields in the eurozone's third-biggest economy soared to more than 7% in late 2011, there were clear signs of panic. UniCredit, Italy's biggest bank, held more than €400 billion ($530 billion) of the country's sovereign debt, and its stock price hit a 23-year low. The prospects of a crisis in the banking sector hit the wider equity markets.

Equity investors that had not paid much attention to bond yields before were now sitting up and taking notice. But the ECB brought Italy, and the others, back from the brink. It offered cheap financing for eurozone banks, bought bonds and promised to buy more. Though Mr. Draghi's pledge has yet to be really tested, it has been enough to convince the markets. Italy's bond yields have fallen back sharply, as have the bond yields of others such as Spain and Greece.

Investors who bought in to sovereign bonds in late 2011 have, of course, enjoyed strong gains. But this could be the time to take profits. Some believe the optimism has been overdone.

The Threadneedle European Bond Fund is among those to have recently cut its exposure to eurozone peripheral bonds. Martin Harvey, manager of the fund, said he had recently reduced exposure to Italy “as valuations became stretched.”

“As we head into 2014, we are concerned that focus will shift back toward longer-term debt sustainability,” Mr. Harvey said in an e-mail.

“As debt projections shift higher, and the initial growth rebound levels out, the Italian government may face renewed scrutiny from the European Commission.

“We had been very cautious of peripheral bonds while the crisis was at its peak, but always saw ECB intervention as key in reversing the fortunes of this sector,” he said.

The strong performance of Italian bonds since last year was largely due to the “return of investors who had previously allocated away from peripheral bonds because of rating and default concerns,” he said.

He also cited buying from domestic banks, “who continue to allocate larger portions of their balance sheets to government bonds.”

Paul Mumford, senior fund manager at London-based Cavendish Asset Management, said in an interview that eurozone bond yields may only have come down because of the very low yields available on bonds in other countries such as the U.K. or the U.S. “People have been searching for more income,” he said.

Data supporting this view is abundant. U.S. Treasury yields, for example, though up about one percentage point since April, are 2.7%, far below the 50-year average of 6.5%.

Mr. Mumford is among the skeptics about the eurozone's economy.

He believes the economic backdrop isn't “particularly bright,” citing indicators such as youth unemployment of more than 50% in Spain and Greece.

Worries persist about the austerity measures some countries, especially those that have seen bailouts, have had to implement. Mr. Mumford confesses he “can't understand why people's attention has come off” the eurozone crisis

While acknowledging a “risk of renewed sovereign debt concerns across a number of countries,” Legal & General Investment Management has upgraded its stance on eurozone equties to “overweight,” basing its case on valuations and a lack of other options, as well as better economic prospects.

In a briefing Aug. 28, LGIM points out that since U.S. equities have returned a “staggering 250% since March 2009” compared with 75% for the eurozone. LGIM managers now believe that “superior economic performance appears more than adequately priced” in the U.S. market, adding “the risk/reward ratio of eurozone equities is deemed more attractive.”

“To qualify for a bubble, equity valuations would need to be significantly above average, but this is not currently the case,” the LGIM briefing said generally. Although returns going forward may not be spectacular, LGIM says the case for equities “largely depends on the alternatives; where could one generate greater expected returns over the next decade? … Equities still look like the only game in town. Investors who are worried about a possible bubble in equities must surely be horrified at valuations in bond markets.”