Stay Bullish On The Eurozone

This article first appeared on our sister site in the U.S, ETF.com

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features John Forlines III, chairman and chief investment officer of Long Island, N.Y.-based JAForlines Global.

Visiting with advisors this spring has been eye opening in this respect: Almost everyone thinks either the bond or equity markets are overvalued, or that one or both are about to come crashing down. I doubt that's what markets have to look forward to, and here's why.

There are plenty of reasons both bond and stock prices could stay in a modest upward trend for a long time. That doesn't mean you can't expect bumps in the road. We've already had a couple this year—corrections in U.S. small-cap and emerging market stocks, as well as a collapse in U.S. biotech stocks.

If you want to find more support for risk markets, look no further than Europe early this month. Things look placid on the surface—bond yields are at pre-crash levels, manufacturing is improving and the fiscal drag of deficit reduction is finally beginning to lessen.

We've written about our belief in targeted funds such as the iShares MSCI Europe Financials ETF that are well designed to benefit from the slow healing of Europe's banking sector, but we also believe much broader eurozone-focused funds like the iShares MSCI EMU ETF are quite prospective as Europe slowly regains its footing.

But don't get me wrong. Huge problems still remain: Unemployment is high and the European Central Bank (ECB) continues to miss its inflation target.

Rallying Markets

That said, the ECB definitely passed the first big test on June 5, when it cut the bank deposit rate into negative territory and introduced a long-term financing operation (LTRO).

The LTRO is a process by which the ECB provides financing to eurozone banks. The stated aim of the LTRO is to maintain a cushion of liquidity for banks holding illiquid assets, such as bad loans and real estate from the crash that's still being restructured.

But the really big news was the announcement that preparations for a U.S.-style quantitative easing (QE) program are definitely in the works, which would be highly supportive to asset prices.

As part of its staged approach, ECB President Mario Draghi said that, "If required," further monetary easing through unconventional measures—including QE—could swiftly follow. Some pieces of QE—an asset-backed bond purchase program—were part of Thursday's announcement.

It was the right policy mix for now, and EU equities—as well as risk markets around the world—rallied on the news. We have been very comfortable with a large overweight to eurozone equities and its banks this year as we believed the formula for stimulating the EU economy would begin to track the U.S. program from 2011-12.

And does it matter to global equities? Take a look at this chart from The Economist that shows just how co-dependent large corporations are to regions other than their "home" jurisdiction:

It wasn't lost on us that the announcements by the ECB were around the 70^th anniversary of D-Day, where allied forces joined together to stop Germany's tyranny. Let's not forget that the whole concept of a European Union rose out of the ashes of World War II.

This is why I'm constantly amazed by calls by pundits and commentators for the breakup of this amazing political and economic union. There are flaws aplenty, such as separation of national debt issuance from the common currency and there are plenty of cultural and social differences between northern and southern members.

On the political front, the recent European Parliament elections seem positive for centrists who want the EU to succeed.

Political Storm Clouds

That said, the rise of the anti-EU right was pronounced. And in conjunction with the Socialists who are anti-banks and corporations, this could lead to a dangerous policy mix down the road.

This is old news to U.S. observers, as far-left and far-right political factions here in the States have conspired to hold fiscal governance hostage for years. But it is a big problem for the EU where demographics are worse than in the U.S. and where growth has been limited to the most part since 2009 to Germany and to EU "partner" the United Kingdom.

This is clearly a case where "the center must hold" politically in order to keep the EU together. Irony abounds since Germany is the country with the most to lose if the EU fails and the most to win if it succeeds is the "glue." In the end, it's Germany's conservative and centrist parties holding it all together. Check out what I mean by looking at the pie chart below that breaks down the EU by political affiliation.

What could go wrong is clear to see—a 372-379 left-right split that spell U.S. style gridlock—and it would likely be far worse than the kind of political dysfunction that is occurring in the U.S.

The U.S. has survived an anti-growth, left-leaning president for six years. But to be clear, I'm absolutely convinced that a pro-growth right-leaning president who may be next up in the White House will preside over very similar dysfunction.

It doesn't matter as much because the U.S. economy has the underlying strength and entrepreneurial zeal to survive its politicians. The EU simply doesn't have that luxury.

JAForlines Global (JFG) provides investment advisory services to clients of broker dealers, their registered representatives and independent RIAs. JFG specializes in constructing actively indexed portfolios using ETFs, which are available for private wealth management investment or in qualified retirement plans via a Collective Investment Trust (CIT). Contact the firm or visit their website below at +001 516-609-3370 or [email protected] or www.jaforlines.com