How To Play Europe's Growing Recovery

[This article originally appeared in our June issue of the ETF Report.]

I’m going to assume for a second that you have to either decide on Europe or not, and you can’t say, ”Well, I like Germany, but I don’t like Spain.” I’d rather own Europe than Germany for a host of reasons. But if I can’t make that determination, do I want to be overweight Europe? How do I play that? Is it eurozone Europe only? Because a lot of people don’t realize that a large portion of the MSCI Europe Index is the U.K. And maybe you only want continental Europe.

In general terms, we’ve been overweight Europe in our global asset allocation portfolios for quite a while because of valuation, improving fundamentals and, right now, momentum.

Just take a look at the momentum in actual price. Look at WisdomTree Europe Hedged Equity (HEDJ | B-55) or Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF | B-73). Both of those products are up double digits year-to-date. And the non-hedge ETFs are up single digits.

I think, to a certain extent, HEDJ is a little bit more interesting if you want to own the exporters, which is what they do. But I actually just saw a note from Morgan Stanley saying they were taking their hedge off, and they were going to a cap-weighted index which is more heavily weighted towards domestic cyclicals.

A lot of it has to do with the fact that I think the eurozone and the euro have come to grips with how much a Grexit might cost. And it’s not as bad in their opinion as everybody might say. And so, they’re asking, “OK, well, if it’s not so bad, what’s the big deal?’

The other part is that, if you just look at Greece, if you look at the politics behind it all, it’s all just posturing. Everybody knows Greece can’t make it without some sort of help. The Greeks know it. But the politicians in Greece have to say, “Well, we’re not going to let the Europeans tell us what to do,” which is totally ridiculous, because if the Europeans abandoned them, they’d be toast.

So in my mind, it’s political posturing. But at the end of the day, everybody’s going to be pragmatic. The EU in general has sort of gotten over the idea that if the Greeks leave, it’s going to be a disaster for everybody except the Greeks.

There are a couple reasons why Europe has not followed the U.S. higher. If you look since the trough in '09, the U.S. has greatly outperformed Europe. And the question is, why has that happened?

Well, one of the reasons is that Europe was behind us in terms of quantitative easing and making the system more liquid. The second reason is very interesting, which is the earnings growth has just not been there. Europe was in recession much longer than the U.S., much longer than anybody thought. And so, the earnings haven’t followed and the stocks haven’t followed.

Also, a couple years ago we were talking about whether the euro was going to survive at all. I don’t think anybody’s talking about that now, which is one of the reasons I think people are saying, “You know what? The euro’s down 40%. The economics in all those countries are getting pretty good. The ECB’s got the wind at its back. And it’s cheap relative to the rest of the world, at least in most people’s eyes. That’s a pretty good mix.”

What concerns me the most is how consensus a call of owning Europe is right now. Look at the flows this year going into HEDJ [$12 billion] and DBEF [$9 billion]. When everybody starts talking about the same trade and the same thing, it always concerns me.

And here’s the other side of that. We’re in the very early innings of a cycle of U.S. underperformance. So if that’s the case, Japan’s got to do something. Europe’s got to do something. And emerging markets have to do something. You can’t have Japan underperforming big, Europe outperforming big and EM underperforming, and still have a cycle of international outperformance, really.

When you look at why you should be more bullish Europe versus other regions, you have the whole concept of a multiyear mean reversion—meaning, we’ve been overweight U.S. assets for quite some time, and underweight European assets structurally for quite some time. Think about that in a statistical term: Back in 2008, stock market capitalization of the U.S. exceeded that of Europe by $1 trillion. Seven years later, the U.S. market is now over $10 trillion in market cap larger than European equities.

That mean reversion just in dollar terms is so wide that it doesn’t take a lot to see that outperformance in their asset prices.

In its most generic and top-down sense, being long the European indexes with a bias towards the German equity market—the DAX—on a currency-hedged basis where you don’t take the brunt of euro volatility, up or down, is the simplest and most beta approach to gaining exposure to that.

If you want to narrow it down further, you can find yield in Irish REITs. Where can you get value? In the Swiss Market Index. Where can you get outright market beta? In the Spanish equity market, at the whole.

There are a wide variety of opportunities, but in its most generic sense, if you want to gain exposure, you should just buy an ETF that gives you broad market exposure to the main engine of Germany or the broader European on a currency-hedged basis.

There are two things that go hand in hand. The first one is called the European Central Bank’s quarterly lending survey. That is not widely disseminated in the media or on a Bloomberg terminal. You actually have to go to their website. It comes out once a quarter, two to three weeks in arrears.

That is, to me, the most important data set. It’s the equivalent of what we call in the U.S. the Federal Reserve lending survey. And what it basically does is give you all the credit metrics to nonfinancial institutions and households. It tells you, in a nutshell, if the local citizen is starting to borrow money again, which would portend to an upturn in a credit cycle. That’s No. 1.

No. 2 is what’s called the European Central Bank monthly bulletin, which builds on that, which includes money growth, or “M3.”

The combination of those two reports is really the crux of available credit, and who’s borrowing money, and why they’re borrowing money, and where it’s being channeled to.

Absolutely. Evidence around where that’s going is wide and dispersed. It’s not thematic across every bucket. But you’re seeing in certain increments or segments borrowing levels or data points that you haven’t seen in three and four years. That’s been leveraged up because of QE, the lower interest rates and the lower price of crude oil. So you have a very powerful combination of drivers at the moment.

It’s not necessarily an apples-to-apples comparison—the reason being is that we’ve had easy financial conditions for five-plus years. That is fairly new there. And we’ve been oscillating at a positive growth story somewhere between 1.5 and 3% for quite some time, whereas, they were coming from a flat-to-small negative base during that time.

And Europe’s market is a very export-based one, whereas the U.S. is very service-sector-oriented. And arguably, given that it’s a 70% service market, we’re considered a closed economy, whereas they’re a much more open economy.

Rather than reduce exposure outright to U.S. equities, the opportunity is more on a relative basis now. It’s more about having a greater long position in Japan or China or Europe specifically. And broadly speaking, to me, that’s the same thing as just saying, “I want to be long world equities or overweight world equities, ex-U.S.” And you can take part in that via various ETFs, of course.