Europe's darkest hour may finally be giving way to dawn.
Signs that the economic darkness over Europe is lifting are everywhere, giving investors hope that the region is ripe for investing. Among the promising signs of Europe's much-awaited daybreak: an improvement in the eurozone's PMI, or the purchasing managers index, a critical gauge of the economic health of the manufacturing sector. In August, it rose to its highest level in two years, moving even further above the critical 50 mark. The improvement was broad-based, covering Italy, Spain and Ireland, countries hard hit by a double-dip recession that nearly led to the breakup of the European Union.
In another sign, the so-called peripheral economies the weaker, most troubled countries in the eurozone have recorded trade surpluses for the first time in many years. For example, Portugal increased its exports 6.2% in the second quarter from the comparable period in 2012, according to data from Portugal's national statistics institute.
And numerous consumer and business indexes have been positive. The Citi Economic Surprise Index for the eurozone, which tracks a variety of economic indicators, for example, moved into positive territory, meaning that the economic situation there is improving faster than many people expected.
"The Citi Economic Surprise Index tries to measure the difference between what the market thinks what consensus thinks and what actually happens," says Dave Mazza, head of ETF investment strategies for State Street Global Advisors.
Up until May, the index was negative, with "economic prints" coming out of Europe that were worse than people thought. The move into positive territory is an "indicator of the potential for positive returns from the marketplace," Mazza says.
The strength of the indicators has led many analysts and economists to predict that Europe will emerge from the recession by year-end and enter a period of slow growth. Many are encouraged as Europe loosens austerity measures and provides stimulus and support to the weakened economies in the region.
As conditions improve, albeit slowly, industry analysts are placing bets on Europe. "We think there are a number of catalysts there that could create some pretty attractive opportunities in Europe," says Mike Smith, consulting director for Russell Investments' U.S. advisor-sold business.
Yves Cochez, the chief investment strategist at Webster Bank, looks to broad macroeconomic factors, such as GDP, to assess the investment opportunity.
Nominal GDP in Europe is still below where it was prior to the financial crisis, unlike the U.S., which is up 13% from pre-crisis levels. "There is a big potential catch-up for Europe as soon as they emerge from recession," he says. "I would look at Europe as being potentially one area to focus on going forward."
Many analysts point to attractive valuations on European stocks, citing metrics such as price-to-earnings, price-to-book and price-to-sales ratios. All those measures of relative valuation, says Smith, make Europe attractive compared to other parts of the world and even its own historical norms.
Take, for example, the price-to-earnings ratio for the SPDR Euro STOXX 50, an exchange-traded fund that tracks the Euro STOXX 50, Europe's leading blue-chip index for the eurozone. The exchange-traded fund, listed on NYSE Arca as FEZ, had a price-earnings ratio of 12.97% as of Sept. 18, 2013, substantially cheaper than the exchange-traded fund that tracks the Dow Jones Industrial Average, which had a price-earnings ratio of 14.14%.
Moreover, the price-earnings ratio for the Euro STOXX 50 ETF is at a low. "Historically it was closer to 15%, so it's actually trading at a very large discount relative to its historical average," says Mazza.
Dividend yields for European stocks are also superior to those in other parts of the world, Mazza notes. The dividend yield for the Euro STOXX 50 ETF on Sept. 18, for example, was 3.11%, while it was only 2.2% for the SPDR Dow Jones Industrial Average ETF.
Rising optimism that European companies are on the mend is reflected in the Euro STOXX 50 ETF. Inflows to the fund for the year through the end of August topped $1.4 billion, double the $700 million the fund took in last year. During the same eight-month period in 2011, the fund lost $13.93 million in outflows.
"The eurozone is now really coming on more investors' radar," says Mazza.
Despite the good news, there are plenty of potential pitfalls that could crimp investment returns, say some analysts.
Monetary conditions are still too tight for peripheral nations, according to Webster Bank's Cochez. High unemployment and the challenge of further harmonizing and integrating the eurozone could also dampen recovery prospects.
Furthermore, growth expectations are modest, even for the developed parts of Europe. "For Europe, economic growth expectations are -0.4% and 1% for this and next year," Florent Bronès, BNP Paribas' chief investment officer, writes in a recent investment strategy letter.
Indeed, the window of opportunity may already have passed, says Allan Nichols, a senior equity analyst at Morningstar. "European stocks have come off their lows from a month ago," he says, adding that the bounce "removed some of the value that was there." According to Nichols, the bounce occurred in August when the U.S. started talking about tapering its bond-buying program, leading investors to pull money from the U.S. market and place it in Europe.
"Since that initial compression, you've had some improvement in some sectors in Europe," Nichols says.
As a result of the bounce, Nichols believes European stocks are not quite as attractive as they once were. "Overall, we think it's relatively fairly valued to slightly undervalued," he says of the European equity market.
He notes that there are a few pockets of undervaluation, particularly in France, which is "slightly undervalued" but not nearly as much as before. Yet, in the end, Nichols concedes that Europe overall is a good place to invest for individuals with a long-term horizon.
"You need to be a patient investor if you're going to be going into Europe in a significant way," he says.
Investors also need to be very selective in making their buying decisions, he says. "There are big divergences across sectors, countries, and more specifically, companies," Nichols warns. "There are some companies that we think are very overvalued and some that we think are very undervalued."
Russell Investments' Smith agrees. "There's going to be a somewhat different story between the north and the south," he says. Countries, such as France, Germany, Switzerland and the Netherlands are looking stronger going forward than the southern peripheral countries that might struggle.
In the eurozone, Germany is "leading the pack," says Detlef Glow, head of Lipper EMEA Research at Thomson Reuters. And Italy, which was not as affected by the financial crisis as Spain, is starting to look better again.
Cochez also gives Germany and Italy a thumbs-up. "Germany remains attractive given the strength of the economy and valuations levels. However," he warns, "German companies are most exposed to the current weakness in emerging market economies and the weakness of the Japanese yen."
For that reason, Cochez sees "more significant upside potential with Italy and Spain, given the extent of the past recession and the potential for earnings recovery."
Even the cautious Nichols is somewhat bullish on Italy and Spain. Fear of interest rate increases has pushed stock prices down in those countries, making them slightly undervalued, he explains. But don't expect prices to jump anytime soon as fears of interest rate hikes are unlikely to go away overnight, he warns. For investors waiting for an upswing, he offers a dose of reality: "It's going to take time," he says.
