Steadfast on Europe’s Strongest

Our European plays have not performed as well as we’d hoped over the respective periods since initial recommendation. The iShares MSCI France Index Fund (NYSE: EWQ) is down about 22 percent since we first recommended it almost one year ago, while iShares MSCI Germany Index (NYSE: EWG) has lost about 10 percent since we recommended it one month ago. The one saving grace is that iShares MSCI France Index Fund has slightly outperformed the Euro Stoxx 50 Index,  the benchmark index representing the fifty largest European companies.

Of course, valuations were our main rationale for recommending these exchange-traded funds (ETF), and our investment case remains valid now that they’ve become even cheaper. Unfortunately, investors should prepare for the possibility of further declines, as the European sovereign debt crisis deepens. Nevertheless, our long-term view is that the EU will eventually resolve this mess, but, in typical European fashion, progress will occur haltingly.

The European political establishment will likely broker a deal that requires Europe’s stronger economies to act as guarantors for the weaker economies. In exchange, the countries currently in turmoil will be expected to implement structural changes to their economies and enact sound longer-term financial policies. In order for such a regime to be successful, the EU may need to create a central authority that will guide these countries toward implementing these new policies.

As we mentioned earlier, the European political process can move at a glacial pace, often getting sidetracked due to market developments and social forces. Given such obstacles, the EU may not move quickly with these reforms until after conditions deteriorate further and the market forces it to act.

Additionally, equity investors are also contending with the massive shift of money from stocks to bonds. Although fearful investors can drive stocks down in the short term, the market’s worst fears rarely materialize and savvy investors use these opportunities to pick up stocks at bargain prices.

Although we expect the EU will ultimately arrive at a solution to its debt crisis, it is possible that the political process could fail. In addition, a full-fledged recession could also be on the horizon. In either case, the markets could renew their descent.

At the moment, however, Europe does offer low valuations and solid dividend yields. And from a contrarian standpoint, it’s often profitable to invest when market sentiment is at pessimistic extremes.

With regard to iShares MSCI France Index Fund, France is in the process of reducing its total deficit to 5.7 percent of gross domestic product (GDP) in 2011 from 7.1 percent of GDP in 2010. The country’s leadership also plans to further reduce its deficit to 4.6 percent in 2012 and 3 percent in 2013.

To achieve these deficit reductions, France will reform its tax code by cutting deductions and eliminating loopholes. French companies will face an increase in the corporate tax rate, while wealthy individuals could also face higher tax rates.

At the same time, the government will keep spending cuts modest to avoid social unrest. But after the 2012 elections are completed, the French government may make further spending cuts because France has one of the highest spending-to-GDP ratios in the eurozone.

Nevertheless, France’s economy performed strongly in the first half of the year, which should allow for full-year GDP growth of a little less than 2 percent. We expect a similar performance next year.

Investors should continue to purchase iShares MSCI France Index during periods of weakness. The ETF offers solid growth potential with its portfolio of resource- and infrastructure-related companies. The fund boasts a dividend yield of 3.5 percent, a result of its exposure to pharmaceutical and telecommunications names. Buy iShares MSCI France Index up to USD25.

Germany’s economy has been doing quite well because the country’s exports have been in strong demand by fast-growing emerging economies, particularly China. Indeed, the BRIC economies (i.e. Brazil, Russia, India and China) are estimated to contribute around 25 to 30 percent to Germany’s export growth. On the other hand, recent data indicates that Chinese import growth of German goods fell in the second quarter to 15 percent from 55 percent in the first quarter. Overall, the German economy remains in relatively good shape, with unemployment around 7 percent along with strong wage growth.

The German market has been hit hard lately as investors grow increasingly anxious about Europe’s financial future. Furthermore, as Benjamin Shepherd noted in a recent issue of Global ETF Profits:

“One of the headwinds facing German markets is banks’ exposure to debt issued by Portugal, Ireland, Italy, Greece and Spain, the so-called PIIGS nations. According to data from the International Monetary Fund, international European banks had $1.54 trillion in exposure to debt issued by PIIGS nations in 2010. Germany’s share of that total amounted to $522 billion, spread across the nation’s major institutions.

These exposure levels are a cause for concern. But a default in any individual PIIGS country wouldn’t bring Germany’s industrial economy to its knees. Although German industrials rely primarily on bank lending for financing, they could certainly tap the capital markets for funds if necessary.”

We view the recent selloff in Europe as an opportunity to buy quality companies with good dividend yields and strong balance sheets. The iShares MSCI Germany ETF offers exposure to such companies, and remains a buy up to 25.

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