Call #1: Maintain Underweight European Banks

This week, our attention first turns to European banks, which we first highlighted back in late February and then focused on again in March. Since February, the sector is down more than 15% versus a 3% drop for global developed markets. Back in February, our thesis was that European banks were not taking adequate account of the ultimate hit they were facing due to write downs on European sovereign debt. We don’t think the taking account process is finished, and with Greek debt back in the spot light and likely to stay there, we still hold an underweight view of this group (potential iShares solution: EUFN).

Call #2: Maintain Overweight Germany

While we are still advocating a negative outlook for European banks, we believe that much of core Europe now appears very cheap, and is reflecting a lot of bad news.  In particular, we continue to believe German equities look attractive for long-term investors.

We first highlighted Germany in late 2010. Year-to-date, even with a recent drop off, the iShares MSCI Germany Index Fund ETF (EWG) is up around 7%. Past performance does not guarantee future results. For standardized fund performance, please click here.

Part of the reason for the strong performance is that while the US economy is slowing, the Germany economy continues to grow at a healthy clip. In the first quarter, the German economy expanded at a +6% annualized pace. Indeed, while Germany suffered more than most economies during the downturn, unlike the US, it has come roaring back to life over the past 18 months. And while German economic resilience is no longer a secret, German equities still appear cheap. The market is trading at 12x trailing earnings and just 9x next year’s earnings. German stocks also appear inexpensive based on the price-to-book value ratio, with the DAX Index trading at 1.85x book, a 20% discount to other developed countries.

The current discount on German stocks appears difficult to justify based solely on Germany’s fundamentals. Return-on-equity for German companies is above its long-term average. On a macro basis, Germany is not facing the same fiscal head winds as other developed countries. For example, for 2011 Germany’s budget deficit is expected to be around 2.5% of GDP, while the budget deficit makes up roughly 10% of GDP in the US.

Obviously, for many investors, the source of the German discount is related to its role within Europe as the largest economy in Europe, and ultimately the funding source for many of the peripheral bailouts. Investors are rightly concerned over what contingent liabilities Germany may be forced to bear and what would be the ultimate impact on German banks should Greece or another peripheral European country default on their obligations.

We share these concerns, and are not particularly optimistic on the long-term prospects for Greece. That said we do think that Greece aside, the rest of Europe’s sovereign debt issues look manageable in the intermediate term. While we expect Europe’s sovereign debt issues to be a chronic issue over the coming years — like in the US — we do believe that these issues are already reflected in the price of German stocks. As a result, we are still advocating an overweight view of Germany (potential iShares solution: EWG).

Disclosure: Author is long EWG

Source: Bloomberg

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility.