Investing opportunities abound in Europe

After six straight quarters of contraction, eurozone may perform as well as the S&P 500 this year

By Carl O'Donnell

Feb 20, 2014 @ 12:49 pm (Updated 5:29 pm) EST

Ready to take a break from America's sputtering equities market? Consider an investing vacation to Europe.

After explosive gains of nearly 30% in 2013, the S&P 500 is forecast to climb by a comparatively pedestrian 6% or less this year. European stocks, meanwhile, may offer a better option, say analysts.

The eurozone is expected to grow by 1% in 2014, a sharp increase from last year, when the continent finally pulled out of six straight quarters of contraction, according to a report by the International Monetary Fund.

Investors, meanwhile, are just beginning to warm back up to Europe. As of Jan. 1, only 3% of all assets in U.S.-listed ETFs were in European funds, said Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ.

“If you believe, as we do, that economies are going to improve in Europe, augmenting exposure to the continent is worth looking in to,” Mr. Rosenbluth said.

So far this year, European equities are eking out slightly better returns than their American counterparts. A broad-based exchange-traded fund of European stocks, iShares MSCI EMU (EZU), has posted gains of 1.31% for the year to date. Meanwhile, the SPDR S&P 500 (SPY), is off 0.9% after January's correction, according to Morningstar Inc.

“You could make the case that Europe is at an earlier point in the cycle, similar to where the U.S. was 12 to 18 months ago,” said Barry Fennell, a senior research analyst at Thomson Reuters Corp.

(More: Advisers betting heavily on Europe's growth)

Plenty of investors appear to be taking that view. In January, investors pulled $14 billion from U.S.-focused ETFs, and put a net $4 billion into Europe, according to Blackrock Inc.

Mr. Fennell cited a number of arguments for a strong 2014 in the eurozone. One early indicator of a fledgling recovery is the health of small-cap stocks, which have enjoyed significant gains, he said. Strong small cap stocks typically signal an economic rebound because they are heavily exposed to consumer demand.

“Germany, France and Southern Europe are all releasing pent-up demand from the recession,” Mr. Fennell said.

Countries in Europe's core, including Austria, Germany and Switzerland, are also experiencing a boost in exports of high-tech machines as manufacturing picks up in Europe and Japan, he said.

Germany remains one of Europe's strongest performers, with healthier inflation rates, lower levels of private- and public-sector debt, and modest GDP growth, Mr. Fennell said. ETFs tracking small-cap German stocks have performed well, with iShares MSCI Germany (EWGS) and Small-Cap ETF Market Vectors Germany Small-Cap ETF (GERJ) notching 6.17% and 6.25% gains this year, respectively.

But one downside of Germany's quicker recovery is that the country's stocks are already getting expensive, said Moritz Ritter, a professor of economics at Temple University. The price-earnings ratio on iShares MSCI Germany ETF (EWG), for example, is 22.16, according to Blackrock Inc.

(The biggest threat to the global economy in 2014)

Despite solid upside potential, European stocks still have plenty of room for volatility, analysts say. Europe's unemployment picture continues to be bleak, ranging from 7.2% in the U.K. to nearly 30% in Greece, said Mr. Fennell. The specter of deflation also looms large, with the continent's headline inflation declining to 0.8% from 2.2% over the course of 2013, he said.

In export-reliant Germany, there is fear that slowing growth in China could stymie demand for the country's manufactured goods, he added.

“The economy isn't going gangbusters in Europe, but it's still overall in an expansionary mode,” Mr. Fennell said.