Investing well in today's turbulent market is hard enough. But imagine having the added handicap of seeing your portfolio diminish in value--by nearly a quarter over the past 16 months--for reasons that are completely independent of your investments' performance. That's been the challenge for managers of Europe's mutual funds, who have watched the value of the euro sink to record lows against the dollar since its launch in January, 1999.
After touching $1.18 right after its birth, the euro has made a steady descent, to around 90 cents lately. Fortunately for investors, European equities have continued to perform well, more than making up for foreign investors' currency losses. Morningstar figures that from the beginning of November through the end of April, 2000, the average European mutual fund--both load and no-load--generated a 23.46% return in dollars vs. a paltry 6.39% for the Standard & Poor's 500-stock index in the U.S. Even with a pullback in some markets since the beginning of May, some European funds are still up for this year (table, page 244). "There has been a strong correlation between declining European currencies and strong European equity markets," says Michael Hartnett, senior international economist at Merrill Lynch in New York.
Corporate restructurings and market reforms are helping fuel the gains. Germany's pending new tax laws, for example, will unlock cross-corporate shareholdings, encouraging more efficient redistribution of capital. The cheap euro, meanwhile, is powering an export boom, with industrial production now growing faster than 5% a year and unemployment falling under 10% for the first time since December, 1992. Gross domestic product is thus expected to expand by well more than 3% this year--at the very moment Alan Greenspan is trying to restrain the U.S. economy.
The sum of all these factors: sizzling euro-profits. I/B/E/S International projects earnings of euro-zone companies will swell 16.2% in 2000, well above the region's 13.9% earnings-growth rate in 1999. French earnings per share alone is expected to be up nearly 20% this year. And Italian profit growth may come close to 30%. All this growth spells more good news for stock prices.
Many fund managers think the euro's decline is nearly over, and they are not particularly worried it will dampen local equity markets. Several European funds, after all, were doing well before the ill-starred euro debut. Take Scudder Greater Europe Growth Fund. With more than $1.5 billion in assets, it's among the largest European funds and has been averaging annual returns of better than 26% for the last three years.
Dresdner RCM Europe Fund and Invesco European Fund have treated investors to annualized gains of 33% and 29%, respectively. But no fund has come close to the performance of Deutsche European Equity. Its portfolio appreciated by 151% in the six months ending Apr. 30, and is up 85.03% so far this year. Says co-manager Michael Levy: "The structural changes that have been taking place in government policy and corporate boardrooms have created industry powerhouses in Europe."
While the fund has profited from several initial public offerings, it also holds shares in European giants Siemens, Royal Philips Electronics, Nokia, TotalFinaElf, and Vodafone AirTouch. But the French media group Canal+, which has been driving the integration of media and the Internet, is also producing gains for the fund. Its shares soared 149% in local currency terms in 1999 and are up 59% so far this year.
An even less-well-known holding is Finland's Sonera, Scandinavia's leading mobile-service provider. Sonera, which has moved aggressively into e-banking, e-commerce, and Eastern European markets, saw its shares soar 350% in 1999. This year, though, amid the global-tech pullback, Sonera's shares have declined 17%.
While most European funds share many of the same big-cap holdings, Scudder Greater Europe's fund manager, Carol Franklin, is intrigued by newer companies that are willing to embrace unconventional strategies. For example, upstart regional Italian bank Gruppo BIPOP-Carire was one of the first financial institutions in Europe to exploit the potential of Internet banking and e-trading. And Marschollek Lautenschlager und Partner (MLP), a highly successful German-based financial-services company, started out serving a segment of the market that was traditionally ignored: students and young graduates.
Fund managers differ in the ways they deal with the falling euro. Some hedge their foreign-exchange exposure by using forwards--contracts to buy specific quantities of foreign currency in the future at a set price and date. But Dresdner RCM Europe's co-managers, Barbel Lenz and David Plants, also search for companies with costs in euros and revenues in dollars and other strengthening currencies.
The currency difference provides a natural hedge. "European luxury goods maker LVMH [Louis Vuitton Mot Hennessy] is one such play," explains Plants, "with significant sales not only in dollars but also in yen, against which the euro has depreciated to an even greater degree."
AN ADDED BOOST. Scott Clemons, co-manager of 59 Wall Street European Equity fund, likes one of the Netherlands' most appreciated exports, Heineken, for the same reason. He also points to French oil giant TotalFinaElf as a superb play on current petroleum market strength. "Not only did the company enjoy a tripling in oil prices in 1999," Clemons notes, "but it further benefited from the fact that the commodity is always quoted in dollars." When converted back into euros, "this gives revenues an added boost."
How long will the cheaper euro continue to provide fuel for economic and profit growth? Alison Cottrell, chief international economist for PaineWebber International in London, thinks "there's still a good deal of momentum going against" the currency.
Indeed, capital continues to flow from Europe to the U.S. But that trend is likely to slow, if only because European assets have become so cheap as a result of the weak euro. And with the Federal Reserve possibly pushing U.S. interest rates up another 100 basis points or more this year, American corporate profits may falter. To Cottrell, these indicators suggest the euro will recover by summer and climb back toward $1 by yearend.
Deutsche's Michael Levy is even more sanguine about the impact of the euro. "What seems to be lost in the daily hysterics about the tumbling euro is that the drive for common currency is what made European economic recovery possible," he says. The drive forced fiscal discipline on governments, helped open up closed markets, and introduced a pricing transparency that's intensifying cross-border competition as well as mergers, acquisitions, and restructuring.
These improvements won't go away, whether the euro ends up at 80 cents or $1.10. They are perhaps the best reason of all to consider a European fund--even in the face of 16 months of currency movements that have given many investors a case of the willies.