Why Americans Are Loving European Stocks

Old World bourses have been an investor's delight due to corporate restructuring, solid economies, M&Asand especially the rising euro

Summertime, and the living is easy—not to mention, profitable—for investors who have placed their bets on Europe's stock markets. From Frankfurt to Madrid, European equity markets have run rings around their American counterparts this year. And American investors in European stocks have done even better: Thanks to the rising euro, they've scored world-beating gains on the Old World's bourses.

The numbers are indeed impressive. Since the start of the year, Germany's DAX index and France's CAC 40 have risen 5% and 6%, respectively, in euros, and are up 13% and 15% in dollar terms. Spain's benchmark IBEX has soared a whopping 19% in dollars, while Britain's FTSE 100 is up 14%. Only China and Peru have performed better. The Dow, S&P 500, and Nasdaq, meanwhile, have either declined or posted low single-digit gains.

Investors can thank an improving economic picture, positive earnings growth, and a flurry of merger-and-acquisition activity for their good fortune. But the biggest factor for American buyers has been the rising euro, which is up 7.75% against the dollar this year. "The currency is the most notable dynamic," says Alec Young, an S&P equity strategist. U.S. investors in European companies have "benefited disproportionately" from this trend.

A lot of buyers have taken notice. According to research from Citigroup, about three-quarters of total equity inflows during the first half of this year, or $114.4 billion, went into international funds. At the same time, the falling dollar acted as a disincentive for foreigners to invest in the U.S.


  The question now, of course, is whether it will last. After 17 consecutive interest rate increases, the U.S. Federal Reserve now appears ready to take a breather. At the same time, the European Central Bank is widely expected to hike rates to 3% at its meeting on Aug. 3 (See BusinessWeek.com, 7/20/06, "ECB Paves Way for August Rate Hike"). Those two moves—signaling inflationary concerns in Europe and slowing growth in the U.S.—could throw investors for a loop.

What's been behind Europe's bull run? To some extent, it was about catching up to U.S. equities. Ten years ago, the price-earnings premium for U.S. stocks vs. European stocks was about 30%, says Jonathan Stubbs, a European equity strategist with Citigroup in London. Now, that premium has narrowed to just 15%.

The reason? European companies have spent the last decade streamlining and restructuring, and now they're reporting profits and growth at the top of the pack. Companies such as Telefónica (TEF), Daimler Chrysler (DCX), and Nokia (NOK) turned in first-half earnings that met or exceeded expectations, adding support for rising European share prices.


  Europe's M&A wave has also raised equity prices and put executives on alert that national borders are—for the most part—no longer protection against takeover. Big-ticket deals such as the takeover of the British Airport Authority by Spanish construction giant Ferrovial and Lakshmi Mittal's successful run at Luxembourg-based steelmaker Arcelor have created a higher-value environment for European stocks (See BusinessWeek.com 6/27/06, "Ferrovial: Building a New Future"; and 6/26/06, "What Price Mittal's Victory?"). And they've made executives more conscious than ever of the need to push out strong profits—or risk seeing shareholders give in to takeovers.

Corporate Europe is "getting its act together," according to S&P's Young, who currently sees the region as the best-performing major equity asset class in the world.

Europe is also benefiting from macroeconomic trends: the lowest levels of unemployment in a decade and rising consumer confidence in many countries. The European Commission now expects the euro zone economy to grow this year at its fastest pace since 2000.


  What's likely to happen the rest of this year? Europe's uptick is feeding inflation worries, and an ECB rate increase is likely, even as the Fed stops tightening. That would narrow the interest rate premium for the dollar, potentially making it weaker and boosting the relative attractiveness of euro-denominated stocks.

On the flip side, the declining gap between U.S. and European price-earnings ratios could dampen further appreciation in Europe issues.

Then there are the wild cards: A U.S. housing slowdown, for example, could drag on the consumer economy and the stock market. And geopolitical concerns or another sell-off in emerging markets could bring investor capital back to the U.S. "When U.S. investors are nervous about the state of the global economy, they pull back," said Darren Read, head of global equity strategy at UBS in London.

In the end, European stocks are still something of a bargain compared with U.S. issues (See BusinessWeek.com, 7/31/06, "Stocks: Big, Cheap, and European"). But analysts still tend to see the U.S. as the safest haven. We could still see those big money flows turn back to the U.S.

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