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Europe calling... should you disconnect? - Outside View by PersonalFN

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Europe calling... should you disconnect?
Jan 31, 2014

Last Year, predicting a sharp recovery in the U.S. markets, a few mutual funds in India had launched U.S. focused funds. All of them generated excellent returns and outperformed even the top performing diversified funds investing in Indian markets. The year 2013 belonged to matured markets. Rising dollar remained the main theme and story of offshore investing was woven into it. Taking cues from the success of last year, mutual funds are now gearing up to sell the theme - Europe this year. In the first month of the New Year, three fund houses, JP Morgan Mutual Fund, Religare Invesco Mutual Fund and Deutsche Mutual Fund have launched Europe centric fund of funds. If you are confused about to invest or not to invest in these funds, you must understand advantages they might provide you along with risks they might expose you to.

Why Europe focused funds?

At macro level there have been certain positives for Eurozone economies which might work well for investors.

  • It is widely believed that after a having witnessed a double dip recession over last year and half years, Eurozone economy is poised for recovery in 2014. There is a growing consensus about integrity of the Eurozone remaining intact. Few years ago, it was speculated that, economies such as Greece, Spain, Portugal and Ireland and Italy might default on their debt and may exit Euro. However, these fears have receded now as evident by sharply falling yields. This makes many investors believe that worst is over in the Eurozone. Growth outlook remains positive in Eurozone and growth in GDP is expected to sustain even in 2015

  • Although the currency used by all Eurozone countries is the same, economic conditions are different across countries which give an opportunity to diversify within the region. For example, Latvia, a country that recently joined the Euro has been growing at about 4.0% while Greece still has a negative growth rate. On one hand, there have been nations such as Spain and Italy which have current account deficits but have been the headquarters of some of the world's best known companies. On the other hand, there are countries such as Germany, Netherlands and Sweden which run strong current account surpluses and providing opportunity to invest in some niche businesses. For example, auto companies in Germany have been growing tremendously all over the world, despite a general slowdown.

  • From the valuation perspective, it is believed that, European stocks are below their cyclical peaks and cheaper even in comparison to their global peers, say against U.S. stocks. Profitability in the region is likely to improve going forward leaving room for valuation upgrades.

  • Unlike that in the U.S., monetary policy stance in the Eurozone is expected to remain expansive for longer duration as economic recovery is still fragile in the region.
What may spoil the party?

Although the rationale behind investing in Europe may appear sound, it should be taken with a pinch of salt. Although there are no immediate threats of disintegration of Eurozone; what future holds may be difficult to predict. Things that might drag the performance of your investment in Eurozone are as follows:

  • Although, rise in unemployment has come down substantially, it is still high at about 12%. National debts are still high and growth rates are still very fragile. Portugal has a debt to GDP ratio of 125%. It grew at mere 0.2% in the third quarter of 2013. Spain which is the fourth largest economy of the Eurozone has a debt to GDP ratio of 86% but registered 0.1% growth in GDP. Italy, another big economy in the Europe, has debt to GDP ratio in excess of 100% (at 127%) and has barely managed to record positive GDP growth. This suggests that things might have improved but these nations are far away from reaching to pre-crisis levels as far as macro-economic indicators go.

  • In 2013, Euro has advanced against USD, and fall in Indian rupee has been more against Euro than that against USD. You might feel that rising euro might help you accelerate returns but there is a threat that many of the nations in Eurozone may lose their export competitiveness. This might complicate the process of recovery in this region. If European Central Bank (ECB) injects liquidity through Long Term Refinancing Operation (LTRO), Euro might fall, taking away advantage of currency depreciation for Indian investors.

  • Equity indices in stronger nations of Europe are either at their all-time high or near their pre-crisis levels. The strong economic recovery in Britain, Germany and Sweden is already priced in as stock markets have recorded new-highs in last 1 year. Going forward, there will be a pressure on these economies to meet expectations of investors. Peripheral economies might have cheap valuations but they are facing serious economic problems. Therefore, if mutual funds stay with core Eurozone economies they might generate poor returns, and if they take a bullish call on peripheral markets, they might expose you to high risk.
PersonalFN is of the view that there is a possibility that Eurozone economy might emerge as one of the strongest among matured economies in 2014; but it wouldn't be a cake walk. PersonalFN believes risk- averse investors should completely avoid investing in Europe centric funds. Those with high risk appetite may go for them. However, if you opt to invest in Europe story, stick to fund houses that have some prior experience of managing money in European markets and have understanding of Europe as a region. Those who invest in these funds should make sure that they have adequate portfolio diversification back home first.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

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