Monday, February 2, 2015

Europe Follows the Fed

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The European recovery story has been one that a lot of investors love to hate. Despite the upward run in many of the regional indexes, the underlying economic data can be described as ambiguous at best, leaving a lot of folks scratching their heads.

For instance, if you think back to the early stage of the European crisis, the markets there were on a constant seesaw as some data showed that maybe things weren't quite as bad as they seemed, while other data made the situation look worse. It took nearly a year of successive dominoes falling, from the Greek implosion to the Spanish contagion and the Cypriot collapse, before the region's finance ministers realized that a massive systemic bailout would ultimately be necessary.

If any of that sounds familiar, it is because our own financial crisis followed much the same arc, as regulators initially fiddled while the banks burned. In fact, the two situations are virtually analogous in all but time; the European recovery is current running about a year behind our own.

The latest piece of news out of Europe showing the region's recovery is on track is the fact that Greece was recently able to sell a chunk of five-year bonds at extremely favorable rates. That’s startlingly good news, considering the country's recent past.

When Greece announced that it was planning to sell the bonds, demand was already high. While the country said that it was only planning to raise between EUR2.5 billion and EUR3 billion from the sale, the bankers doing the legwork on the deal said they received more than EUR20 billion in bids. The yield on the bond also came well under expectations, demanding just 4.95 percent versus the forecast yield of between 5.25 percent and 5.5 percent. This marks the country's first successful longer-term bond sale since 2010.

Granted, Greece wasn’t compelled to have the monies to pay its upcoming bills, because it has been raising money through the sale of short-term notes for the past few year! s. But this was a critical testing of the waters for the country, showing that global bond buyers believe that the situation on the ground in Greece is improving and that they have faith in the commitment of European financial authorities to maintain the country's stability. That's saying a lot, considering that Greece defaulted on EUR200 billion of its debt just two short years ago, when it had to offer yields of nearly 20 percent in order to refinance those obligations.

Make no mistake, Greece is nowhere near out of the woods. A crippling recession has shrunk the country's economy by more than 25 percent, more efficient revenue systems must still be put in place and political issues remain to be settled. However, the country is clearly on the path towards sustainable recovery. The falling cost of insuring those five-year bonds with credit default swaps is another element of proof.

The Russian takeover of Ukraine's Crimea region has also had the unexpected effect of bolstering confidence in European political and financial authorities. With the European Central Bank (ECB) and the International Monetary Fund stepping in with financial aid packages, politicians tearing down trade barriers such as tariffs on Ukrainian goods, and closer military cooperation with the US and the North Atlantic Treaty Organization, the Russian invasion has fostered a greater degree of regional cooperation.

The European recovery is entering the final phase of its recovery. As the US Federal Reserve tapers off its stimulus efforts, the ECB must now shift from crisis containment mode to fostering a broader based recovery across the region. While we've yet to see the exact form those measures will take, odds are the ECB will essentially follow the road map laid by its American counterpart.

Consequently, while the European recovery has been gaining momentum for several months, at least a few years of positive market performance is probably ahead. Keeping in mind that the US bull market has run! for more! than five years, closely tracking the Fed's stimulus efforts, there's still plenty of time to take advantage.

Vanguard European Stock Index (NYSE: VGK) is an easy, low risk play on the region's recovery.

With an expense ratio of just 0.12 percent, it's one of the cheapest broad based European exchange-traded funds (ETFs) available, as well as one of the largest with $16.2 billion in assets.

The ETF’s portfolio is also well allocated to take advantage of the typical recovery. As you'll recall, the US recovery began with the banks as they stabilized in the wake of the central bank's efforts to contain the crisis. While European banks have been serious laggards for more than a year, we're clearly beginning to see the effect of the ECB's stabilization measures, which means that the banks should begin to turn the corner over the next few months. That's particularly true if consumer confidence in the regional continues to show improvement, helping to spur greater loan demand.

The ETF will also benefit from a continued recovery with another 20 percent of its assets divided between industrial and energy names, both of which will likely pick up in about another year if the economic recovery stays on course.

In the meantime, though, 13 percent of the fund's assets are devoted to health care with another 12.8 percent to consumer defensive names, helping to reduce the volatility of its portfolio. While the fund's beta is roughly in line with the broader European market, its standard deviation is actually slightly lower while producing a superior return. It also offers an attractive 3.9 percent yield despite its focus on large, mature companies such as Nestle (OTC: NSRGY), Novartis (NYSE: NVS), HSBC (NYSE: HSBC) and BP (NYSE: BP).

With more good news coming from Europe every day, Vanguard European Stock Index rates a buy up to 65.

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