This Lagging Market May Be Ready To Beat The S&P In 2016

It’s been difficult to make a bad bet on the U.S. markets over the last six years. Historically low rates set off a run in asset prices that has topped averages for bull markets. While economic growth hasn’t surged higher than pre-financial crisis levels, it has rebounded relatively well compared to that of other countries. 

But it’s beginning to look like the ride may be coming to an end. The first rate increase in nearly a decade could usher in an era of tighter monetary policy. While low energy prices could provide some upside on consumer spending, the energy sector has acted as a huge drag on corporate earnings where the group accounts for 6.6% of the S&P 500.

#-ad_banner-#In fact, the S&P 500 has risen just 0.3% this year for its worst performance since 2011 and the third worst year of the last decade.

Contrast this with another market that has lagged behind the S&P 500 in four of the last six years but faces significant tailwinds in 2016: Europe. While the United States was pumping hundreds of billions in fiscal and monetary stimulus into its own economy, this market was fighting fiscal tightening and slower monetary stimulus growth. 

The winds are changing and a reversal of fortunes for these two markets may be the best macro play of 2016.

Europe Goes From Laggard To Leader
The European economy has lagged that of the U.S. for years as monetary authorities overseas focused on fiscal austerity rather than monetary stimulus. Economic growth in the United States increased by an average annual pace of 2.3% over the three years through 2014 while the Eurozone economy contracted in 2012 and 2013, and increased just 0.9% in 2014. Shares of the iShares MSCI Eurozone ETF (NYSE: EZU) have fallen 0.6% over the last five years versus a gain of 60.7% in the S&P 500.

While rate increases in the United States are expected to remain modest, borrowing costs will still increase and could act as a drag on the economy. In contrast, the ECB has extended and deepened its new program for monetary stimulus. The ECB has committed to buy 60 billion euros ($65 billion) of debt monthly through March 2017 and has cut its benchmark interest rate into negative territory. 

If low rates in the United States set in motion a corporate cash bonanza, imagine what may happen in Europe, where the 10-year bond rate averages just 1.15% across the Euro-area, nearly half the rate of U.S. Treasuries.

Europe’s economy is forecast to pick up by 1.8% in 2016 from 1.5% growth this year. Economic growth in the United States is expected to pick up only marginally in 2016 to 2.8% from 2.7% this year. While growth in the United States will still be higher than in Europe, it’s the relative change that holds the most potential to move stock prices. The difference in business cycle stages, peaking in the U.S. against early expansion in Europe, could set off a buying binge of European equities as investor sentiment swings to favor the eurozone.

Along with a relatively better economic outlook for Europe, the region also faces a wildcard of sorts. More than one million refugees have fled into Europe this year from civil conflict in Syria and sluggish economic opportunities in periphery countries like Greece. While tragic on a humanitarian level, the exodus has an economic upside. The German Counties Association estimates that added spending could boost GDP by 0.25% next year as humanitarian relief and public spending increases. Unemployment rates across the Eurozone, especially in key countries like Germany, are around all-time lows and these economies should be able to integrate immigrant workers. Over the longer-term, the refugees will help offset effects of the region’s shrinking labor force.

Two European Funds To Watch In 2016
The fact that European equity markets are relatively mature and liquid means many of the listed companies haven’t felt the need to list on the U.S. exchanges as American Depository Receipts (ADRs). There are just 69 ADRs of companies domiciled in developed Europe that trade on the NYSE versus 55 ADRs of Chinese companies alone. For U.S. investors, the best way to tap Europe is through one of the regional funds that hold shares of stocks listed on foreign exchanges.

The iShares MSCI Eurozone ETF (NYSE: EZU) provides broad exposure to large- and mid-cap companies in the region without the weighting to UK companies you find in other regional funds. The Eurozone ETF provides access to many smaller companies in consumer staples that will more immediately benefit from the influx of refugees but that don’t trade as ADRs. The fund trades for just 17.9 times trailing earnings of the companies held, a discount of 5.3% to the iShares Core S&P 500 ETF (NYSE: IVV).  

While German companies compose 30% of the larger Eurozone fund, investors may want to take a look at the iShares MSCI Germany ETF (NYSE: EWG) as well. Germany has historically been a growth engine for the region and growth of 1.9% next year is expected to outperform the larger eurozone. 

The country has been the most inviting of refugees and could be the most immediate to benefit from increased spending. Besides German chancellor Merkel leading the political front in the migration crisis, the Federation of German Industries (BDI) has championed the economic benefits and called for fast-tracking immigrants’ right to work. Shares of the fund trade for a steeper discount of 15.6 times trailing earnings compared to the European fund and include no weighting to the struggling energy sector. 

Risks to Consider: While popular backlash against the wave of immigration has not become a problem, a strong political or civil movement against the refugees could increase uncertainty in the market. This could cause a short-term drop in shares even as the longer-term theme remains intact.

Action to Take: Take advantage of the potential shift in economic fortunes to take profits on U.S. shares and position in the Eurozone market heading into 2016.

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