Based on this year's 17% spike in the Stoxx Europe 600 Index, it seems investors have found a home in European stocks. They're especially enthused about the German market, which is currently sitting on more than a 23% gain and recently cracked 12,000 for the first time.
As Europe's strongest economy, and the world's fourth largest, Germany may seem like a no-brainer investment. Especially now, as the European Central Bank (ECB) embarks on a historic bond-buying program aimed at sparking economic activity across the region.
However, I think many investors are following the herd into European (and German) stocks on the assumption that these equities have nowhere to go but up.
While investing in Europe still makes great sense for the long haul, investors may become disappointed with the results of ECB stimulus.
Best House In A Tough Neighborhood
So what does Germany have going for it? Jobs and wage growth, for starters. After peaking at about 8% during the last recession, German unemployment is down to 4.7% -- low by any standard and a far cry from the region-wide average of 11.2%. Youth unemployment, which remains at alarming levels in southern Europe, is a more modest 7.1% in Germany.
Moreover, wages have gradually climbed despite the recession and other shocks.
From January 2006 to January 2014, gross monthly earnings in Germany rose more than 2% annually to nearly 3,450 euros, according to the latest German government statistics, as reported by TradingEconomics.com.
Analysts at ING Group project 3% wage growth this year, based on a similar increase during the past 12 months for workers represented by IG Metall, Germany's largest union. Wage activity for these workers is widely considered a proxy for German wage trends overall.
The combination of ultra-low interest rates, cheap oil, record-low unemployment and higher wages are all fueling consumer spending -- a major element of the German economy. Such spending rose 1.3% to more than 1.5 trillion euros in 2014 and hit an all-time high of 383 billion euros in the fourth quarter.
Recently, Germans have been splurging on high-end kitchens and other costlier home improvements, as well as on restaurants, consumer electronics and premium apparel. In January, retail sales grew at their fastest pace in nearly five years and consumer optimism reached its highest level in more than a decade, analysts say.
Rising domestic consumption is especially noteworthy for Germany, which is known for frugality and has typically relied substantially more on exports for economic growth.
With help from the declining euro, German exports have been showing greater vigor, too. Last year, they rose nearly 4% to more than 1.1 trillion euros, with especially strong demand from China and the United States for cars, medical technologies and industrial machinery, among many other products.
While geopolitical tensions have contributed to more difficult export conditions in the past few months, Germany could still achieve nearly 4% export growth again this year, since the falling euro and declining oil prices are likely to stimulate export activity, analysts say.
Still, the German economy displays worrisome trends. Capital investment has been weak for years, with uncertainty about the Ukraine crisis and Greece's debt situation among the latest factors to worsen delays in expansion plans.
The evidence of this: Germany's stagnant capital investment-to-GDP ratio. At about 18%, the ratio is roughly where it's been for the past five years and mirrors those of some of Europe's weakest economies, including Italy and Spain. It's not far ahead of Greece's 14% investment-to-GDP ratio.
Nearly a 4% drop in factory orders in January bodes ill for the manufacturing sector. Recent contraction there is related mainly to a sharp decline in export orders from the eurozone, economists say. While preliminary indicators suggest manufacturing rebounded slightly in February, this activity remains well below the more robust levels of early 2014.
And while investors' zeal for Germany is largely based on expectations that ECB stimulus will foster export growth (thanks to a weaker currency), Germany actually isn't optimally positioned to benefit from a weaker euro. Some 20% of the nation's corporate profits come from emerging markets.
Trouble is, the euro is only down roughly half as much against emerging markets currencies as it is against the dollar, and in some cases it's actually higher. So investors may be overestimating the positive effect of a weaker euro on the German economy.
Risks To Consider: There is no escaping the fact that Germany is at the heart of a still-troubled economic region. There's still ample potential for the Greek debt crisis to further destabilize the region, and a Greek exit from the euro isn't out of the question. Also, Germany generates a substantial chunk of corporate profits in China, where economic growth is slowing sharply.
Action To Take --> By all means, devote some of your portfolio to German equities. Just be mindful of the downside and temper your long-term return expectations. Be ready for volatility, too, especially as tense debt negotiations between Greece and the rest of Europe continue to play out.
To minimize risk, consider using a broadly diversified investment. Those seeking passive management should consider iShares MSCI Germany (NYSE: EWG), an exchange-traded index fund that holds 54 German large- and mid-cap stocks representing 85% of Germany's investable market capitalization, according to Morningstar. For investors who prefer active management, there's The New Germany Fund (NYSE: GF), a closed-end mutual fund that invests at least 80% of assets in German equities.
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