Finding Opportunities in Europe

European shares have underperformed U.S. shares in the past 5 years, a result of the ongoing debt crisis. Germany has held up rather well, but markets such as Greece, Italy and Spain have dragged Europe- wide returns lower. It is unlikely that the debt crisis is over; talk of yet more bailouts for Greece continues. However, unlike American stocks, European stocks have priced in a lot of this risk.

When considering any foreign market, it’s easiest to concentrate on trends making headlines, the biggest of which is currency. The major factor in relative performance between Europe and the U.S. is the relative performance of the U.S. dollar and the euro. As one currency outperforms the other, investors shift assets into that region’s markets. Even if the U.S. and Europe are equally valued, a rising euro will draw in more investment, pushing up European real estate and equity prices. After several years of outperformance, European assets will appear overvalued to American assets and the capital flows will reverse. There are always other factors at work, such as the European debt crisis, but all of this is eventually priced into the currency market.

Typically, currency cycles run for several years; the U.S. dollar bottomed in 2008 after underperforming the euro for roughly 7 years. The U.S. dollar may have peaked in 2010 when the crisis in Greece first erupted and sent the euro below $1.20 (well below the recent exchange rate of $1.38), and since it has been six years into a dollar rally, it could be coming to an end. For certain, European stocks have taken more lumps than U.S. shares. Where Greece, Spain and Italy have had a debt crisis erupt, the U.S. has avoided state level problems for now, even with the bankruptcy of several cities. By comparison, the U.S. market is starting to look rich, with investor optimism on the rise. From this view, there is the possibility Europe could outperform over the next 3 to 5 years.

There are still headwinds though. Heading into 2014, the big risk to Europe is still the credit market. Credit growth was negative 2.2 percent in January, which means there is the possibility of a recession. Adding to that problem are troubles in emerging markets such as Turkey, as European banks are far more exposed to emerging markets than U.S. banks. Finally, the situation in the Ukraine has a greater effect on Europe than the United States; to start the month European shares opened sharply lower in the wake of Russian troops entering Ukraine’s Crimean peninsula.

Simply said, the risks in Europe are very clear and immediate. However, for a long-term investor, the relative value in European shares is becoming more attractive relative to U.S. shares. As long as Europe fares as well as the U.S. economically and financially, it makes sense to pick up the relatively cheap European shares. Short-term investors may want to wait and see whether the continent’s problems are over.

The Investor Guide to Fidelity Funds covers a number of equity funds dedicated to Europe:  Invesco European Growth (EGINX); U.S. Global Eastern Europe (EUROX); Fidelity Europe Capital Appreciation (FECAX); and Fidelity Europe (FIEUX).  Each fund falls into Morningstar’s large blend category, which helps when comparing their portfolios. At this time, however, both FECAX and EGINX are closed to new investors.

Given limited availability, the first option is EUROX due to its focus on Eastern Europe. Obviously, this is the riskier fund of the four and events in Ukraine will have an impact on short-term performance. More than 40 percent of assets are in Russian shares, and Russia is the most highly exposed to Ukraine’s financial system.  Moreover, there are threats of sanctions being brought against Russia by the United States as well as numerous European countries, due to its intervention in the Ukraine.

The presence of Russia also means the fund has a high correlation with BRIC and emerging market funds as well. There is high potential reward if emerging markets, specifically Russia, can rally, but there is also very high risk. Additionally, the fund is expensive with management fees at more than 2 percent.

Of the two diversified European Funds covered in the newsletter and open to new investors, Fidelity Europe (FIEUX) is clearly the best option. It is also the cheapest offering, with low turnover, and delivers solid exposure to developed Europe.  FIEUX has 31 percent of its holdings in the United Kingdom, followed by Germany at 14 percent, France at 13 percent and Switzerland at 12 percent.  It completely avoids Russia and emerging markets.

In addition to these funds, there are international funds with sizable European exposure: Fidelity Total International (FTIEX) and Fidelity Overseas (FOSFX). Of the two, Overseas offers the greater exposure to Europe, with 70 percent of assets on the continent. Another 18 percent of assets are in Japan, making it a European heavy, developed market dominated fund. FTIEX, in contrast, has 50 percent in Europe followed by 20 percent in emerging markets. For investors in search of European exposure, FOSFX is the better choice.

Finally, Fidelity also offers a regional fund, Fidelity Nordic (FNORX). This fund has been an outstanding performer in recent years thanks to several Nordic countries refusing to use the euro.  Sweden and Norway use their own currencies, while Finland did adopt the euro. Denmark also has its own currency, but it is closely pegged to the euro. As mentioned earlier, the difference in currency can often be the deciding factor between investments abroad, but in this case, while FNORX has beaten Fidelity Europe (FIEUX) in the past year, the euro has appreciated against the Swedish and Norwegian currencies.

The main reason Nordic shares have outperformed is because they have less currency risk. It is the same reason the German stock market has held up very well; if the euro were to break apart, investors expect a new German currency to appreciate. Even more so, the Nordic countries that do not use the euro are insulated from this currency risk. The Swedish and Norwegian currencies have seen safe haven buying during flare ups in the European debt crisis. Additionally, Norway’s government is well funded by its oil exports and Sweden’s banking system was reformed in the 1990s, having already gone through a major crisis. This may be an attractive haven for investors wanting European exposure without the currency risk.

While there is significant short and intermediate-term risk for European stocks due to the volatile situation in Russia and the Ukraine, over the long-term, there may be some value opportunities for investors.  Over the next few weeks and months, follow the European markets closely. There may be buying opportunities; with increased volatility due to speculators, you may be able to purchase undervalued funds.