Europe ETF Enthusiasm

As has been widely documented, exchange traded funds investors have been flocking to ex-U.S. ETFs this year. Resurgent European equities are providing investors with reasons to embrace diversified developed market funds as well as dedicated Europe fare, such as the iShares MSCI Eurozone ETF EZU.

The $14.7 billion EZU tracks the widely followed MSCI EMU Index, a marquee benchmark of Eurozone equities. France and Germany account for over 62 percent of EZU's geographic exposure. In order, Germany and France are the Eurozone's two largest economies. More important than market heft are the rebounding earnings profiles seen in ex-U.S. developed markets.

“The earnings pick-up unfolded in Europe and Japan this year despite the drag of stronger currencies on exporters,” said BlackRock in a recent note. “Both regions are expected to see earnings growth outpacing that in the U.S. for 2017. We think this trend has more room to run, in part because we see this year’s euro and yen strength slowly reversing.” 

Currency Conundrum

For the bulk of this year, the euro has been strong against the dollar, a scenario that benefits EZU because the ETF is not currency hedged. However, the U.S. Dollar Index has traded modestly higher since the start of the fourth quarter.

Investors willing to bet on a prolonged euro slump can consider the iShares Currency Hedged MSCI Eurozone ETF HEZU, which is essentially EZU with a currency hedge overlay. If the euro remains firm, EZU is the better bet as evidenced by its 1,000-basis point outperformance of HEZU this year.

“A bout of euro and yen strength earlier this year raised some doubts about corporate performance, yet ended up doing little to dent improving profitability,” said BlackRock.

Being Selective

For a significant portion of the bull market in U.S. stocks, European equities have been an afterthought — and rightfully so — for many investors. Now, Europe is showing signs of turning a corner, potentially entering a lengthy period of outperformance over the S&P 500 and other bellwether U.S. equity benchmarks. With that in mind, investors may want to add a cyclical profile to their Eurozone and developed markets exposures.

"Yet cyclicals are in a strong position in this environment, we believe. Financials have made up about 20 percent of global earnings growth this year —a share we see rising in 2018 as bond yields rise,” according to BlackRock.

EZU allocates over 48 percent of its combined weight to the financial services, industrial and consumer discretionary sectors, all of which are cyclical groups.

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