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So far so good for some key themes in this column in 2013: increase portfolio exposure to international equities, mainly in the United States, and take advantage of a falling Australian dollar relative to the Greenback. Now a third theme, European equities, looks more interesting.

Increasing exposure to troubled European economies may seem like the mother of all contrarian plays. But behind the headlines are faint signs of improvement in the Eurozone, and enough to suggest a modest asset-allocation increase towards European equities in the next 12 months.

For the record, I still favour US equities as the pick of global sharemarkets. The recovery in the US housing sector has a long way to run, and rising US house prices will eventually translate into more confident consumers buoyed by the increase in their property wealth. An improving manufacturing sector and the benefit of cheap shale gas further confirm the US’s status as the global growth engine.

I also expect the Australian dollar to fall further against the Greenback, although losses from here will taper. An Australian dollar at US85 cents by year’s end still seems a reasonable bet as interest rates are cut, probably once more this year, and as commodity prices ease or stabilise.

Buying US equities in unhedged currency terms – to profit from a weakening Australian dollar – has worked well this year, and should continue to do so for the next six months.

Japan, too, has further to run in the next few years. I wrote earlier this year that the Nikkei 225 index was due for a significant pullback, which came to pass, before the market started to rally again in late June and July. After a multi-decade bear market, Japan has plenty of room for further gains, thanks largely due to its incredible monetary stimulus program under Prime Minister Shinzo Abe.

I’m still concerned about emerging-marketing equities and believe investors should stick to stgeloped markets. China is slowing faster than expected and may have more negative growth surprises ahead. The eventual end of the US quantitative easing program could also hamper emerging markets.

The Eurozone looks a better medium-term bet, albeit a higher-risk play for more experienced investors. Europe has been a somewhat quiet performer, with the MSCI Europe ex-UK index outperforming the MSCI AC World index since May 2012. As so often happens, the European market started to outperform global equities just as it was on its knees and investors gave up on it.

In a note late last month, Macquarie Equities Research wrote: “On the assumption that the recovery in Europe continues, we think it is reasonable to expect European equities to post new highs within two years. This is dependent on a recovery in the periphery, especially in Italy and Spain. We think this is already occurring and that Europe is probably two years behind the US in its economic recovery.”

Macquarie added: “In short, we think there is less reason to be fearful of downside risk in Europe. In fact, we think investors should shift to an overweight position in stgeloped European markets.”

Macquarie’s analysis supports my view on Europe. As the key economies of Germany and Switzerland continue to perform, European corporate earnings should collectively start to stabilise and improve. At the same, the European Central Bank could engage in more aggressive monetary policy stimulus to boost economic growth and help the region’s exporters compete with Japan. Less fiscal austerity in Europe than the market expects would remove another market headwind.

As with the US and Japan, the easiest way to gain exposure to improving European equity markets in the medium term is through an ASX-listed exchange-traded fund. The iShares Europe ETF and iShares MSCI EAFE ETF provide exposure to Europe, although the latter is also exposed to Australasian and Far East Asian equities. Of the two, the iShares Europe ETF provider purer exposure to Europe.

It is based on the Standard & Poor’s Europe 350 index, which tracks 350 stocks across 10 market sectors in Europe and the United Kingdom. Almost half the index is made up of financial, consumer staple and health-care stocks – sectors I prefer – and there was only a 7.9 per cent weighting to materials at July 1, 2013. The ETF is unhedged for currency movements.

The iShares Europe ETF returned 32.87 per cent over one year to June 30, 2013. Over five years, it has an average annualised return of negative 0.57 per cent, and since inception in July 2000, the ETF has returned negative 1.08 per cent annually.

After such a long period of underperformance, European equities could surprise in the next two years as the troubled Eurozone economies slowly improve, and surpass beaten-down market expectations.

 

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Jul 17, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.