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A recurring column theme this year has been to increase allocations to international equities, favouring stgeloped equities over emerging ones, and using unhedged currency exposure to position for a lower Australian dollar. The strong preference was US equities, followed by those in Japan and Europe.

I wrote about European equities in July: “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.” The story noted that European equities were a higher-risk idea.

So far so good. The iShares Europe Exchange Traded Fund (IEU) is up 26 per cent so far this year (in Australian dollar terms) and 38 per cent over one year to August 31, 2013. The ETF aims to replicate the price and yield performance of an index over large European and UK stocks, and about 20 per cent of its assets under management are invested in financial service stocks.

Over five years, the iShares Europe ETF has returned 0.32 per cent on average each year – a shocking performance for long-term investors, but also a signal that further gains are possible as Europe slowly recovery, with continued volatility along the way.

To be consistent, my recent columns have suggested investors take some profits in international equities, particularly in the US. Its equity markets look fully valued and ripe for correction as tensions build over servicing US government debt later this year.

After rallying 38 per cent, the iShares Europe ETF is also due for a pullback in the next few months. But price weakness might provide a better entry point for experienced investors with at least a 2-3 year outlook, and tolerance for bouts of high volatility as debt crises in smaller European economies inevitably resurface.

Macquarie Equities Research earlier this year forecast European equities would post new highs with two years – a good call – on the assumption the European recovery continues. It needed to see better economic news in peripheral European economies and thought the recovery was two years behind the US.

That scenario looks plausible. The European Central Bank this month improved its outlook for the Eurozone economy, predicting a contraction of 0.4 per cent the year compared to previous forecast in June of a 0.6 per cent reduction. That’s still weak, but not as bad as the market feared.

The Eurozone technically emerged from recession in the second quarter of 2013 after 18 months of contraction. Total economic output grew 0.3 per cent between April and June, ahead of the consensus forecast of 0.2 per cent expansion. Germany, France and Portugal grew, and Spain, Italy and The Netherlands contracted, although less sharply compared to the previous quarter. Rising consumer demand and exports lifted activity.

In July, The International Monetary Fund forecast the European Union would contract 0.1 per cent in 2013, and expand 1.2 per cent a year later, in its World Economic Outlook report.

That is tepid growth and the latest quarterly read in Europe is below that in the US, Japan and United Kingdom. Overall, risks remain to a short-term Eurozone recovery, and there are still few tangible signs of significant economic reform and modernisation in smaller European countries.

But Europe, for all its faults, has surprised the market with stronger-than-expected growth, especially in France, and German growth has improved. Doomsayers who expected Europe to be mired in recession for years have been caught short with the rally in its equity markets.

European Central Bank president, Mario Draghi, has expressed slight optimism for a Eurozone recovery and the ECB expects a gradual recovery. The question, now, is whether Europe is likelier to surprise on the upside, leading to stronger gains in equity markets.

The Financial Times this month reported US pension funds and other US investors poured US$65 billion in European stocks in the first six months of 2013 – the largest in 36 years. Professional investors are clearly betting on continued recovery in the Eurozone, and believe European stocks are collectively undervalued relative to historical averages and to their US peers.

Investors who took some profits on US equities and are looking to deploy back into US shares after an inevitable correction, might direct more funds to European shares. The long-term outlook for US shares remains bright, but making subtle asset allocation shifts from fully valued markets to undervalued ones, such as the Eurozone, can make a big difference to returns.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis are at September 18.2013.

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