Investors appear to be embracing Europe again. Flows into the region have increased in recent months on signs the eurozone economy is stabilizing. And as I wrote last month, I now believe that investors underweight European equities should raise their allocations to the region.
But while European growth looks better than it did a year ago and eurozone stocks are attractively valued, I'm not yet advocating that investors should overweight European equities. Why am I only cautiously embracing the eurozone market? There are two major regional issues that remain unresolved. Here's a look at these two, plus the signposts to watch to gauge whether the issues will be resolved anytime soon.
The job of integrating the region's fragmented banking system remains a work in progress. All important decisions regarding this issue have been postponed until after the German federal election on September 22. While the election may produce some short-term market volatility, I believe the most likely outcome is either a continuation of the current coalition government or a return to the Grand Coalition (CDU and SPD) of Chancellor Merkel's 1st term. Under either scenario, policy is unlikely to change significantly.
But even after the federal election, the road to a banking union will be choppy. There are many details that still need to be figured out, including which banks will be included and what European-level authority will handle the resolution of troubled banks. In addition, before integration can occur, the European Central Bank (ECB) needs to conduct a banking sector asset quality review program and a stress test, both scheduled for next year.
Critical structural reforms and budget cuts are still needed. While countries that have received financial aid from their neighbors– e.g. Greece, Portugal, Ireland and Cyprus — have strict reform targets to meet, larger economies such as France and Italy are also a cause for concern. For example, France has two more years to trim its budget deficit to meet Maastricht Treaty requirements and was expected to carry out far-reaching structural reforms. Yet proposed measures so far have fallen short of what policymakers expected and could spark fresh tension with Brussels. In addition, in Italy, a country dealing with high debt levels, a Senate vote, likely in October, on the possible expulsion of Silvio Berlusconi poses a significant threat to the stability of the ruling coalition and its austerity program.
Elsewhere, other Southern European countries – such as Portugal and Greece — need to implement reforms and austerity programs in order to secure their bailout packages. The next signpost to watch related to this issue comes on September 29 in Portugal. If the current governing party doesn't do well in these elections, local pension reform and the current coalition government could be at risk. Then, in early October, the troika of international lenders (the EU, ECB and IMF) will review whether Greece's fiscal reform is still on track enough for the country to receive its final loan installment. It's likely that there will be a debate on the restructuring of sovereign debt in Greece, and the prospect of official creditors taking a haircut over Greece could raise concerns about Cyprus and Portugal requiring similar restructurings.
Unfortunately, the resolution of these issues will likely be a long-term process complicated by political instability and voter fatigue with austerity. Reforms undertaken during a debt crisis are only viable if they have the necessary political backing. However, reforms that disappoint a large part of the population are unlikely to be popular once the immediate threat of default or market pressure has disappeared, threatening the political power of those who implemented the reforms. In the meantime, improving growth and cheap valuations in Europe suggest investors may want to consider some exposure to eurozone equities.