While Greece is now cleared to receive a second bailout and Spain and Italy are facing lower borrowing costs, Europe is not yet out of the woods. Greece, for instance, still has unsustainably high debt levels, and Portugal’s rising yields are becoming increasingly worrisome.
Given these lingering issues, I recently advocated that investors avoid Spain and Italy, markets that are cheap for a reason. Now, I’m adding another country to the list of European markets to consider underweighting: the United Kingdom, a market that has its own issues separate from those of the euro zone.
Currently, equities in the United Kingdom appear overvalued, especially when you consider the numerous signs that the country is teetering on the brink of another recession. As of this writing, UK stocks are trading at a relatively rich valuation of 1.7x book value, higher than the 1.5x book value average for developed countries.
At the same time, economic conditions in the United Kingdom are deteriorating. Expectations for UK growth have decreased over the last six months, and UK corporate sector profitability has dropped since the end of last year. In addition, UK mortgage rates have increased and unemployment remains at a 17-year high, headwinds for an economy where household spending accounts for roughly 2/3 of gross domestic product.
While UK inflation is declining, it’s still elevated at 3.6%, a level well above both the Bank of England’s target rate and UK wage growth. Thanks to the United Kingdom’s relatively high inflation, it appears unlikely that the Bank of England will provide further quantitative easing in the near term, meaning the UK economy will have less growth support. Finally, the United Kingdom may be trying to reign in its deficit too quickly by raising taxes and cutting spending, potentially raising the risk of another recession.
So where should investors consider investing in Europe? I continue to believe that much of Northern Europe represents a good value for long-term investors and I particularly like Germany, the Netherlands and Norway (potential iShares solutions: NYSEARCA: EWG, NYSEARCA: EWN, NYSEAMEX: ENOR).
Disclosure: long EWG.