PEF: European Equities Suffer U.S. Fallout

by: Don Dion

Disappointing earnings reports sent European stocks tumbling last week, ending a brief early-spring rally and leaving PowerShares FTSE RAFI Europe ETF (PEF) down about 9% for the year through April 14. The fund’s losses were almost identical to the S&P 500’s fall for the period but compared favorably with the nearly 15% slide of the pan-European Dow Jones STOXX 600 Index.

PEF ranked 25th on the PowerShares Momentum Tracker Table last week thanks to a 19-spot gain from February 27, making it the table’s top-ranking international fund. The fund’s mediocre performance last week could drag on that momentum. That said, the struggles of the U.S. economy could smooth the way for PEF to ascend to the table’s upper reaches.

PEF offers a broad sampling of the major players in European markets. Its portfolio recently included 456 holdings, with 90% of those stocks classified by Morningstar as giant- or large-cap. U.K. stocks accounted for about a third of the fund’s assets, while equities from France and Germany took up about 17% and 14% of assets, respectively. Financial stocks recently represented almost a quarter of PEF’s portfolio, while the con- sumer goods and energy sectors each held about 14% of assets. The fund takes a stake in every major market sector, but health care and technology recently played the small roles, taking up only about 4% and 2% of the fund’s assets, respectively. That’s a considerable difference from the U.S. market: Technology recently represented almost 16% of the S&P 500, while health care accounted for nearly 12% of the index.

The recent turmoil in the U.S. economy has begun to spread across the globe, sending real estate prices plummeting in locations as diverse as Ireland and India and unnerving financial markets in scores of countries. The question in European bourses these days is whether the U.S. economy’s troubles will spread across the Atlantic in the form of a tidal wave or a ripple.

Until recent weeks, the European Central Bank [ECB] agreed with many financial analysts that the worst of the damage would likely be limited to major banks and other institutions with exposure to securities backed by subprime mortgages. But the picture has changed in recent weeks. The International Monetary Fund last week advised the ECB to prepare for an all-out economic downturn, predicting in its World Economic Outlook that European growth will slow to 1.4% in 2008 and 1.2% in 2009. Last year, GDP growth in the Eurozone—the 15 nations that use the euro as currency—clocked in at 2.6%. The IMF also predicted slowing economic growth in the U.K., which is not included in the Eurozone. Business activity in the U.K. last month rose at the slowest level in almost five years, according to a survey the Royal Bank of Scotland released Monday.

The IMF’s report, along with a number of profit warnings from major multinational firms—General Electric, Phillips and DSG International, to name a few—helped convince some investors that European stocks aren’t likely to rally again until the U.S. economy shows signs of emerging from its current funk.

What’s more, consumer spending appears to be slipping across much of Europe; inflation in the Eurozone and the U.K. is creeping dangerously high; and a weak U.S. dollar spells shrinking profits for the many European firms that peddle their products in the New World. The upside, according to Patrick Schowitz, European equity strategist at HSBC, is that all the bad news has sent shares down far enough to leave little risk they’ll fall farther. "Valuations are so cheap,” Schowitz told the Wall Street Journal on April 14. “Even if earnings disappoint, I still think valuations look good.”

One attractively valued stock Schowitz points to is PEF’s recent top holding, British Petroleum (NYSE:BP). Shares in BP trade at less than nine times their expected 2008 earnings following a 9% year-to-date decline through April 14. If BP were to suffer a 30% drop in earnings, Schowitz told the Journal, the stock’s expected 2008 price-to-earnings ratio would climb only to 12.5, a figure that compares favorably with its 10-year average of 15.4. As it is one of the largest oil companies in the world, with an extensive portfolio of oil fields and refineries, there are reasons to think that BP should profit handsomely in the coming years. For one, the firm’s heavy emphasis on exploration and production should give it a leg up over competitors as long as oil prices remain near record highs. The big catch for this firm could be its heavy reliance on Russia. More than a third of BP’s oil comes from a Russian producer, and the Russian government has repeatedly shown its willingness to wield the country’s oil as a political weapon—leaving firms like BP in the crossfire.

Investors interested in Europe might also want to keep an eye on PowerShares Dynamic Europe (PEH). The fund offers exposure to many smaller European stocks that don’t fit into PEF’s fundamentals-based weighting system. PEH ranked far behind PEF last week on the PowerShares Momentum Tracker Table, at number 39, but it had quickly moved up 20 spots in six weeks to reach that position. If the European economy manages to shrug off the remaining fallout from the subprime mortgage mess, both funds have a good chance to outpace broad U.S. market indices. In that case, a small stake in Europe through one of these funds could provide a healthy boost to a portfolio’s performance.