European stocks have disappointed investors since 2010, lagging behind U.S. equities despite periodic bursts of optimism. 

European rallies were short lived because of a series of unfortunate events, including the European debt crisis, the surge in the U.S. dollar and the U.K.’s Brexit vote. It may be hard to ignore the drumbeat of troubling headlines surrounding Brexit and upcoming European elections, but equity investors who have been avoiding Europe may want to consider investing in the region.

Global growth is improving and leading indicators suggest that positive growth trends will continue. Eurozone GDP rose an estimated 1.7% in 2016, as falling unemployment and rising wages provided a boost to household spending, while capital expenditures began to rise from depressed levels.  Inflation indicators are approaching ECB targets, easing fears of deflation. 

The global and regional economic backdrop contributes to rosy forecasts for corporate earnings. Consensus estimates are for European earnings growth to grow at double-digit rates in 2017, ahead of estimates for the U.S. and rest of the developed world. 

The favorable outlook for earnings growth in Europe is coupled with undemanding valuations, as stock market valuations in Europe are lower than that of the U.S. The risk of a dollar “melt-up” in 2017, which would detract from European returns in U.S. dollar terms, may be overstated since measures like purchasing power parity indicate that the euro may be somewhat undervalued relative to the dollar. 

Consensus expectations are for the U.S. dollar to rise relative to the euro, given an environment in which the U.S. Federal Reserve is biased to raising rates while the European Central Bank (ECB) maintains an easing bias. However, interest rate differentials are only one component of relative currency valuations, and the ECB may be more likely to taper monetary policy this year than is projected by the market.

On the Other Hand… 

European markets are unloved by investors for a simple reason: geopolitics! 

The Brexit vote and election of Donald Trump are fresh in the minds of investors who expected vastly different results, leading to heightened fears about the survival of the Euro. The recent widening of credit spreads between France and Germany highlights market concern about the potential breakup of the currency union. 

Despite a deluge of negative headlines, elections may not upset the status quo in 2017. 

It is likely that governments in the Netherlands, France and Germany will remain in the hands of leaders who favor the Euro, despite the inroads made by populist candidates:

Netherlands: Geert Wilders, the anti-immigrant leader of the Freedom Party, has a narrow lead in recent polls. However, Wilders’ party is expected to win about 30 seats in the Dutch House of Representatives, far short of a majority in the 150-seat House. Wilders and the Freedom Party don’t have the support necessary to form a governing coalition, and centrist parties in a country that highly supports the euro are expected to form a majority that excludes Wilders.   

France: As is the case in the Netherlands, the vast majority of French citizens support the euro.  Marine Le Pen, the leader of the anti-Europe and anti-immigrant movement, is leading polls to win in April’s first round of the French Presidential election. Le Pen is hoping to follow the lead of Donald Trump in upsetting the conventional wisdom, but she lags far behind either of the potential candidates she is likely to face in the May runoff election, Francois Fillon or Emmanuel Macron. Against both Fillon and Macron, Le Pen is significantly farther behind in the polls than Trump was relative to Hillary Clinton with three months to go.  Although it’s too early to write off Le Pen’s chances in the runoff, checks and balances within the French political system and constitution would make it extremely difficult for her to lead France out of the European Union and the eurozone. 

Germany: Angela Merkel is running for re-election, but recently fell behind in the polls to Martin Schulz. With a long way to go until the fall election, Merkel has ample time to rebound.  Although a Merkel loss would disrupt the status quo in Germany, leading candidates to replace her (including Schulz) are market and euro-friendly. The euro continues to have very high support in Germany, and election of an anti-Euro candidate is extremely unlikely.

Italy:  Investors may be spared an election in Italy during 2017, but Italy represents the greatest existential risk for the Euro. Support for the common currency has reached multidecade lows, and establishment parties are barely ahead of populist parties. However, the populist Five Star Movement has made a pledge not to enter into a coalition government, making it more likely that it will remain a vocal opposition party rather than a governing party. 

So to conclude, despite recent challenges and likelihood of ‘headline’ risk, European equities should be a core holding within diversified portfolios. European stocks may provide diversification in an unpredictable world, while offering growth potential.  Although European political risks will continue to be a distraction, investors may be underestimating the prospects for European stocks in 2017.  

See Dan Kern’s other recent blog postings:

Are ETFs Breeding Systemic Risks?

‘Dude, Where’s My Drone?’ and Other Potential Threats to Trump Rally