Some investors who have heavily underweighted euro zone assets may have more reasons to change their mind in the coming week as the resilience of the region's economy contrasts with persistent hints of a U.S. double dip.
Given a surprisingly robust economic performance, especially in Germany, investors are becoming more sanguine about the single currency region's sovereign debt troubles — once the biggest drag for investors in euro zone stocks and other assets.
Concerns that the U.S. economy is slowing, or possibly returning to a recession, has affected other markets, as seen in Friday's fall in Asian and European stocks.
But long-term asset managers are looking beyond knee-jerk reactions and evaluating the risk of being overly underweight in assets from a region starting to look less ugly than its U.S. counterpart.
By way of example, mainstream fund managers polled by Bank of America Merrill Lynch this month have become overweight euro zone equities for the first time since November.
More leading indicators on the euro zone manufacturing sector and German business morale, due in the coming week, could accelerate this trend, at a time when investors are increasingly worried about the U.S. economy's worsening prospects.
Prudential International Investment Advisors upgraded the euro zone to modest overweight while cutting the United States to underweight.
"Solid growth momentum in the core euro zone is likely to offset weakness in the periphery. Earnings are expected to be solid around 31 percent (growth) in 2010," noted John Praveen, chief investment strategist at Prudential.
"The U.S. is unlikely to outperform other markets."
This year's earnings growth for major U.S. firms on the S&P 500 index is expected at 35.8%, according to Thomson Reuters data, but many analysts warn of downgrade risks.
The BofA Merrill poll found that fund managers are now underweight in the United States, with a net 49% of respondents in Europe saying local equities are undervalued. Year to date, European stocks, measured by the FTSEuro 300 index, have fallen around 1%, outperforming the S&P 500 index which dropped 3.5% and the MSCI world equity index which lost nearly 5%.
In the credit market however, euro zone assets have a lot of catching up to do, especially in the high-yield space.
Total return on euro high-yield corporate paper, rated BB, stood at 4.3%, according to BofA Merrill data. This compares with 5% for similarly-rated U.S. bonds.
RATES VS RISK APPETITE
In the foreign exchange market, the euro is down nearly 9% on a trade-weighted basis while the dollar has risen 6% against a basket of major currencies.
"The euro has stabilised over the past week, and… it does appear that fundamental drivers, rather than positioning, will drive the next major move," Deutsche Bank said in a note to clients.
Investors have been pushing back the timing of the next interest rate hike by the Federal Reserve after the central bank decided earlier this month to buy more government debt with the cash from maturing mortgage bonds. They expect the Fed to leave interest rates on hold until mid-2011.
The U.S. two-year note yield hit an all-time low of 0.472% on Friday while the benchmark 10-year yield set a fresh 17-month trough of 2.550%.
Spreads between the U.S. and euro zone 10-year yields have fallen to around 26 basis points, near the lowest level this year, compared with an April high of 91 bps.
"Recent correlations suggest that rate spreads are becoming more important, overtaking risk appetite, while the sensitivity to peripheral euro area concerns are waning. On balance, we would expect such a shift to favour gains in the euro," Deutsche said.
