There were two expressions of popular will last weekend, both significant for the European Union (EU).
One, Britain’s seemingly damaging vote for exit, in which a major EU participant decided to leave the European Union altogether. The other, perhaps of less long-term significance, was the Spanish election, in which the center right party of prime minister Mariano Rajoy increased its support from December’s inconclusive election, and can probably now form another stable government.
The risk in Europe is less than it appears, and the current market weakness may be a good time for income investors to increase their positions.
Despite the initial shock, the British exit won’t greatly damage the European Union, nor will it be strongly resisted.
The truth is, Britain, with its globalized economy and its close contracts with the United States and other English-speaking countries, never fit into the European Union all that well anyway, and the misfit became worse as the European Union moved towards fuller integration.
For many EU leaders, Britain was an obstacle to the goals they sought, and those goals will be easier to reach without it.
The EU of the Future
The most likely destination for the EU is a polity that falls short of a full federation, but includes a single currency joint defense force and a high level of central control over national budgets, along with a formalized system of bailouts for countries that get in trouble.
Generally, it’ll be social democratic, with a high level of government spending. There will be a tendency for that to increase as a result of the bailouts and the habit of its statesmen to engage on witless state spending “stimulus” programs every time the economy turns down.
In spite of its heavy burden, the EU will remain home to much of the world’s finest technology and engineering, as well as an unparalleled range of luxury and near-luxury goods producers.
While these companies may not have the glamour and rapid growth of Silicon Valley and the emerging economies of Asia, they will offer income investors substantial yields and the opportunity to increase those yields with the growth of their operations.
Since interest rates are extremely low and likely to remain so for the foreseeable future, these companies will thus represent attractive investments for the long-term oriented income investor, provided they aren’t bought at extravagant valuations at the peak of the economic cycle.
Income Investment Strategies
Spain’s election on June 26 was especially interesting.
The anti-austerity left, led by the Podemos party – a Spanish counterpart to Greece’s left-populist Syriza party – was expected to take power. Instead Spanish voters, possibly spooked by Britain’s Brexit vote, gave more support to the center-right Rajoy.
Consequently, the chance of runway budgets across the whole Mediterranean is greatly reduced, and Europe’s economic potential increased, as a result.
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Spain in particular has been coming out of a deep recession under Rajoy, and is expected to enjoy growth above 2% in both 2016 and 2017.
For potential investors in Europe, I will suggest two exchange-traded funds (ETFs) with a European specialization and moderate yields, and two companies with higher yields.
For pure income investors, the most effective way to play Europe is probably the WisdomTree Europe SmallCap Dividend ETF (DFE).
This $1 billion ETF specializes in small-cap stocks, where the greatest dynamism in Europe lies, yet trades on an average price-to-earnings (P/E) ratio of only 15 times. Its main disadvantage is a yield of only 2.7%, reflecting the years of low interest rates in Europe as in the United States.
The fund also has an expense ratio of only 0.59%, and only 11% of its holdings are in financial services, a satisfactorily low ratio.
For a pure-play on Spain with a higher yield, the iShares MSCI Spain Capped ETF (EWP) tracks the index of that name and yields 3.9%. It trades on an average P/E ratio of a reasonable 14 times and has an expense ratio of a very reasonable 0.48%.
Or, for a search in Spain’s bargain bin that still gives a decent dividend yield of 5.8%, you might look at Banco Santander S.A. (SAN). This is Spain’s largest bank, which also owns a large operation in Britain (hedging you inside and outside the EU) and several substantial operations in Latin America. It trades on a very reasonable 8.9 times historic earnings, 57% of book value and an even more reasonable 7.4 times 4-traders’ estimate of 2017 earnings.
Finally, Germany’s Daimler AG (DDAIY) offers the possibility of growth, yet carried a yield of 6.1%, a historic P/E ratio of only 7.3 times and a P/E ratio based on 4-traders’ estimate of 2017 earnings of only 6.3 times.
The automobile sector is highly cyclical, but Daimler operates in a high-margin area of that sector, and those valuations suggest income investors could find an excellent bargain here.
Europe still offers an attractive diversification from the U.S. market, and its most attractive countries offer nice yields and the possibility of growth.