HOW TO PLAY IT: Recession still Europe's greatest worry

Tue Dec 13, 2011 4:50pm EST

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(Reuters) - An agreement between European leaders to help save the eurozone fails to address one main problem: Europe's economies are growing too slowly.

The deal, announced on Friday, attempts to prevent another fiscal crisis by imposing strict budget guidelines for nearly every member of the European Union. The United Kingdom was the lone holdout.

The agreement "is about a vision of what Europe will look like in the next 100 years, but markets are worried about the next 10 days," said Nicholas Colas, chief market strategist at ConvergEx Group, a New York-based financial technology firm.

With slow growth, high debt burdens and cost-cutting austerity measures that could further weaken spending in countries like Italy and Greece, a Europe-wide recession looks more likely, analysts say.

Standard & Poor's expects that a recession that began in Spain, Portugal and Greece over the last year will spill over into larger economies like France and Germany in the first six months of 2012. GE Capital's CFO Jeffrey Bornstein said last week that the company expects there to be a recession in Europe.

Here are three considerations for investors on how to play a looming EU recession:

IN EUROPE, BUT NOT OF IT

Exports have been a key reason the German economy has held up better than its European peers. But the German government said Friday that exports fell 3.6 percent in October from the month before. Declines in Europe, which collectively makes up more than half of all German orders, are partly to blame.

Select German exporters remain good bets based on current valuations and also on expectations that exports to the U.S. and China may outweigh any current weakness, some investors said.

"Speculators have been using German stocks as a proxy for their (European-wide) market viewpoints" ignoring individual stock fundamentals, which has made some valuations attractive, said Geoffrey Pazzanese, manager of the $550 million Federated InterContinental Fund (RIMAX). The German market is trading at nine times forward earnings, compared with a 12 times forward multiple for the S&P 500.

Pazzanese is buying shares of Daimler AG because of its strength exporting automobiles to the U.S. and China. He expects the U.S. auto sector to be strong in 2012 because consumers have largely delayed replacing their vehicles since the U.S. recession. He expects more than 20 million vehicles to be sold in China, making it a larger market than the U.S.

Daimler trades at a price to earnings multiple of seven, well below its 52-week high of 19, and offers a yield of 5.4 percent. Siemens AG is another global company that, with a yield of 4 percent, offers a high dividend.

"These companies are not value traps, and Germany is not a value trap," Pazzanese said.

Another undervalued option: The iShares Germany ETF (EWG), which is down 16 percent this year, holds Germany's largest 50 companies and yields 3.3 percent. Siemens makes up 10 percent of the fund's assets. Daimler accounts for 5 percent.

The United Kingdom is another option for investors. It is part of the European Union but does not share the euro giving the UK an ability to control its currency rates through measures like quantitative easing, something barred by the European Central Bank.

Quincy Krosby, market strategist at Prudential, said that she expects UK's FTSE index to outperform other European countries over the next year. "We're in an environment where global growth is slowing, and countries in which central banks can control their currency will see their markets do better," she said.

One broad investment option: HSBC's FTSE 100 ETF (UKX), down 3.7 percent this year, tracks the largest 100 UK companies. Its top holdings are multinationals like BP, GlaxoSmith Kline, and British American Tobacco.

BE MINDFUL OF EUROPEAN EXPOSURE

U.S. investors' domestic holdings are not immune to the impact of a European recession. Sales in Europe make up about 20 percent of revenues for companies in the S&P 500 index.

Some companies derive even more revenue from Europe. A full 56 percent of sales at Cisco Systems come from Europe, according to Thomson Reuters Datastream. McDonald's gets 42 percent of its sales from Europe. For Kraft Foods it's 32 percent.

"You can't imagine that (these companies) aren't going to face headwinds in terms of Europe," said Bill Stone, chief market strategist at PNC Financial. That makes it prudent to sell such stocks before any further decline in Europe.

Cisco, in particular, may have further to fall. Its shares are among the five most-shorted on the Nasdaq, a likely drag on stock performance. The company is down 6 percent this year, compared with a 4 percent gain for the Nasdaq index.

Industrial and technology companies, which are the most like to export goods to Europe, may also be expensive. "The valuation gap has narrowed, making (these sectors) less attractive," Jonathan Golub, chief strategist at UBS, wrote in a note to clients.

EURO FALLING

Analysts say that the euro will likely continue to fall as the debt crisis continues, leaving open currency plays.

Pazzanese, the international fund manager for Federated, has seen a negative effect of the weakening euro on his returns. "We're dollar denominated investors," he said."While we might have a good stock idea, our returns on the trade will be in euros and we then translate that into dollars," a process that sometimes makes him lose on the exchange rate. He protects his stock investments by simultaneously shorting the euro.

The PowerShares DB US Dollar Index Bullish (UUP), an ETF that tracks the performance of the dollar against the euro and five other currencies, is one option for cover.

"This fund could provide a useful hedge to U.S. investors with substantial holdings in European equities" by balancing out the currency risks, noted Michael Rawson, an ETF analyst at Morningstar.

(Reporting by David Randall; Editing by Jennifer Merritt and Walden Siew)

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