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Investing in Europe: Proceed With Caution

Investors should be aware of the potential implications of further political upheaval, says Morningstar Investment Management's Dan Kemp.

In Europe, the rise of nationalism has been curiously tolerated, as equity markets rallied 5% in both the U.K. and Europe in December. This came despite growing anxieties regarding the implications of a "Hard Brexit" as well as decisive results in the Austrian election and Italian constitutional referendum.

If Brexit and the U.S. presidential elections have taught us anything, the public are cynical of the status quo and are willing to express this discontent with their votes. This is a key risk to the European Union as we approach the French elections in first half of 2017 and the German elections in the second half.

It must therefore be considered a risk for investors. While 2016 has powerfully demonstrated the folly of making political predictions, and thereby drawing market inferences from political changes, investors should be aware of the potential implications of further political upheaval. Under such a scenario, it is wise to demand a margin of safety in assets that could be exposed to such event risk.

Looking ahead, there are many more hurdles to jump. Valuations are evolving under our feet and the macroeconomic environment continues to throw curve balls. This will not change. 2017 looks set to be another showstopper with plenty of news headlines and seemingly important structural changes. The availability of this news is tempting investors to speculate on the cyclical or structural nature of reflation and sending them on a path of short-termism and sector rotation. Investing is always a long-term endeavor and so this temptation must be resisted.

Investors Should Show Caution Far more critically, valuation pressures continue to mount in many key markets. This should create a growing sense of caution among prudent investors, especially those relying on fixed-income investments to protect them against a decline in equity prices. Bond yields are still largely negative in Germany and Japan, out to a seven-year maturity, and Eurozone sustainability is far from secure.

In the end, asset prices are subject to the gravity of fundamental valuation. Therefore, while Europe may be perceived as an area of short-term risk, portions of it can also be considered an area of long-term fundamental opportunity; we have been positive about emerging Europe through 2016. This can be countered against the U.S. which has a high level of perceived safety but with poor investment outlook as valuations stretch further.

Learning From the Past If 2016 contained just one lesson, the key is to avoid being whipsawed in the short term. The rise of populist politics has been one of the key features, and if this phenomenon continues to gain momentum, further disruption to the European project should not be disregarded. However, investors need to stick to a robust and repeatable investment process that acknowledges structural shifts in an intelligent and pragmatic manner and views them in the context of valuation. As prices become dislocated from fair value, we must focus more on the preservation of capital, while thoughtfully allocating assets towards pockets of opportunity that offer compelling valuation advantages and a margin of safety.

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