European stocks have made solid gains, but even so, the gusher of money into Europe should continue as investors who shunned it since the financial crisis return.
Despite continued concerns around Brexit and the upcoming U.K. elections, money continues to flow into the region. According to Lipper Research, European focused, U.S.-based domiciled funds alone saw net inflows of $4.2 billion in May, bringing total net flows year-to-date to $9.2 billion.
According to research from Bank of America Merrill Lynch, so far this year investors moved $13.7 billion to European funds.
Analysts say investors have been underinvested in Europe for a variety of reasons, from the Greek debt crisis to the French election. They have been catching up, but it's going to take time. "We think the economic fundamental drivers are very solid. We think there's an earnings upturn. ... It's early on," said Paul Christopher, chief international strategist at Wells Fargo Investment Institute. "We think it's still a good time for clients who have been scared of Europe, underweight Europe for years, to get back to even weight."
Political risks in Europe still exist, but analysts point to recent figures that suggest the euro zone economy is growing at its fastest rate in years, much faster than the U.S. economy. In many countries, wages are rising, unemployment is falling, and credit conditions are easing as well, the European Commission reported.
The German DAX is up 12 percent year-to-date, at a record high Friday. The French CAC is up 10 percent, and the U.K. FTSE, up 5.5 percent for the year, was also at a record high.
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Christopher and other analysts say European stocks do appear to be getting pricey, but they are still going to benefit from earnings improvements, which are at an early stage.
"From a short-term perspective, what we're advising clients to do is to use dollar-cost averaging when buying European stocks. We think the earnings recovery will be long-lived enough to sustain averaging over a couple of quarters," he said.
Bank of America Merrill Lynch European equity strategist Ronan Carr said there's a noticeable pickup in interest from U.S. investors. Some of them have had large "underweights against European benchmarks for five to 10 years. That served them well," he said.
Diversifying across the pond
As U.S. stocks set new highs, some strategists expect only modest gains in the S&P 500 over the next couple of months. "We have stronger conviction, not so much about the reflation trade in the U.S. but the resynchronization trend that's going on," said Ron Sanchez, chief investment officer at Fiduciary Trust.
"I think there are better opportunities in Europe, and I think investors continue to position themselves in the post-credit crisis world," said Sanchez. "We're seeing a regime change, and we are seeing a resynchronization, and the global economy is getting much better, while the U.S. continues to muddle through from an investment standpoint."
But Europe is not without its risks. The European Central Bank meets Thursday, and there are expectations it could tweak the language in its statement to show it is coming close to a time when it would remove accommodation.
BlackRock's Kate Moore said she's not worried about the central bank at this point, because there will still be so much easy policy in place.
"If the ECB were to pull back now ... normalization has a long way to go to get to normal policy. Arguably, taking rates to positive from negative or zero would be a nice supportive move for the banks, which make up a quarter of the market," said Moore, chief equity strategist.
The euro and European equities became more attractive after Emmanuel Macron emerged the victor in France's presidential election last month. He beat Marine Le Pen, who wanted to take the country off the euro.
Europe is still not without its political risks. The U.K. has a parliamentary vote Thursday, and while Prime Minister Theresa May is expected to see her Conservatives win a majority, some polls in the past week threw that in doubt. May sought the election as a way to gain a strong mandate for Brexit, and any upset of that could impact U.K. stocks.
"If you buy the FTSE 100 because May's going to win, then everything is going to be okay. If you buy the FTSE 100 and if May doesn't win, the currency gets hit and that's good for earnings," said Marc Chandler, chief foreign exchange strategist at Brown Brothers Harriman.
There's also Italy that may have an early general election this fall, and there is concern the antiestablishment Five Star party could make gains.
"If the Italians schedule elections at the same time as the Germans, it seems really dumb," said Christopher. "If they do, that may give the markets some additional pause."
Sanchez said there is always political risks in the markets, but there is now less in Europe since the French election is over. For the United States, there is policy risk as investors worry President Donald Trump's pro-growth agenda has stalled out.
"Europe does have a lot to prove," Moore said, noting there are investors who were disappointed with the quality of earnings over the last six years. "I think there are a lot of investors who think this is a market to rent, not to own."
"We upgraded Europe at the end of last year. I think we have been quite positively surprised about how strong the earnings were in the fourth quarter. If there hadn't been a slew of positive surprises and there hadn't been strength across multiple sectors, that would have been a warning," she said.
"The challenge would be if you have a huge amount of inflows without a continued improvement in fundamentals. There were such outflows out of European equities in both actively managed and passively managed funds," said Moore, adding that investors want to see positive economic and earnings trends continue for multiple quarters.
