Could European Stocks Post Surprise Reversal This Year?

While global investors have shunned European equities this year, fund managers tell CNBC they are beginning to grow their exposure to the region’s battered stocks, with expectations of a pick-up in the second half of the year.

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Increasing clarity over how policymakers are going to resolve the European debt crisis as well as low valuations will support European stocks, according to Richard Harris, Chief Executive at Port Shelter Investment Management, who says they could even outperform their U.S. peers this year.

“We are at a stage where the U.S. (economy) may start rounding off and Europe may start to recover. We could see a surprising reversal of relative performance there. One market has been whacked – and another market has done quite well - I think the market will look to equalize those,” Harris said.

“There’s a big fighting fund (in Europe) now – we could see a small pickup in growth and there’s a good chance that overall equity markets there will be underpinned,” he added, noting that he is beginning to rotate out of the U.S. into European equities, which he had previously been underweight.

There are already signs of a small recovery for European stocks. The FTSEurofirst 300, which tumbled after Greek voters dealt a blow to pro-bailout parties in the first election held on May 6, has recovered somewhat in recent weeks.

Still, stocks in Europe are now trading at a cheaper valuation than the U.S. The S&P 500 is currently trading at a price-to-earnings ratio of 12.8, while the U.K.’s FTSE 100and France’s CAC 40 are trading at around 9.5 times 2012 earnings.

JP Morgan Asset Management’s Global Strategist, Geoff Lewis, says he added a tactical overweight position in Europe equities last month.

“They (European stocks) have been oversold, and if they get some good news – in terms of (policymakers) going ahead with setting up the EU wide banking system - they could have a bit of a bounce,” he said.

Franklin Templeton’s Global Equities Group, which is overweight European equities, also sees value in the region’s stock markets.

"Investors fleeing Europe as the crisis unfolds may miss potential opportunities to own quality companies at bargain prices,” Heather Arnold, Executive Vice President and Director of Research at Templeton Global Equity Group, said in a note on May 24.

“With more than 60 percent of corporate sales from European firms originating internationally, the long-term prospects of well-diversified European multinationals are less correlated with their domestic macroeconomic outlook than the market appears to believe,” she added.

US Stocks to Decline

Harris says he doesn’t think U.S. markets will extend their gains over the second-half, pointing to the recent disappointing macro-economic data including the unemployment report, which showed that jobs growth was tepid for a fourth straight month in June.

“We are seeing this drip, drip, drip of not very good news coming out of the States – look at the employment data, inflation is low, growth is slowing – the arrows are pointing more south than north. The stock markets like growth, but if the stock markets see there’s little growth in the U.S., this could drive the rotation out of the U.S.,” he said.

The U.S. second quarter earnings season, which kicks off on Monday, will be an important signal for investors.

The aluminum maker Alcoa, the first to report earnings, is expected to post only a 5-cent per share second-quarter profit, compared with 32 cents per share in the same quarter last year, according to Reuters.