iShares MSCI Germany: Will Likely Outperform European Stocks if Recovery Holds

Since the European Union��s (EU) founding in the early 1990s, the currency union has been criticized for being just that: a monetary union that attempts to embrace fragmented fiscal interests and concerns. And while this monetary union might have worked initially with its 12 core member states, there are now 23 countries using the euro while pursuing their own fiscal interests.

Because of the EU��s lack of fiscal unity, a monetary and fiscal crisis was largely inevitable. The EU��s founding members hoped that somehow fiscal unity might emerge over time. Over the past 25 years, however, Europeans have been slow to address the issues that have prevented them from achieving a greater degree of fiscal unity.

But after two years, the continent��s sovereign-debt crisis reached a critical stage that finally compelled leaders of member nations to take action.

During a meeting earlier this month, European heads of state struck a deal aimed at restoring order to the region��s economy and financial markets. The tentative fiscal compact would limit budget deficits by member states and create sanctions to enforce budget discipline.

Unfortunately, doubts abound as to the extent to which the deal can truly be implemented. The proposed fiscal rules aren��t going to be incorporated into a customary EU treaty, so each country will have to adopt the rules as they would any other law in their home jurisdictions. As a result, the rules are subject to each member nation��s political process, whether that involves parliamentary debate or ratification via referendum. As such, there is substantial political risk that the new rules may not survive this process in some countries.

The markets haven��t given the proposed deal a vote of confidence; the euro recently hit an 11-month low, equity prices in the region have continued to fall and yields on Italian bonds are rising once again.

This pessimistic reaction is understandable, but such pessimism is largely overblow! n.

The primary concern is that the EU will ultimately splinter as a result of this crisis, but that��s an unlikely outcome.

That��s because the consequences of a breakup �� particularly if it��s not handled in an orderly fashion �� would be dire. From an economic standpoint, the EU��s raison d'��tre is to facilitate trade within the region, which would collapse in the event of a breakup.

And dissolution of the currency union would require the reintroduction of former national currencies. As a result, citizens would be anxious to move their cash into the countries which have the strongest national currencies. That would spark bank runs which, in turn, would require nations to introduce capital controls and recapitalize their now isolated banking systems, as well as restrict the movement of both people and currency across their borders. In order to fund those efforts, private assets would have to be seized and hyperinflation would be a likely consequence. Naturally, social disorder would be rampant in the midst of this activity. That��s not an environment conducive to friendly trade.

There are orderly ways in which a dissolution could be handled which largely sidestep many of the unpleasant consequences of a drastic change. But the temper of the European public is not favorably disposed to these changes.

So European governments have heavy incentive to keep the currency union together and transform what was initially an experiment into a viable long-term societal evolution.

Germany stands to gain the most from a eurozone resolution even though it may be liable for financing the bulk of the deal.

Presently, the EU is tentatively committed to funneling EUR200 billion into the International Monetary Fund, about a quarter of which will likely be funded by Germany.

With Germany��s deep trade ties in the region, that��s a small investment to ensure markets remain open to its goods and services. On the other hand, Germany is bet! ter posi tioned to weather a collapse of the EU.

For one, Germany also has extensive trade relations outside of Europe: 6.7 percent of annual German exports are bound for the U.S. with a further 4.7 percent going to China. So while a disintegration of the EU would be a shock for German exporters, they don��t rely solely on the EU for revenue.

And if the Deutsche mark were to be revived, the former German national currency would be one of the strongest currencies in Europe due to the conservative monetary policy of the Bundesbank, Germany��s central bank.

Because of this relatively positive outlook, shares of iShares MSCI Germany Index (NYSE: EWG) remain undervalued in our opinion.

The exchange-traded fund (ETF) tracks the country��s 50 largest companies. The ETF��s portfolio has significant exposure to companies that derive a sizable percentage of their earnings outside the EU, including industrial companies involved in emerging-market infrastructure projects. We expect the gross domestic product (GDP) of emerging market nations to continue growing at a pace at least double that of the developed world, so that should cushion earnings for German blue chips.

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