3 ugly-duckling investments

By Jon Markman

If there are three asset groups or sectors that the conventional wisdom suggests should be avoided right now, they are industrial Europe, high-yield bonds and municipal finance. Yet all three have intriguing features that should be appealing for investors who are not averse to taking on a little risk in a modestly improving investment environment. Let's take a quick look at each of them.

The center of the industrial economy in Europe is Germany, and what a disaster it has become in the past year and a half. The German economy plummeted at a record pace in the first three months of this year, by around 14.4% annualized, or more than twice as much as the U.S. decline. Exports fell 9.7% in the first quarter, and business investment fell 7.9%.

The country's major automakers -- Volkswagen (VLKAY, news, msgs), Porsche (POAHF, news, msgs), BMW (BAMXF, news, msgs) and Daimler (DAI, news, msgs) -- have suffered unprecedented sales declines. Leading electronics giant Siemens (SI, news, msgs) and asset manager Allianz (AZ, news, msgs) have seen 75% drops in growth and their share prices. National unemployment is 8.3%. Every stat reveals the worst economic conditions since World War II.

But there is a growing sense now that businesses and consumers worldwide cut back on their orders for European goods more sharply than called for by economic conditions last winter, giving the efficient German economy an opportunity to defy its critics and stage a stunning rebound. Manufacturing orders and exports rose in April, and business confidence is advancing sharply. Consumer spending rose 0.5% in the first quarter. And fiscal stimulus ordered by Chancellor Angela Merkel has been much stronger than expected: at least $115 billion already, and counting.

German stocks rose 16% between April 1 and May 25, as forward-looking investors tried to bet on a lasting, if slow, recovery.

The profitability of low expectations

So economists and policymakers must be excited, right? Not at all, as most shellshocked analysts who failed to foresee the downturn now give the Continent little chance at making a full recovery in the next few years, much less the next few months, calling it a drag on the global economy. German banks, telecommunications service providers and industrial giants are all expected to flat-line at best this year, then work back into growth mode very slowly by mid-2010 as they pay dearly for building up excess capacity via debt and undue optimism in the mid-2000s.

Yet this pessimism may be an overreaction, if recent industrial output trends are to be believed. German business confidence rose to a six-month high in May, according to data released this week, pointing at minimum to stabilization at a relatively low level. Considering that it had been falling continuously for 14 months, the upturn is welcome relief of the sort that has augured rebounds in the past.

Pessimism is so deep that lousy expectations will be relatively easy to surpass. Why could Europe shock the world by not falling into the Atlantic as quickly as pessimists expect?

Part of the reason is structural: German, French, Swiss, Belgian and Dutch consumers are not suffering their nations' economic troubles nearly as much as Americans due to labor laws that make it hard to fire workers and then offer generous unemployment packages. In short, they have a lot more to spend than their U.S. counterparts due to a strong social safety net. If demand from China, India and other emerging markets for German machinery picks up as much as current forward-looking data suggest, factories will be humming again soon, and the period of lag when consumers paused will look slim.

The European Central Bank may be the only institution with a firm grip on this reality. It had been criticized for 18 months for not acting to lower interest rates as aggressively as its peers in the United States, the United Kingdom and Japan. But pretty soon it may be lauded for doing the best of the three at preventing its economies from overheating in their initial stages of recovery and keeping inflation at bay.

The largest exchange-traded funds tracking Continental economies -- iShares Germany (EWG, news, msgs), iShares Austria (EWO, news, msgs), iShares Sweden (EWD, news, msgs), iShares Netherlands (EWN, news, msgs) and iShares Switzerland (EWL, news, msgs) -- all crashed last year but have stabilized for five to six months and turned higher. They're not cheap but will be buyable in small quantities for risk takers if their prices fall.

For the least risk in the most diverse economy, you may wish to start with iShares Germany. This is a country where big business really is big: Just seven companies -- Allianz, Siemens, drug maker Bayer, business software maker SAP (SAP, news, msgs), chemical maker BASF (BASFY, news, msgs) and carmakers Daimler and Volkswagen -- account for 49% of the ETF's holdings. Expectations are dismal, which means that news doesn't have to be good to support shares -- just not catastrophic.

Continued: Doomsday discounts

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