[Editor’s Note: This special report on the Eurozone economy is part of Money Morning’s annual “Outlook” series, which will forecast the prospects for commodities, U.S. stocks and other top profit opportunities in the New Year. Make sure to watch for upcoming installments in the days and weeks to come.]

If you wanted to describe how most of the European nations fared in 2010, you would do so quite easily by citing the old adage: “If it wasn’t for bad luck, they’d have no luck at all.”

Truth be told, Europe was in the news for most of 2010 – but for all the wrong reasons. A series of financial panics hit the weaker Eurozone countries hard, forcing draconian austerity measures in many countries and igniting concerns that the euro may not survive as a currency.

Against such an unappealing backdrop, it’s no real surprise that any positive information tends to be overlooked.

And that’s truly unfortunate, since for much of Europe – and for its stock markets – 2011 should be a pretty good year.

Better Than It First Appears

[ad#Google Adsense]For 2011, the team of forecasters for The Economist is projecting 1.3% growth for the Eurozone (the 16 out of 27 EU countries that use the euro currency). At first blush, that appears to be decidedly inferior to the projected U.S. growth rate of 2.3%.

But it’s not that simple: You must also factor in the reality that the Eurozone’s annual population growth is only 0.1%, versus 1.0% in the United States. Once you do that the growth rates are almost identical – 1.2% in the Eurozone versus 1.3% in the United States.

What’s more, the overall European rate of growth masks some big divergences between countries.

For instance, Europe’s overall performance is being held back by a group of underperformers, whose economies are growing slowly, or even declining. For instance, Greece’s gross domestic product (GDP) is expected to decline 3.6% in 2011. Other laggards (with their GDP growth/decline rates in parentheses) include Portugal (minus 1.2%), Italy (plus 0.9%), Italy (plus 1.0%) and Spain (plus 0.4%, an estimate I believe is highly over-optimistic).

In those countries, the austerity necessary to remain members of the euro community will cause some real economic pain. Factor those out, and it’s clear that Europe contains some real bright-spot economies.

When East Pursues the West

As has been the case for the past decade, the best growth rates continue to be among the countries of Eastern Europe. Those economies are still catching up to their Western counterparts in terms of their living standards, and are often more-free market in their orientation.

Poland is expected to grow at a brisk 3.8% pace. Latvia and Slovakia are both expected to post growth rates in excess of 3%. And the economies of Lithuania and Estonia will each advance at rates approaching 3%.

When the recession hit in 2008, these countries were expected to do particularly badly – with Latvia, Estonia and Lithuania written off as basket cases. As it’s turned out, however, after a horrendous 2009 that saw their GDPs dropped by more than 10%, all three Baltic states are now rebounding nicely – as is Slovakia.

Poland, whose currency was not linked to the euro, was able to absorb recession through devaluation. It’s now racing ahead even faster.

There have been some losers, however – those countries of Eastern Europe that were genuinely badly run. One example: Hungary. Growth is expected to be only 2% and debt levels are dangerously high.

Engine of Growth

Last but not least, there is Germany. The Economist panel is projecting growth of only 2%. But that’s almost certainly another example of Anglo-American economists underestimating Germany’s real potential. Its growth rate in 2010 is actually expected to be 3.3%.

Germany now has a substantial labor cost advantage over its neighbors in the euro community, and is growing relatively rapidly, as the costs of absorbing the former East Germany fade into the past.

As was the case back in the 1980s, Germany is one of the world’s great growth economies, with a structural trade surplus due to the efficiency and quality of its manufacturing. The euro, holding down Germany’s exchange rate through the inefficiencies of its European neighbors, only accentuates this trend and increases Germany’s growth potential.

As an investor, your portfolio needs exposure to Europe; it’s a huge part of the world economy, and growth and profitability in the better parts of Europe are highly satisfactory.

However, not many European companies are readily available to U.S. investors these days: As we warned you about several years ago, the expensive Sarbanes-Oxley registration requirements have driven many of them to cancel their Big Board (New York Stock Exchange) listings. That means that your best bets are one or more of the attractive-country exchange-traded funds (ETFs) that are available.

Actions to Take: Investors need to have capital deployed in Europe. It’s a huge and very-key part of the world economy, and growth and profitability in the better parts of Europe are highly satisfactory.

Exchange-traded funds may be the most effective ways to do this. Choose one or more from this list:

  • iShares MSCI Germany Index Fund (NYSE: EWG): This ETF covers Germany, currently Europe’s strongest economy, an export dynamo recovering rapidly on the basis of some of the world’s soundest economic policies. At $1.6 billion, with a 0.55% expense ratio, a Price/Earnings (P/E) ratio of 11 and a yield of 1.4%, this fund should be a core holding of any portfolio, even if other investments are mostly domestic.
  • iShares MSCI Sweden Index Fund (NYSE: EWD): Americans tend to think of Sweden as a dozy, socialist economy, but it has actually revived itself considerably in the aftermath of a horrid crisis in the early 1990s. While not ignoring the tragic events of this past weekend, it’s important to note that the World Economic Forum has recently rated Sweden as the world’s second-most competitive economy, ahead of the United States (which is in fourth place). EWD is a $250 million fund, with a low 0.55% expense ratio; the P/E is a bit higher at 15, though the fund’s yield is a respectable 2.1%.
  • iShares MSCI Eastern Europe Index Fund (NYSE: ESR): This is a small fund, at only $14 million, but it gives you access to the growth areas of Eastern Europe, where it is very difficult for U.S investors to invest directly. Its expense ratio is a slightly higher 0.70%, but its P/E ratio is only 10. And we all know that a low P/E and a higher growth is more often than not a winning combination.

— Martin Hutchinson

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Source:  Money Morning