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For Europe ex UK investors, the strong euro has been a godsend. Performance is likely to be schizophrenic in the year ahead, warn managers.

From mid-2005, Europe’s late recovery was driven by cheap money and lazy credit conditions. The crunch changed all that and European economies heavily reliant on housing markets quickly felt the pinch.

Six months ago, Spain was enjoying 20-year-lows in unemployment as housing continued to sprout along the Costas and around Madrid and its biggest companies were leveraged up for a worldwide spending spree. Now the bubble has burst and unemployment is suddenly at a nine-year high. Local retail investors have deserted the market, house prices plummeted and new-home starts have crashed.

Feras Al-Chalabi of the Odey Continental European fund points to other countries facing similar problems. The Celtic Tiger has fled as the Irish speculative property bubble burst and he warns: “Those reliant on their housing markets will continue to suffer.”

In general, the weakest EU economies, called PIIGS (Portugal, Italy, Ireland, Greece, Spain), are best avoided in the near term. Emerging Europe has also gone from darling to dearth. Countries such as Hungary face ballooning debt repayments, having borrowed heavily in euros as their national currencies fell.

Mr Al-Chalabi predicts German growth will be down from 2.7 per cent last year to 1.3 per cent this year. But the country has fared far better as housing has a lower impact on the overall economy. The average home costs €210,000 (£166,245), almost the same price it attracted 15 years ago.

Germany has cut costs and made its industry far more efficient, by as much as 15 per cent, compared with cost increases of 30 per cent in Italy over the same period. MAN and Daimler had threatened to move jobs eastward to crush union protests, slashing jobs and curtailing pay demands in the process. With wages making up 60 per cent of European costs, they posted impressive profit gains.

But the lid cannot be kept in place forever. German steel workers recently asked for 8 per cent and got 5.2 per cent. German rail workers wanted 31 per cent. With headcounts trimmed to the bone, overtime is on the up and Deutschland AG is having to recruit – at a price.

European sectors tell a similarly mixed story.

“Banks were clear shorts for as long as the liquidity crisis persisted. Now they are just not interesting,” says Mr Al-Chalabi. He now draws similarities with the telecoms sector that bought assets at high prices with a great deal of leverage, before facing massive writedowns and regulatory action in 2003.

France Telecom’s share price was €20 five years ago and remains there today. Regulator intervention hampers investor returns, thinks Mr Al-Chalabi, and will do the same for banks.

Food retailers stand out in the consumer market as most able to ride out the choppy markets and inflation bugging Europe. While big names are far fewer than in the UK, the likes of France’s Carrefour and Holland’s Ahold can pass on food inflation and increase margins at the same time. If French consumers can swallow a recent 10 per cent hike in cheese prices, other nations are sure to follow, he says.

Elsewhere in consumer, the picture looks rather bleak. Aside H&M (Hennes) and Inditex (Zara), quoted retailers are thin on the ground on Europe’s high streets. Those that exist have suffered and weak consumer confidence will not make their situation any better.

Not surprising, conditions have made fund performance difficult but have provided a cushion against sharp Anglo-Saxon credit-crunch markdowns. Over the year, Europe ex UK dropped just 2.6 per cent to the end of April, compared with a fall of 8.5 per cent for UK All Companies.

Fund managers admit returns could have been worse, had it not been for the sharp appreciation of the euro on the world’s currency markets. Having traded between 65 pence and 70 pence, it spiked 20 per cent in six months recently.

Britain and America have switched focus to supporting their fragile growth rates, but the ECB is holding out at 4 per cent, a rate in place since June last year and before the credit crunch took place.

Not surprisingly, the stance has made the euro an attractive buy, good news for European importers, bad news for exporters and for anyone looking for a cheap bargain break in Paris, Barcelona or Rome.

Rensburg Sheppards’ chief investment officer Chris Hills says that even small changes in the euro’s relative positioning against other currencies now make a big difference. He says: “Historically, most currency transactions were based on natural trade. Portfolio capital trades and derivatives are now much larger and are opening up the arbitrage market. For sterling investors, it has been a huge bonus. Index performance has been rather pedestrian but it certainly looks nice in sterling terms.”

The strong euro has added between 10 per cent and 15 per cent as the currency stealthily takes over from the dollar as the world’s favourite currency and the ECB battles inflation that hit 3.6 per cent in March.

Thankfully, the strong euro is not yet hurting the Mittelstand, Germany’s small and medium businesses that drive the country’s economic growth. They are reaping the rewards of Asia’s boom, being among the only companies still able to produce the complex machinery needed for certain manufacturing processes.

But all has not been plain sailing. Tim Cockerill from IFA Rowan & Co Capital Management has been disappointed by performance on some of his core European fund holdings.

Cazenove European, run by Chris Rice, held its own with its benchmark-orientated large-cap stance. But Schroder European Alpha Plus lost 4.51 per cent, enough to push it into the fourth quartile as manager Leon Howard-Spink’s mid and small caps took a battering. Mr Cockerill says: “He is a logical manager, but when markets become driven by rumour and sentiment, these types of managers struggle.”

Equally hit was Artemis European Growth. The SmartGARP tool is always behind the curve in volatile markets, explains Mr Cockerill. But while existing investors may not be best pleased with its 7.78 per cent losses now could be a good time to buy into the fund.

As is often the case, Neptune funds remain top of the tree. Mr Cockerill says performance looks good but risky strategies such as an inventive use of gold ETFs last year makes their profiles an unsuitable fit for his investors.

Neptune European Opportunities tops the sector over three and five years by a considerable margin. Shorter-term figures were boosted by ditching financials ahead of other players, says Rob Burnett, head of European equities.

He says: “We have been generally defensive. We also sold industrials and materials a bit early but then got that all back in quarter four and the first quarter of this year.”

He is optimistic about the prospects for Europe, feeling more bullish than at any time in the last 12 months. Banks are still off his shopping list in general, although a few private banking operations and brokers are creeping into his portfolios. Cash is down from 20 per cent to just 7 per cent and set to fall lower as he makes pro-rata increases across the portfolio.

Raj Shant, head of the European equities team at Newton, says progress to the end of the year could prove schizophrenic, highlighting the extremes between the Franco-German economies and the rest of Europe, and between large and small caps.

Like construction, European car manufacturers could also be undone by the liquidity crisis. Not only is consumer spending likely to fall, but many producers will find their over-reliance on providing finance rather than on manufacturing itself will falter as cheap credit dries up.

Mr Shant adds: “Finance deals are just brought-forward sales. They also face more bad debt as we go through the year and even if debt is not on the books, they will struggle to find the credit they need to keep the finance going.”

The same applies to bigger ticket retailers, including furniture stores, and Mr Shant believes many of their woes have yet to materialise.

Private equity has all but disappeared, leaving European mid caps stranded as real and theoretical buyouts evaporate. Outperformers from 2000 to mid 2007, mid caps have fallen hard but still have further to go. That said, mid-cap agriculture, materials and energy stocks could do well as their sectors hold out against further batterings.

Hugo Greenhalgh is editor of Investment Adviser