Of course, it’s hard to go wrong with Germany, which proved its mettle during the financial crisis and has emerged as the strongest economy in the beleaguered region. Indeed, the Credit Suisse Germany Index has risen roughly 90% in the past half-decade, nearly matching the gains of the S&P 500.
Yet U.S.-based investors haven’t done quite as well. The sharp drop in the euro has led to a huge impact on portfolio returns. For example, the iShares MSCI Germany fund (EWG) has fallen roughly 6% since the start of 2014, while the WisdomTree Germany Hedged Equity ETF (DXGE) has risen roughly 12.5% in that time.
That gap has led many investors to pose a simple question: to hedge or not to hedge? The answer is not quite as straightforward.
Currency markets are all about reversals. A drop in one currency tends to alter trade balances and foreign direct investment flows to the point where the stronger currency (in this case, the U.S. dollar) tends to see outflows and an eventual pullback.
This time around, that trend may not play out so neatly. While Europe is embarking on massive bond-buying and is expected to keep interest rates at ultra-low levels, the United States Federal Reserve has already completed its bond-buying program and is expected to soon start raising rates. As a result, the factors that have pushed the euro lower may stay in place for some time to come.
Cumberland’s Kotok thinks the currency shift has ample time to play out. He figures the euro, which is currently worth around $1.10, is headed to parity with the dollar in the near term, and perhaps to below 90 cents over the long haul.
“The euro has been below 85 cents before, and that level may represent the long-term clearing price,” Kotok says. That view is shared by economists at Goldman Sachs, who also think the dollar will materially strengthen against the euro in coming quarters.
A weaker currency should set the stage for export strength in Europe, which is a key theme for certain strategists. “Europe is a much bigger exporter—relative to their GDP—than the U.S., so they’re really depending on stronger world growth,” says BBH’s Chandler.
Buying Time
Economists note the ECB’s massive bond-buying program was primarily intended to buy time for European companies to enact badly needed structural reforms. The process is under way across the Continent, with mixed degrees of success. “Spain has certainly done the right reforms to comply with EU loan packages,” says James Hunt, a portfolio manager at Tocqueville Asset Management.
BlackRock’s Koesterich also thinks Spain is making tangible progress, which should help to unshackle the historically constrained economy. “You’re going to see a solid rebound in Spanish consumer demand,” he predicts.
Alessandro Valenti, a portfolio manager at Causeway Capital, is a big fan of Spain’s CaixaBank (CAIXY). It is the country’s largest bank focused on the domestic economy. (Rivals such as Banco Santander have vast operations outside of Spain as well.) “Management is working very hard to unlock value by exiting non-core real estate segments,” he says, adding that the moves should free up a lot of capital to return to shareholders in the form of dividends.
The Margin Gap
At first blush, European stocks aren’t a profound bargain relative to U.S. stocks. The S&P 500 is valued at around 16 times projected 2016 profits while the Stoxx Europe 600 is valued at roughly 15 times next year’s earnings. But on a price-to-book basis, a sharper disparity emerges.
Ron Saba, a senior managing director for Horizon Investments, notes that European stocks trade for only two times book while American stocks trade for three times book. “The U.S. continues to get more expensive while Europe has not,” he says.
Europe Rumbles To Life
September 1, 2015
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