Implications for Equity Investors
All this talk about taking additional monetary policy measures to counter the deflationary trends caused by the euro’s strength leads to a natural question: What about the large flow of assets that has gone toward European equities banking on a growth recovery? The vast majority of the investment products in the United States targeting exposure to Europe should consider two sources of risk:
1) Equity Market Risk: Exposure to movements in local European equity market prices
2) Currency Risk: Exposure to the movements of the euro and other European currencies such as the Swiss franc and the British pound against the U.S. dollar
Why take the additional currency risk when the head of the ECB is telegraphing very plainly that he does not want to see the euro appreciate much further and, if it does, he will take action? Further ECB monetary easing could be beneficial to growth in the economy, helping companies’ profits.
But these programs potentially render the currency exposure a source of unrewarded volatility. Therefore, one should very strongly consider currency-hedging European equities.
If this sounds familiar, it should. This was a central case in 2013 for Japan, a country that has seen the strong yen fuel a cycle of deflationary trends for much of the last 15 years. The head of its central bank unleashed an unprecedented monetary easing program to dislodge deflation and was rather successful, seeing the beginnings of an inflationary cycle in the first year. Current inflation readings in Japan are three times the inflation levels of Europe (1.5% inflation in Japan versus 0.5% inflation in Europe).5 No one is expecting Draghi to embark on as bold a program as the Bank of Japan, but at least he seems to be moving in that direction. This can be seen as a positive step for the eurozone, but again, why would one want to assume euro risk when seeking to access exposure in this region?
1Source: Chris Giles and Claire Jones, “ECB Preparing to Unleash Unconventional Monetary Policy,” Financial Times, 4/12/14.
2Stefan Riecher and Catherine Bosley, “Jordan Says SNB Minimum Exchange Rate Extremely Important,” Bloomberg, 4/14/14.
3Source: “Weidmann Says ECB Quantitative Easing Not Out of the Question,” Reuters, 3/26/14.
4Source: Kiran Moodley, “Nowotny: Strong Recovery Will Ward Off Deflation,” CNBC.com, 4/11/14.
5Source: Bloomberg, with Japanese inflation measured by the Japan Nationwide Consumer Price Index and European inflation measured by the Eurozone Consumer Price Index. Most recent available data as of 3/31/14.
Important Risks Related to this Article
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Investments focused in Europe or Japan may be significantly impacted by events and developments associated with the region, which can adversely affect performance.