One of the most important trends in the markets in 2014 has been the rise of the U.S. dollar and the collapse of the euro and the yen. We’ve written a lot about utilizing hedged equity strategies to isolate international equity markets without adding the layer of euro and yen exchange rate risk. We believe the exchange rate risk to be a critical factor influencing returns and think investors should concentrate on the local equity opportunities in these regions without the currency volatility.
The euro and the yen are the two currencies at the focal point for international investors given central bank trends, but below we show how a combination of these two markets tracks to a few broad international benchmarks.1
Divergent Monetary Policies in Europe and Japan = Potential for Currency Weakness
In looking at the central bank policy landscape today, the big story tilting away from the side of aggressive easing is the United States Federal Reserve (Fed), which ended its program of bond purchases during 2014. On the opposite end of the spectrum, the most aggressive “monetary easer” is the Bank of Japan (BOJ), with the European Central Bank (ECB) exploring further easing options. A greater degree of monetary easing could lead to a greater degree of currency weakness for the euro and the yen compared to the U.S. dollar.
Taking Action in Developed International Markets
The euro and the yen are also the two biggest currency exposures in most traditional benchmarks targeting developed international stocks. For instance, within the MSCI EAFE Index, Europe—specifically the markets utilizing the euro currency—(approximately 31%) and Japan (approximately 21%) comprise just over 50% of the total Index and exist in approximate 60%/40% proportion to each other.2
Given that Japan’s and Europe’s respective policy landscapes are bringing them into focus, we show how a 60% Europe/40% Japan hedged equity blend3 compares to the MSCI EAFE Index both in local currency and U.S. dollars.
The WisdomTree Hedged Equity Blend: Close Tracking to MSCI EAFE Equities (as of 11/25/2014)
• In 2014, the year-to-date differential from the WisdomTree Europe/Japan (60/40) blend over MSCI EAFE in U.S. dollars was more than 10 percentage points. This shows just how important currency was as a driver of international returns in 2014.
• The WT Hedged Blend Performs Well Compared to EAFE in Local Currency: Over this period, we can see clearly that the blend outpaced the EAFE in local currency. The correlation between the two was actually 0.95—a very high number—showing how closely tied these two markets are to the overall international benchmarks.
• Japan Drives the Relative Gains: Over the past two years, Japan has been a robust generator of strong equity market returns—returns that if unhedged would be significantly cut by the depreciation of the yen. As we have written here, we remain optimistic on prospects for Japan from a standpoint of valuation as well as increased flows from the Bank of Japan, the Japanese pension funds and other institutional investors.