This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
In recent weeks, I’ve discussed increased US market volatility—some of which is due to eurozone uncertainty. Invesco PowerShares believes the long-term outlook for European stocks is favorable. The eurozone accounts for just over 17% of global GDP – second only to the United States – and the strength of the US dollar relative to the euro has made European exports more affordable in world markets. I expect a devalued euro, coupled with more stimulative monetary policy, to give a lift to European stocks well into 2016.
Near-term, however, investors in European equities may experience a bumpier ride.
Quantitative easing exacerbates currency risk
The European Monetary Union itself has generated headwinds to growth, due to inherent disparities between European Central Bank (ECB) policy goals and the divergent needs of member countries. A case in point is Greece, which requires a weaker currency than its peers to support tourism, but can’t get that with the euro. Additional overhangs include overstretched equity valuations and uncertainty about whether eurozone economies can maintain consistent growth rates.
To jump start the economy, the ECB has recently begun the process of quantitative easing. Policy makers in Brussels have slashed the refinancing rate – a rough equivalent to the US federal funds rate (the rate at which banks lend balances to each other overnight) – to the point of creating negative deposit rates throughout the eurozone. This has exacerbated foreign currency risks.
European equities historically volatile
Today’s currency concerns are just the latest chapter in the story of European volatility: European equities have generally demonstrated more volatility than US stocks over the past 10 years. As you can see from the chart below, the volatility of the MSCI EMU Index was 14% greater than that of the S&P 500 Index from 2003 through 2014 – and that’s with the EMU index denominated in euros. In US dollar terms, the MSCI EMU Index was 37% more volatile than the MSCI EMU local currency index over this same period, and 56% more volatile than the S&P 500.1
A two-pronged approach to volatility and foreign currency risk
So how can one maintain exposure to the potential long-term growth of European markets, while buffering against volatility and currency risk? Investors facing this conundrum may wish to consider strategies that emphasize low volatility stocks and currency hedging.
This week, Invesco PowerShares introduced the PowerShares Europe Currency Hedged Low Volatility Portfolio (FXEU). FXEU uses a low volatility index methodology in concert with a foreign currency hedge.
Here’s how it works: FXEU tracks the S&P Eurozone Low Volatility USD Hedged Index. The 80 holdings in this index are weighted inversely to their volatility, so that stocks with the lowest volatility receive the highest weights. The portfolio is then hedged to the US dollar using one-month forward contracts.
FXEU provides a compelling exchange-traded fund solution for investors looking to help mitigate volatility and foreign currency risks, while capturing the growth potential of investing in European stocks.