The euro continued its slide against the US dollar after European Central Bank (ECB) President Mario Draghi hinted that the ECB’s program of quantitative easing would likely continue through the year and possibly expand in December. Draghi stated that the ECB is “willing and able to act by using all the instruments available within its mandate,” and added that those instruments could include lowering overnight deposit rates.1 The news pushed the euro down to $1.1108 – its lowest level since Aug. 19.2 The ECB’s accommodative tone also prompted the German two-year note yield to plummet 30 basis points to -0.3%.

European conundrum

What does this news mean for US investors with exposure to Europe?

  • Against a backdrop of negative interest rates, equities are one of the only ways to generate return on capital in Europe. (After all, investing in short-term paper raises the specter of negative returns.) Dividend-paying stocks are a particularly compelling option, in my view.
  • The ECB’s lack of confidence in economic growth is an indicator of economic risk, and highlights the need for downside equity protection. Stocks are driven by earnings, and earnings growth currently appears uncertain — particularly given the ECB’s statements. Low volatility strategies can be an attractive option in this type of environment. Of course, low volatility cannot be guaranteed.
  • Negative yields at the short end of the yield curve in Germany present additional risk to the USD/EUR exchange rate. Given these negative rates, capital flows are more likely to stay clear of Europe, putting further pressure on the value of the euro, in my view. Already, the spread between the US two-year Treasury note and the German two-year note is 93 basis points – its widest level since the mid-2000s.

Japanese questions remain

Japan is experiencing similar outcomes for slightly different reasons. The Japanese economy shows signs of softening and it appears the trade sector is feeling the pain of slower global growth. Japanese exports increased only 0.6% on a year-over-year basis in September, and have decelerated of late.2

Japanese exports

This weaker export profile may lift the USD/JPY exchange rate further, while presenting profit risk to Japanese firms. Monetary policy in Japan is unlikely to change in the short term and could be a headwind to higher interest rates.

In addition, Bank of Japan (BOJ) Governor Haruhiko Kuroda went on record in mid-October stating that the BOJ would continue quantitative easing until inflation stabilizes at 2%. Underscoring potential risks, the Citigroup Economic Surprise Index has declined from over 100 in July to a recent reading of 8.8, indicating a loss of economic momentum relative to expectations.3

What does this mean for US investors in Japanese securities?

  • The Japanese two-year year bond is hovering around 0.01% and offering little return.2 Low rates in Japan provide little reason to hold the yen, in my view.
  • As in the eurozone, however, this low rate environment presents a reason to own equities for return potential, as well as a need to help mitigate potential foreign exchange risks.
  • Institutional investors that know the Japanese market well are putting their capital in equities. The Wall Street Journal recently noted that Japanese life insurance companies were buying Japanese stocks for yield and improved returns.3

Amid these conditions, investors might wish to consider a multi-factor strategy that incorporates a low volatility screen and currency hedge. PowerShares recently launched the PowerShares Japan Currency Hedged Low Volatility Portfolio (FXJP), a Japan-only, currency-hedged, low volatility smart beta ETF, as well as the PowerShares Developed EuroPacific Currency Hedged Low Volatility Portfolio (FXEP), which offers exposure to Europe, Japan and developed parts of the Pacific Rim using a low volatility approach with currency hedging to mitigate downside risk.

1 European Central Bank, Oct. 22, 2015, www.ecb.europa.eu/press/pressconf/2015

2 Bloomberg, L.P., Oct. 22, 2015

3 The Wall Street Journal, Oct. 23, 2015, www.wsj.com/articles/japans-life-insurers-shift-investments-to-domestic-equities-1445519021

Read more blogs by Nick Kalivas.

Important information

Volatility measures the amount of fluctuation in the price of a security or portfolio over time.

Spread represents the difference between two values.

One basis point equals one one-hundredth of a percentage point.

The fed funds rate is the rate at which banks lend balances to each other overnight.

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