In a global context, currency dynamics are a major component of investors’ total returns. In addition to positive currency effects, unhedged portfolios typically outperform hedged portfolios because: 1) the cost of hedging subtracts from hedged portfolio returns; and 2) fallible human beings often get the direction of the hedge wrong.

However, adverse foreign exchange (FX) swings can completely wipe out any gains one might see in local currency terms. That’s why it’s important to identify equity markets that move in the same direction as their currencies, and Eurozone stocks are a good example. Contrary to popular belief, there has been a direct relationship between the euro/U.S. dollar spot exchange rate and the performance of Eurozone equities relative to U.S. stocks since 2003 (Exhibit 1).

Exhibit 1: There’s been a direct relationship between the euro/U.S. dollar spot exchange rate and the performance of Eurozone equities

As for the claim that you can’t have euro and European equity strength at the same time, history shows that a stronger euro relative to the U.S. dollar has coincided with the outperformance of European stocks relative to U.S. equities.

Why? It’s a classic “flow” argument. As foreign capital flows into Eurozone equities, it lifts the euro. Rising shares and an appreciating currency attract additional investor flows into euro-denominated stocks. It’s a virtuous, self-reinforcing cycle.

Modest economic growth in the U.S. and a firming macro backdrop in Europe suggest the U.S. dollar is unlikely to be a barrier for U.S.-based investors. True, the euro has appreciated significantly in a short period of time. However, long-term purchasing power parity (PPP) models indicate the euro is still only fairly valued, suggesting plenty of room for more upside.

Conceptually, the recent strength of the euro is a modest headwind to Eurozone earnings. Vis-à-vis the U.S. dollar, the euro has appreciated by 6.7% on a year-over-year basis. Nonetheless, the MSCI Euro Index’s 12-month forward earnings per share (EPS) are up 10.9% year-over-year, 0.4% faster than the MSCI USA Index’s 12-month forward EPS growth. Clearly, the domestic European economic recovery is a stronger tailwind for European earnings.

The bottom line for investors: After a tumultuous decade, the long-awaited revival of European corporate profits is finally upon us. Eurozone companies are being rewarded by higher expectations for earnings growth and the future is bright, given the upward trajectory of leading indicators of business activity in the European Union.

Read our accompanying white paper for more reasons why we think European stocks should continue to outperform U.S. equities.