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).
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.
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The MSCI Europe Index represents the performance of large- and mid-cap equities across 15 developed countries in Europe, including Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and United Kingdom.
The MSCI USA Index is designed to measure the performance of the large and mid- cap segments of the US market
The indexes are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Fund. Past performance does not guarantee future results.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Equities are subject to market risk and volatility; they may gain or lose value. Investments in securities of growth companies may be especially volatile. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Eurozone investments may be subject to volatility and liquidity issues. The mention of specific countries, regions, or sectors does not constitute a recommendation by any particular fund or by OppenheimerFunds, Inc.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.