IS IT EURO € TIME?
Many US investors have avoided European markets over the last several years as US markets have surged with a strong dollar while other developed markets struggle. Is it time to take a fresh look at international opportunities? Some evidence suggests that it may be time to take another look at global investing.
Dollar $ vs. Euro €
This story has been building momentum over the past nine months. From 6/30/14-3/31/15, the U.S. dollar surged in value against a basket of major currencies. The U.S. Dollar Index (DXY) rose by 23.3% over that period. While most U.S. investors probably think of a strengthening dollar in terms of its potential impact on the value of any foreign securities they may be holding, there is also the question of how it may impact U.S. stocks, and the U.S. economy. Some investors were paying attention a few years ago when U.S. stocks were rallying off the weakness in the dollar. A report released on 4/10/15 by Citi Research, a division of Citigroup Global Markets, concluded the following about the dollar’s influence on equities: “The dollar generally has not determined stock price direction for the broad market but there is some correlation with large and small caps, though the relationship is not consistent.”
There is a big difference the last 12 months ending February when the EAFE was up 13% in local currency, but with the strong dollar, EAFE was flat in USD. Investors may want to consider indexes or managers who hedge out the currency exposure from their international portfolios to protect against moves like that.
The strong dollar eventually has a self-correcting effect. Cumulatively, international sales account for 30-40% of revenue for companies in the S&P 500. As the dollar strengthens, our goods and services become more expensive globally vs. European competitors; gradually weakening the dollar as demand for Euros rises. There is no alarm that will go off notifying us of the end to this cycle but we can see some evidence. George Soros, a relatively successful forward thinker, recently moved his $2 billion in outside managed hedge funds into European equity….unhedged!
So what are other factors pointing to a more imminent economic expansion in the Eurozone leading to potentially stronger international equity markets?
1. Strong dollar makes European goods and services attractively priced.
As discussed above, a weak Euro helps the value of their goods and services as dollar denominated products become much more expensive.
2. Oil as a catalyst for improved Euro earnings. Most of Europe is a net buyer of oil so lower prices lowers production expenses and improves profits without the offsetting GDP impact of lower profits for natural resource companies like we have in the U.S.
3. Quantitative Easing by the ECB. Europe is years behind the USA in launching a quantitative easing program. European Central Bank (ECB) President Mario Draghi recently announced the launch of an open-ended, expanded monthly 60 billion euro ($70 billion) private and public bond-buying program. The long-anticipated introduction of euro zone government bond purchases, which could amount to as much as a trillion euros, will mean the ECB will join the U.S. Federal Reserve, Bank of England and Bank of Japan in launching a quantitative easing (QE) scheme. The program will be open-ended, lasting until at least 2016, Draghi told reporters at his regular media conference. The hope is that it will boost the region’s painfully low inflation rate, which came in at an annual minus 0.2 percent in December.
4. Exports as a percent of GDP. Exports play a much larger economic role in the Eurozone than in the United States. According to a 2012 study by the World Bank, exports account for 44.75% of the European economy and only 13.52% in the U.S. This would suggest that a weaker Euro could have a much larger impact on the European economy and perhaps be reflected in improving equity market valuations.
5. International markets are cheaper than the US market. In the near-term, the rise in the value of the dollar is expected to have some influence on corporate earnings results for Q1’15. Earnings reporting season commenced on 4/8/15. As of the third week in March, nearly 20% of S&P 500 companies had warned investors on their Q1’15 earnings, with at least 49 companies mentioning that the dollar’s strength did influence results, according to Reuters. In that release, Wolfgang Koester, chief executive of FiREapps, a foreign exchange data analytics firm, estimated that North American public companies could give up more than $25 billion in revenues in Q1’15, due to currency-related volatility. Koester estimates that the strong dollar dinged earnings by approximately $18.66 billion in Q4’14. If the dollar continues to rally moving forward, we believe that some companies could move to implement currency hedging strategies to help mitigate the hit to earnings. Reuters noted that while hedging can help multinational companies with currency issues, most firms do not hedge 100% of their exposure.
As for European markets, the forward P/E ratio for the next 12-month consensus EPS is still lower than that of the S&P 500. On top of this, European stock earnings are still depressed relative to the peak whereas the US has rebounded. With their massive QE still in the early stages, the markets have plenty of upside potential.
Source: MSCI, FactSet, J.P. Morgan Asset Management. Forward Price to Earnings Ratio is based on each index price, divided by consensus estimates for earnings per share (EPS) in the next 12 months (NTM) and is provided by FactSet Market Aggregates. Past performance is not indicative of future returns. Data are as of March 31, 2015.
While many factors can influence the value of a fiat currency at any given time, such as trade, central bank monetary policy, wars and geopolitical events, investors should always try to keep an eye on the bigger picture. Despite all of the fluctuations in the dollar since 2007, which includes the 2008-2009 financial crisis, global nominal GDP still rose from $57.46 trillion in 2007 to $77.30 trillion in 2014, or an increase of $19.85 trillion, according to the International Monetary Fund. For comparative purposes, nominal GDP in the U.S., which is the world’s largest economy, stood at $17.70 trillion at the close of 2014, according to Bloomberg. World economic output has expanded by an amount larger than the size of the U.S. economy in just the past seven years. That is amazing considering the turbulent times we have experienced.
In closing, while we cannot anticipate the length and strength of currency moves, the Euro has moved into territory that many believe give foreign corporations a meaningful competitive advantage vs. their US counterparts. This advantage could certainly be reflected in top line revenue growth and profitability for European companies. Adding the introduction of Quantitative Easing by the ECB could be a strong catalyst for rising valuations in the European equity markets.