Overview:
- Theme YTD has been to focus on Europe at U.S. expense
- Hedged foreign equity ETFs have seen record inflows as USD continues to surge
- Euro could be poised for a rally which means the crowded European-hedged ETFs may come under pressure
- If USD corrects we could see U.S. earnings estimates improve
So far the bullish themes for this year are foreign equities and U.S. bonds with the continued surge in the USD. These themes are borne out when looking at flows into exchange traded funds (ETFs) by asset class and geographic region. This can be seen in the table below that looks at ETF flows from the start of the year through March 26th in which domestically-focused equity ETFs witnessed nearly $7.3B in outflows while internationally-focused ETFs saw $36.6B in inflows or a jump of nearly 9% in assets in just the first quarter alone. Looking at the fixed income market we see the opposite in which domestic bond ETFs have brought in significantly more money than internationally-focused bond ETFs by nearly a 25:1 margin. Why? The USD remains the strongest currency in the world and U.S. interest rates still carry a decent spread relative to other global government bond yields.
Source: Bloomberg
Drilling down into international ETF flows, the bulk of growth in assets has been seen in European-focused ETFs followed by Asia Pacific and Asia-Pacific ex Japan while investors continue to shun the BRIC (Brazil, Russia, India, China) countries and emerging markets. European region ETFs have seen their assets grow by more than 50% in the first three months of the year with Asian-focused ETFs witnessing 9.5-11.5% growth in assets under management.
Source: Bloomberg
Looking at some the this year’s most successful U.S. ETFs bears out the trends mentioned above with the largest growth seen in WisdomTree’s Europe Hedged Equity ETF (HEDJ), which saw nearly B worth of inflows as the fund’s assets nearly doubled in the first three months of the year. The other trend seen in popular ETFs this year are hedged ETFs that protect against foreign currency weakness.
Source: Bloomberg
Given the strength in the USD in the last year investors are right to hedge their foreign equity exposure. Currency weakness has been one of the big drivers in foreign equity markets as they race to debase their currency to stimulate their economies. We’ve seen how powerful the devaluation in the Japanese Yen has been for the Nikkei 225 stock market index. The initial decline of just over 25% in the Yen helped fuel the more than 80% rally in the Nikkei from late-2012 to the middle of 2013. We’ve seen a similar decline in the Euro relative to the dollar where the European Stoxx 50 Index has rallied over 30% since the October 2014 lows.
After that initial 25% decline in the Yen it began to consolidate through the rest of 2013 and through most of 2014 before resuming its decline. As it consolidated its gains so too did Japanese equities and we could be in store for a consolidation in European equities as well for several reasons.
Perhaps chief among them is that nothing moves in a straight line regardless of the fundamentals. Trends often get stretched and lead to a natural countertrend move. The fundamental linkage between the Euro and USD exchange rate in relation to the relative size of the Fed and ECB’s balance sheet is clear as seen below but what is also clear is that investors have likely jumped the gun by discounting most the expected increase in the ECB’s balance sheet relative to the Fed. As seen below, the Euro has slid to more than a five-year low while the Fed/ECB balance sheet rate still remains elevated based on the history of the last five years and suggests the Euro decline may be overdone.
Source: Bloomberg
There is a fundamental catalyst for the Euro to rally and that’s an improved economic outlook. Looking at the Citigroup Economic Surprise indices for various global regions shows the Eurozone economic reports have been surprising on the positive side while U.S. reports are surprising the most relative to its global peers on the downside. The spread between the European and U.S. surprise indices has reached an extreme and should pressure the EUR/USD exchange rate higher in the coming weeks.
Source: Bloomberg
The positive economic surprises in Europe should continue as leading economic indicators for the region point towards a continued acceleration in economic growth. ECB M1 money supply growth rates have jumped to the highest level in years and suggests Eurozone GDP should also begin to accelerate ahead.
Source: Bloomberg
With the improved economic outlook we should see a stronger currency as the Eurozone tends to follow the M1 supply growth rates which have been moving sharply higher recently with the linkage between the EUR/USD exchange rate and leading indicators shown below.
Source: Bloomberg
In addition to an economic fundamental reason for the Euro to rally relative to the USD there is also sentimental positioning to consider which has reached extremes in both the USD and the Euro. Net speculative long futures positions as a percentage of total open interest is at a bullish extreme which typically occurs near a top in the USD.
Source: Bloomberg
On the flip side we see net speculative short futures positions relative to total open interest for the Euro are near the lows seen over the past decade and at levels that marked the large 2012-2014 rally.
Source: Bloomberg
I began highlighting these reasons for a coming correction in the dollar starting about a month ago (see here and here) and we have seen the dollar pull back from its highs since that time. That said, I do not think the correction is over and there is still more downside to go. For example, I monitor the percentage of foreign currency USD pairs that are above various moving averages from short-term moving averages (10-day) to longer term moving averages (200- day). If the dollar is getting ready to correct, then more and more foreign currency pairs to the USD will be above short-term moving averages (10-day) which will then show an increase in currency pairs above intermediate-term moving averages (20-day) as the correction matures.
Shown below are 34 USD-pairs that measure how far exchange rates are above various moving averages (for example, the Russian ruble is 8.89% above its 50-day moving average relative to the USD). When I showed this table a month ago perhaps two thirds of the currency pairs were above their 10-day moving average and one third were above their 20-day moving average relative to the USD. Today, we see that roughly 80% of currency pairs are above their 10-day moving average and 76% of currency pairs are above their 20-day moving average as the near-term weakness in the USD begins to gather steam on a global basis.
Source: Bloomberg
Should the Euro appreciate relative to the USD ahead that may put the brakes on the currency tailwind European equities have enjoyed and lead to a pullback in European equity ETFs, even more so in those that hedge the currency like the WisdomTree Hedge Europe Equity ETF (HEDJ). On the other hand, U.S. equities which have been shunned by investors may get a decent bid should the USD correct which has depressed earnings as large multinational corporations are taking a hit due to the currency as well as commodity sectors like energy and basic materials. A USD correction should lift the sales of the large blue chips that dominate the S&P 500 and would provide a lift to the energy sector which makes up 7.94% of the S&P 500. Should the USD correct, analysts are likely to ratchet up their earnings estimates for the S&P 500 would help bring down valuations somewhat and could spark profit taking in European equities and a movement back into U.S. equities.
My guess is that a pullback in the USD and a rally in the Euro should last several weeks to perhaps a month or two. That said, I do not expect the dollar to end its bull run that began last year nor the Euro to arrest its bigger-picture decline given the slated purchase of assets by the European Central Bank (ECB) to the tune of more than a trillion Euros through September 2016 while Janet Yellen and the U.S. Fed appear determined to raise short-term interest rates within the next year.
Instead, we could be in for a consolidation that sees U.S. equities outperform their European counterparts for several weeks to a month before the Euro resumes its bearish trend and fuels a further European equity rally. Relative to the starting point of central bank balance sheets since 2008, the ECB has a lot of catching up to do with the Fed, Bank of England (BOE), and Bank of Japan (BOJ) and during this “catch up” period the Euro is likely to weaken further relative to the USD.
Source: Bloomberg
Summary
The decline in the Euro has created a powerful tailwind for European equities that has led to a large exodus from US-focused equity ETFs and into European ETFs, particularly hedged European funds. However, the Eurozone economy is expected to improve in the coming months which should lend support to the Eurozone despite continued QE as I argued previously (click for link) that the USD initially rallied with QE 2 and 3 in the US. Additionally, futures positioning has hit an extreme and is ripe for a short-covering rally in the Euro and capitulation in the USD.
We appear to be already witnessing the first signs of a top in the USD as the majority of global currency pairs relative to the USD are already above their short-term and intermediate-term moving averages as the rally against the USD gathers breadth.
If we do see a correction in the dollar and a rally in the Euro the move should not be long lasting given the large amounts of money printing by the ECB over the coming year, but the pullback will serve to help remove some of the excessive bearish froth in the Euro and bullish sentiment in the USD. During this time we could see U.S. equities outperform European peers as the downgrading of U.S. earnings estimates stemming in large part from a vicious USD rally reverse.
Megacap stocks with the greatest share of foreign sales as well as those with a commodity-focus like energy and basic materials should outperform the broad indices that would lend support to the argument that the USD is topping. For a sign that the USD correction is gathering steam I’d look at a decline in the USD Index below its 50-day moving average. Absent that, this could merely be a small pullback in the USD as it defies gravity, though I personally lean to this being the “real McCoy” as fundamental and sentimental catalysts appear to be aligned. Time will tell.
