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Any investor who anticipated the U.S. dollar to weaken against its major rival euro this year would have done well by investing in European stocks.
The iShares MSCI Eurozone ETF EZU, +0.70% is up 21% year to date, compared with a 11% gain for the SPDR S&P 500 ETF SPY, +0.22% But nearly two-third of the gains for European stocks are due to a 12% rally in the euro against the dollar. The same index is up only about 8% in local currency.
The rally in European stocks has not gone unnoticed by U.S. strategists who have dialed up their exposure in client’s portfolios.
This short-term performance of European stocks is only one example of positive currency impact and can be used as a great marketing prop to entice U.S. investors who had been hesitant to diversify thus far.
But short-term currency fluctuations work both ways. The same European ETF underperformed the SPDR S&P 500 ETF in 2016, for example. And a rising euro can be a headwind for export-oriented European companies.
Over the short term, hedging when investing in foreign assets is one way of dealing with the negative impact of a fluctuating currency.
But over the long term, the impact of currency fluctuation on returns is not significant enough to bother with hedging, according to David Kelly, chief global strategist at J.P. Morgan Funds.
In a note to investors on Monday, Kelly wrote that staying out of European stocks due to uncertainty over the dollar is a bigger mistake, as the difference in currency rates disappears in the course of several years.
“Four broad forces determine the movement of exchange rates: trade flows, financial flows, exchange rate policy and speculation on the exchange rate itself. In the short run, the last of these tends to be more powerful than the others,” said Kelly.
The Federal Reserve began raising interest rates in December 2015, while the European Central Bank is still providing quantitative easing by purchasing assets—a scenario that taken at face value would be expected to result in dollar strength.
The ECB, however, is widely expected to begin winding down its purchases in 2018, beginning the process of normalizing policy. That anticipation, underpinned by strengthening eurozone economic data, has been credited with helping to lift the euro, while softer U.S. data and political turmoil are seen undercutting the dollar.
Relying on Wall Street forecasts for clarity on the dollar moves wouldn’t have been all that useful either. At the end of last year, foreign exchange analysts’ predictions ranged from parity at $0.97 to as high as $1.15, according to Wall Street Journal.
On Tuesday, the euro EURUSD, +0.0847% was trading at $1.18, trading near its highest since January 2015, and up about 12% against the dollar year to date.
The dollar is likely to weaken against the euro over the next several years due to trade and financial flows, according to Kelly. If he turns out to be right, U.S. investors can expect to pick up additional returns in European stocks.
On trade, the U.S. is running a current trade account deficit equal to 2.5% of GDP while the eurozone has a trade surplus of 3.3% of GDP, he noted.
“When Americans buy German cars or French wine, they have to first sell dollars and buy euros, increasing the supply of the former and the demand for the latter,” Kelly said. “A steady U.S. trade deficit and European trade surplus should push the dollar down and the euro up.”
Financial flows are more complex. While higher U.S. interest rates have attracted foreign flows into U.S. bonds and helped boost the dollar and prospects for Fed tightening, much of the move has already been built into investor expectations, he said. And since the start of the year, U.S. Treasury yields have drifted lower, while German bund yields have risen, reducing the relative attractiveness of U.S. bonds.
But even without the currency tailwind, the case for European equities is strong: they are still more attractive than U.S. due to lower valuations, higher dividend yield and better earnings prospect, Kelly argued.