The economic recovery in the Eurozone is accelerating as the final quarter of the year gets underway, with stronger output growth in October for the four biggest economies – Germany, France, Italy, and Spain. Eurozone equity markets as a whole have been outperforming. The one-month return (to November 9) for the iShares Currency Hedged MSCI EMU ETF, HEZU, was 4.30%; and the year-to-date gain was 12.48%. We are referring to an ETF that removes the effect on US dollar returns of the depreciation of the euro versus the US dollar over these periods. In comparison, the iShares MSCI ACWI ex US Index Fund ETF, ACWX, was down over the past month by 1.91% and also for the year to date by 3.19%. The US market also has not done as well. The one-month advance in the SPDR S&P 500 ETF, SPY, was slightly less than for HEZU, 3.35%, and the year-to-date gain was significantly less, 2.72%. In this note we discuss the Eurozone economy and equity markets and the importance of currency developments for US dollar-based investors.
The latest indicator of output growth in the Eurozone economy, the Markit Eurozone Composite Purchasing Managers Index (PMI) for October, signaled increasing output in both the manufacturing sectors – in other words, a broad-based upturn. Expansion in the services sector was slightly stronger than that in manufacturing. It is important to bear in mind that services account for 74% of Eurozone GDP. A small upturn in new orders was reported, and job creation increased. Business confidence, however, is not tracking these stronger activity readings. Markit reported that in October business confidence in the Eurozone slipped to one-year lows, particularly in Spain and Germany. Concerns about the slowdown in emerging market economies and the prospect of higher interest rates in the US appear to be the leading causes. Our base case forecast is that the Eurozone’s lagging business confidence, which is shared with businesses around the globe, will be reversed as the economic recovery gradually quickens. Nevertheless, these gloomy expectations are a clear warning that there remain significant downside risks in the global outlook.
The OECD has just released its latest economic outlook, which foresees a modest upturn in the global economy from the current year’s growth of 2.9% to 3.3% next year and 3.6% in 2017. The projected recovery in the Eurozone economy is also modest, from 1.5% this year to 1.8% next year and 1.9% in 2017. For 2016, Ireland again is projected to be the growth leader at 4.1%, but that is a slowdown from this year’s 5.6%. Of the big-four economies, Spain’s growth is also projected to slow, from 3.2% to 2.7%. The other three are all projected to have stronger growth next year as compared to 2015: Germany, 1.8%; France, 1.3%; and Italy, 1.4%. These forecasts look reasonable to us. The solid growth of 1.8% for the zone should be assured by the expected expansion by the European Central Bank (ECB) of its quantitative easing in December. Corporate profits are likely to strengthen, helped by a weaker euro and improving bank credit conditions, and this should help the recovery of investment.
Looking at the four largest economies in the region, the powerhouse, Germany, has recently recorded a sharp plunge in exports along with weak industrial production and new orders. Business expectations have also deteriorated, although they remain positive. The Volkswagen scandal is an understandable concern. On the other hand, household spending remains healthy; and service sector activity, accounting for about 69% of GDP, accelerated in October, with increasing employment. German exports look likely to recover as strong demand from advanced economies offsets the weakness in demand from emerging market economies. In Italy, both the manufacturing and service sectors advanced at faster paces in October. Manufacturing growth in France picked up somewhat in the third quarter but continues to look fragile. Industrial production slowed notably in September. On the positive side, household demand looks relatively strong, although weakness in the labor market remains a constraint. Growth in the Spanish economy is moderating but will continue to advance at one of the strongest paces in the Eurozone. Domestic demand continues as the main driver. Businesses have reportedly become more wary because of the political uncertainties related to the upcoming general election.
One way to participate in the Eurozone recovery is to invest in single-country market ETFs. The iShares Currency Hedged MSCI Germany ETF, HEWG, advanced 6.12% over the past month and 8.80% year-to-date. The unhedged iShares MSCI Germany ETF, EWG, advanced just 0.84% and declined 1.72% over the same periods. The differences in performance between the hedged and unhedged ETFs, of 5.28% for the last month and 10.52% for the year to date, are due to the decline in the euro versus the US dollar. In the case of the other three largest markets, we have to look at unhedged ETFs. (The new hedged ETFs for Spain and Italy are too new to use.) The iShares MSCI France ETF, EWQ, was down 0.97% over the past month, probably reflecting the midsummer weakness in the economy. The year-to-date advance was 5.03%. Italy’s market has been even weaker over the past month: the iShares MSCI Italy Capped ETF, EWI, declined 5.65%. However, it is still up 7.52% year-to-date. Despite Spanish economic growth that is considerably stronger than in the other three economies, Spain’s ETF, the iShares MSCI Capped ETF, EWP, declined 5.39% over the past month and has fallen 9.30% year to date. Evidently, political uncertainty and the recent moderation in growth are the causes. The smaller markets for Belgium and Netherlands are also worth considering, but there are no hedged ETFs for these markets.
Another approach that avoids having to decide which national Eurozone markets are most likely to outperform is to invest in an ETF that covers the whole Eurozone. The capital-weighted iShares Currency Hedged MSC EMU ETF discussed in the opening paragraph does this well. Its main country weights are France, 32.8; Germany, 28.9; Spain, 11.1; Netherlands, 9.13; and Italy, 8.4. Another example is the WisdomTree Europe Hedged Equity ETF, HEDJ, which targets dividend-paying firms and screens for firms that get at least 50% of their sales from exports outside the Eurozone.
The significant gain thus far this year from hedging against declines in the euro versus the US dollar, described above with reference to Germany, should not be overlooked. In the period between March and the latest meetings of the ECB and the Federal Reserve, the euro-US dollar appeared to be range-bound. However, more recently – particularly following the strong US employment data released last week – investors have become convinced that the Fed will finally move to raise interest rates in December. As the ECB is expected to be moving in the other direction in December, expanding its quantitative easing program and quite possibly further reducing the discount rate, the euro’s decline versus the dollar has resumed and looks very likely to continue.
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