Foreign currency risk, low overseas yields make a case for currency hedging and low volatility equity strategies.
The euro continued its slide against the US dollar after European Central Bank (ECB) President Mario Draghi hinted that the ECB’s program of quantitative easing would likely continue through the year and possibly expand in December. Draghi stated that the ECB is “willing and able to act by using all the instruments available within its mandate,” and added that those instruments could include lowering overnight deposit rates.1 The news pushed the euro down to $1.1108 – its lowest level since Aug. 19.2 The ECB’s accommodative tone also prompted the German two-year note yield to plummet 30 basis points to -0.3%.
What does this news mean for US investors with exposure to Europe?
Against a backdrop of negative interest rates, equities are one of the only ways to generate return on capital in Europe. (After all, investing in short-term paper raises the specter of negative returns.) Dividend-paying stocks are a particularly compelling option, in my view.
The ECB’s lack of confidence in economic growth is an indicator of economic risk, and highlights the need for downside equity protection. Stocks are driven by earnings, and earnings growth currently appears uncertain — particularly given the ECB’s statements. Low volatility strategies can be an attractive option in this type of environment. Of course, low volatility cannot be guaranteed.
Negative yields at the short end of the yield curve in Germany present additional risk to the USD/EUR exchange rate. Given these negative rates, capital flows are more likely to stay clear of Europe, putting further pressure on the value of the euro, in my view. Already, the spread between the US two-year Treasury note and the German two-year note is 93 basis points – its widest level since the mid-2000s.
Spread- German 2-year note vs US 2-year Treasury note
Source: Bloomberg, L.P., Oct. 22, 2015
Japanese questions remain
Japan is experiencing similar outcomes for slightly different reasons. The Japanese economy shows signs of softening and it appears the trade sector is feeling the pain of slower global growth. Japanese exports increased only 0.6% on a year-over-year basis in September, and have decelerated of late.2
Source: Bloomberg, L.P., Oct. 22, 2015
This weaker export profile may lift the USD/JPY exchange rate further, while presenting profit risk to Japanese firms. Monetary policy in Japan is unlikely to change in the short term and could be a headwind to higher interest rates.
In addition, Bank of Japan (BOJ) Governor Haruhiko Kuroda went on record in mid-October stating that the BOJ would continue quantitative easing until inflation stabilizes at 2%. Underscoring potential risks, the Citigroup Economic Surprise Index has declined from over 100 in July to a recent reading of 8.8, indicating a loss of economic momentum relative to expectations.3
What does this mean for US investors in Japanese securities?
The Japanese two-year year bond is hovering around 0.01% and offering little return.2 Low rates in Japan provide little reason to hold the yen, in my view.
As in the eurozone, however, this low rate environment presents a reason to own equities for return potential, as well as a need to help mitigate potential foreign exchange risks.
Institutional investors that know the Japanese market well are putting their capital in equities. The Wall Street Journal recently noted that Japanese life insurance companies were buying Japanese stocks for yield and improved returns.3
1 European Central Bank, Oct. 22, 2015, www.ecb.europa.eu/press/pressconf/2015
2 Bloomberg, L.P., Oct. 22, 2015
3 The Wall Street Journal, Oct. 23, 2015, www.wsj.com/articles/japans-life-insurers-shift-investments-to-domestic-equities-1445519021
Volatility measures the amount of fluctuation in the price of a security or portfolio over time.
Spread represents the difference between two values.
One basis point equals one one-hundredth of a percentage point.
The fed funds rate is the rate at which banks lend balances to each other overnight.
The Citigroup Economic Surprise Indices quantitative measures of economic news – defined as weighted historical standard deviations of data surprises. A positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus. The indices are calculated daily in a rolling three-month window.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the Underlying Index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The economies of the countries in the Asia Pacific region are largely intertwined, if an economic recession is experienced by any of these countries, it will like adversely impact the economic performance of other countries in the region.
Currency hedging can reduce or eliminate losses or gains and can also be subject to imperfect matching between the derivative and its reference asset. There is no assurance the fund’s hedging strategy will be effective. Some foreign currency forward contracts are less liquid, which may result in the fund being unable to structure its hedging transactions as intended and may be unable to obtain sufficient liquidity in an underlying currency. As a result, the fund’s hedging transactions may not successfully reduce the currency risk included in the fund’s portfolio.