A resilient US economy, underscored by a hawkish sounding Fed amidst a tightening labour market is preparing investors for a very likely first rate hike since 2004. By lagging several years behind the US recovery, the QE-induced low interest rate environment should remain Eurozone’s crucial support driver for at least until 2016. The diverging policies between the Fed and ECB may widen the interest rate gap between the US and Eurozone. This being fundamentally dollar supportive while undermining the euro, it potentially adds to more euro volatility and depreciation risk. WisdomTree Europe Equity UCITS ETF - USD Hedged (HEDJ) offers investors exposure to a basket of export tilted Eurozone stocks that hedges the euro-dollar exchange rate risk.
US Fed looks beyond commodity slump and seasonality to justify potential tightening
Last month’s meagre GDP growth in Q1 for the US economy was broad-based, attributed to a slowdown in consumer spending, downturns in private investments, exports and state and local government spending. Only increased inventory build-up and federal government spending has worked to offset the weaknesses. And yet despite of this Fed Chairman Janet Yellen gave the clearest signal yet to end the six-and-a-half-year stretch of near-zero interest rates as it looks to hike the Federal funds target rate sometime later this year. As the world’s largest economy is expected to accelerate, there could be no better signal for investors to stay invested in risk assets, most notably in European equity markets that have a strong export exposure and hence cyclical bias to US.
The outlook for US economic activity this year is likely to improve and driven in part by two factors that have slowed down, if not distorted US economic growth this year: the sharp fall in crude oil prices last year negatively impacting the energy sector’s production and investment activity (particularly with respect to shale oil producers) and the harsh winter delaying consumer spending. Both have contributed to the US entering a state of temporary disinflation and weaker domestic demand. However, the stable if not somewhat higher outlook on crude oil prices for 2015 has created a much brighter inflation picture. Because, aside from the stabilizing oil prices’ dissipating base effect of year-on year changes to CPI readings, the years of persistent gains in the jobs market have started to feed through into tighter labour market conditions as the pressure on employers to raise (minimum) wages this year has steadily been building up. This, combined with the summer season that is expected to reverse the weakness in private spending in Q1 as a result of the harsh winter should provide for much stronger demand driven US growth over the summer.
ECB’s QE-induced yield suppression works to contain the euro
With tighter monetary conditions in the US raising inflation expectations and along with it, real and nominal US interest rates, the euro is likely to remain subject to increased volatility. This because with the ECB firmly in exceptional monetary easing mode, the interest rates in the Eurozone will remain actively suppressed. The potency of the ECB controlling sentiment in Europe’s credit markets this way should not be underestimated, as has been demonstrated this month when it announced to accelerate its QE program in anticipation of weaker bond market liquidity conditions in July and August. This has happened to coincide with a sharp sell-off in Eurozone bond markets amidst growing unease over the record low bond yields of German Bunds (with the 10 year issue yielding less than 20 bps at the end of April). Following the ECB’s announcement, tensions have since dissipated and at around 60 bps, the yields on 10 year German Bunds remain anything but appealing, let alone normal. When considering a robust growing German economy to likely post inflation rates well above 1 percent as recovering oil prices feed through, the long dated German bond yields should in fact be potentially much higher in the absence of QE and more closely aligned to the bond yields of US Treasuries. But until QE is wound down at the earlier in 2016, the artificially low interest rate environment is likely to prevail, not least because falling Eurozone bank lending rates leave little room for higher deposit rates, and he risk of contagion.
The contrasting monetary policies between the Fed and the ECB show the extent to which the Eurozone lags behind the US recovery and economic expansion: The ECB announced its QE program in January 2015, more than two years after the Fed announced its QE3 program in 2012 ($40 billion of agency mortgage-backed securities per month in September, $45 billion of US Treasuries per month in December). The result is that the interest rate spread between the US and the Eurozone is expected to remain large for a considerable period, and may even grow wider as upward pressure on interest rates in the US is building up. On chart 1 the long dated bond yield differential between US Treasuries and German Bunds is about 150 bps, a significant yield gap that favour US assets over German (and most if not all Eurozone) assets. This lack of relative fundamental support is likely to be one of the main drivers of a volatile path for the euro-dollar exchange rate and its potential to depreciate further.
The irony is that a weak euro managed by the ECB’s QE policy is helping the bullish sentiment in Eurozone equities to sustain itself. Hence, foreign investors incurring the exchange rate risk may want to consider a currency hedged exposure to Europe’s equity market so as to isolate the potential downside currency returns from the potential upside equity returns. By focussing on stocks with significant export exposure, the WisdomTree Europe Equity UCITS ETF - USD Hedged offers investor an investment that is sensitive the euro-dollar exchange rate. Faced with divergent monetary policies between the Fed and the ECB that may last several years, the ETF may offer investors an efficient bearish euro-dollar, bullish Eurozone equities allocation. Investors sharing this sentiment may consider the following UCITS ETF:
All data is sourced from WisdomTree Europe and Bloomberg, unless otherwise stated.
WisdomTree Europe Ltd is an appointed representative of Mirabella Financial Services LLP which is authorised and regulated by the Financial Conduct Authority. The value of an investment in ETPs may go down as well as up and past performance is not a reliable indicator of future performance. An investment in ETPs is dependent on the performance of the underlying index, less costs, but it is not expected to match that performance precisely. ETPs involve numerous risks including among others, general market risks relating to the relevant underlying index, credit risks on the provider of index swaps utilised in the ETP, exchange rate risks, interest rate risks, inflationary risks, liquidity risks and legal and regulatory risks. ETPs offering daily leveraged or daily short exposures (“Leveraged ETPs”) are products which feature specific risks that prospective investors should understand before investing in them. Higher volatility of the underlying indices and holding periods longer than a day may have an adverse impact on the performance of Leveraged ETPs. As such, Leveraged ETPs are intended for financially sophisticated investors who wish to take a short term view on the underlying indices. As a consequence, WisdomTree Europe Ltd is not promoting or marketing BOOST ETPs to Retail Clients. Investors should refer to the section entitled "Risk Factors" and “Economic Overview of the ETP Securities” in the Prospectus for further details of these and other risks associated with an investment in Leveraged ETPs and consult their financial advisors as needed. Within the United Kingdom, this document is only made available to professional clients and eligible counterparties as defined by the FCA. Under no circumstances should this document be forwarded to anyone in the United Kingdom who is not a professional client or eligible counterparty as defined by the FCA. This marketing information is intended for professional clients & sophisticated investors (as defined in the glossary of the FCA Handbook) only. This marketing information is derived from information generally available to the public from sources believed to be reliable although WisdomTree Europe Ltd does not warrant the accuracy or completeness of such information. All registered trademarks referred to herein have been licensed for use. None of the products discussed above are sponsored, endorsed, sold or promoted by any registered trademark owner and such owners make no representation or warranty regarding the advisability on dealing in any of the ETPs.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, its officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.