WisdomTree recently introduced the new WisdomTree Europe Local Recovery Index, which is designed to provide exposure to the more local side of the European economy by excluding companies whose business is dominated overseas as well as the more defensive sectors of the market.
The Index construction process for this new Index is designed to favor more cyclical sectors and those that are more responsive to changes in the economic growth environment, using one of our favorite leading indicators of the economy: the European Commission’s Economic Sentiment Indicator.
Sector Mix That Has Responded to the Economic Sentiment Indicator
While it’s clear that the sectors we’ve included have tended toward both higher correlations to the Economic Sentiment Indicator and higher responsiveness to equity market movements when viewed in isolation, below we further our case by illustrating how our sector screens for this Index have corresponded to changes in the leading economic indicator used in the Index weighting methodology.
To approach this question, we looked at two subsets of Index blends.
• Included Sectors: The WisdomTree Europe Local Recovery Index includes stocks from the Consumer Discretionary, Energy, Financials, Industrials, Information Technology and Materials sectors. We created a blend of these sectors while maintaining sensitivity to the country exposures of the WisdomTree Europe Local Recovery Index as of September 30, 2015.1
• Excluded Sectors2: The WisdomTree Europe Local Recovery Index excludes stocks from the Consumer Staples, Health Care, Telecommunication Services and Utilities sectors, and we created an equally weighted blend to represent a more defensively oriented positioning.3
Bottom Line: If the blend of included sectors tends to outperform the blend of excluded sectors during periods when the European Commission’s Economic Sentiment Indicator is increasing, it shows an effective positive relationship between the two.
Included Sectors Have Outperformed Excluded Sectors When the European Commission’s Economic Sentiment Indicator Has Been Expanding
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• Performance during Expansions: Here we define expansions as periods in which the European Commission’s Economic Sentiment Indicator increased by 10% or more over the previous 10 years. There were three such periods, and in each case, the blend of included sectors outperformed both the MSCI EMU Index and the blend of excluded sectors.
• Performance during Contractions: Conversely, we define contractions as periods in which the European Commission’s Economic Sentiment Indicator decreased by 10% or more over the previous 10 years. There were two such periods, and in each case, the returns of the included sectors underperformed those of both the MSCI EMU Index and the blend of excluded sectors. These were also challenging environments for the market in general, with the big decline in the sentiment indicator occurring during the global financial crisis, when the MSCI EMU Index fell by more than 50%.
These results align with what we think are natural expectations—cyclical sectors had a tendency to outperform as perceptions of economic growth improved, whereas defensive sectors had a tendency to do the same as those perceptions declined.
Much of the macroeconomic work suggests that the eurozone’s local economic recovery is in its early stages.4 We believe the WisdomTree Europe Local Recovery Index is well positioned for such a growth outlook.
1Blend of included sectors: The blend of included sectors relates to the mixture of sectors allowable for inclusion within the WisdomTree Europe Local Recovery Index, adjusted proportionately for the country exposures of this Index as of 9/30/15. Blend comprises solely MSCI Indexes as follows: MSCI France Consumer Discretionary Index, 9.66%; MSCI France Industrials Index, 9.66%; MSCI France Financials Index, 9.66%; MSCI France Information Technology Index, 4.83%; MSCI France Energy Index, 2.76%; MSCI Germany Financials Index, 8.97%; MSCI Germany Industrials Index, 8.97%; MSCI Germany Consumer Discretionary Index, 8.28%; MSCI Germany Materials Index, 4.14%; MSCI Germany Information Technology Index, 2.76%; MSCI Italy Financials Index, 11.72%; MSCI Italy Consumer Discretionary Index, 4.14%; MSCI Italy Industrials Index, 2.76%; MSCI Spain Financials Index, 4.83%; MSCI Spain Consumer Discretionary Index, 4.14%; and MSCI Spain Industrials Index, 2.76%.
2Subsequent to Index screening, it is possible that a current constituent may spin off a subsidiary company that may be classified as a Consumer Staples, Health Care, Telecommunication Services or Utilities sector firm. Spun off firms that remain in the Index do not get removed between Index rebalances due to their sector classification.
3Blend of excluded sectors: The blend of excluded sectors is equally weighted between the MSCI EMU Consumer Staples Index, MSCI EMU Health Care, Telecommunication Services and Utilities Indexes.
4Source: Bloomberg, as of 9/30/15.
Important Risks Related to this Article
Investments focused in Europe increase the impact of events and developments associated with the region, which can adversely affect performance.