Earlier, we discussed how positive trends in the European economy showing domestic growth are leading the eurozone, while global trade has been one of the weak points.1 We also discussed how our favorite leading indicators of the economy—both M1 growth and the European Commission’s Economic Sentiment Indicator—were showing positive signs that bode well for future trends in the local economy.2 What could be a good way to position toward this local economic recovery?
Creating an Index to Respond Strongly as Economic Conditions Improve
At WisdomTree, we build innovative equity Indexes that offer the opportunity to express certain characteristics or have greater potential to respond to different economic trends. If an economic recovery in Europe is truly taking hold, we wanted to create an Index that best reflects these local economic conditions. WisdomTree thus created the WisdomTree Europe Local Recovery Index to reflect attributes of an improving domestic economy that is less reliant on the global export markets.
Especially over the past five years, certain more defensive sectors of the MSCI EMU Index have exhibited lower correlation to changes in the economy and the leading indicator of activity, the European Commission’s Economic Sentiment Indicator. These defensive sectors thus may not offer the most representative exposures to improving economic conditions within the eurozone.
Over the past five years, those same defensive sectors have exhibited lower betas when measured against the returns of the MSCI EMU Index. In times of turmoil or uncertainty, this could be a potentially positive attribute, but if an investor truly believes in the prospects for a eurozone economic recovery, these lower-beta defensive sectors are likely to be least responsive to a more positive growth environment.
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Positioning in Cyclicals: No Defensives
In positioning for local economy recovery, these data points lead us toward a preference for cyclical sectors over defensive sectors. Within the WisdomTree Europe Local Recovery Index, the Consumer Staples, Health Care, Telecommunication Services and Utilities sectors are not eligible for inclusion.
Two important factors are driving allocations in the WisdomTree Europe Local Recovery Index:
Stock Selection: In addition to the aforementioned sector screens, there is also a geographic revenue requirement to ensure a domestic European focus: constituents must derive more than 50% of their revenue from inside Europe, giving focus to what is happening within Europe and less sensitivity to the global growth outlook.
Weighting: We also employ a weighting methodology to maximize sensitivity to improving economic conditions. This process tilts the weight toward stocks whose returns have been most correlated to changes in economic conditions, defined by the European Commission’s Economic Sentiment Indicator discussed above.
This unique weighting methodology ranks stocks by their correlation to the Economic Sentiment Indicator and, using a smoothed weighting process, tilts weight from the traditional benchmark market capitalization weights toward stocks that are more responsive to changes in economic sentiment and activity.
Formally, the weights are set by two factors: 25% according to their market capitalization percentages, and 75% according to how correlated each stock is to economic activity over the last five years (based on each stock’s returns and its relationship to the European Commission’s Economic Sentiment Indicator).
• Local Focus: WisdomTree Europe Local Recovery Index has nearly 70% of its weighted average revenue coming from within Europe.
• Opposite of WisdomTree Europe Hedged Equity Index: This is a distinctly complementary approach to that employed by the WisdomTree Europe Hedged Equity Index, which requires constituents to derive more than 50% of their revenue from outside Europe. The weighted average revenue exposure from Europe in that Index is only 30%.
• Unhedged Local Exposure Complements Hedged Exporters: There has been a huge amount of interest in currency-hedged eurozone exporters in 2015. The unhedged local recovery basket provides a nice complement both from its unhedged nature and the distinctly different profile of stocks represented in the local recovery Index.
Based on the macroeconomic trends discussed in our blog post “A Recovering Eurozone Economy: Where Should You Position?,” this local recovery index should also be a focal point for traditional unhedged replacements, as the local economy is showing relative strength within the European economy.
1Sources: Bloomberg, Eurostat and WisdomTree, with data as of 6/30/15.
2Sources: Bloomberg, European Commission, European Central Bank and WisdomTree, with data as of 9/30/15.
3Sources: Bloomberg, FactSet, with data 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.