WisdomTree

Currency Hedged Equity, Dynamic Currency Hedging, Equity, Europe

The WisdomTree Toolkit for Investing in Europe

by Christopher Gannatti, Associate Director of Research on March 29, 2016

Central bank activity has become one of the most important and influential factors driving markets today. As the U.S. Federal Reserve (Fed) moves toward a policy rate normalization, both the Bank of Japan (BOJ) and the European Central Bank (ECB) are pushing the boundaries with policies that many wouldn’t have considered merely a few years ago.
 
Quantitative Easing (QE) Will Have Important Impacts

While it is clear to us that one desired impact of quantitative easing (QE) is rising equity markets, the impact across the different sectors may not be equal.
 
QE May Stimulate Financials: ECB president Mario Draghi is focused on stimulating the credit channel in Europe’s economy, and that could ultimately prove to be a positive for Financials. The sector has been volatile thus far in 2016—over some time frames, it’s been the worst-performing sector and at other times the best.
 
Lower-Quality Sectors Performed Well Immediately Following the ECB’s March 10, 2016, Announcement: During the first week after the announcement, the three top-performing sectors in the MSCI EMU Index were Utilities, Financials and Telecommunication Services. These sectors are among the most heavily indebted, but if the ECB is positioning itself as a buyer of corporate and government debt, thereby encouraging lower interest rates, it stands to reason that these sectors may experience a bit of an initial tailwind.
 
Exporters or European Companies Tilted More toward Domestic Demand? While we believe that the thesis underpinning a weaker euro compared to the U.S. dollar is intact, the shorter-term behavior of the euro has not tended to cooperate. For export-oriented firms, it is important to recall that levels between $1.10 and $1.15—while not necessarily as beneficial as $1.00 to $1.05—are still significantly lower that the levels closer to $1.40 that we saw in early May 2014. While we believe the euro could weaken further over the medium to long term, stimulating the competitiveness of exporters, there are other opportunities, be it in more domestic-demand-oriented European companies or even in European small-cap stocks.
 
European Sector Performance One Week after the March 10, 2016, ECB Announcement
Performance after ECB Announcement
 
How to Think About Different Tools, Given the March 10, 2016, ECB Announcement

While no one knows exactly how European equities will perform going forward, there is no shortage of opinions. Thinking through some of the potential scenarios, we see these four possibilities:

 
1. The ECB’s Policy Announcement May Encourage European Banks to Lend: If this happens, the pickup in loan growth in Europe could create a desire for greater exposure to European Financials. One interesting tool to generate that exposure could be the WisdomTree Europe Local Recovery Fund (EZR), which had greater than 30% exposure to Financials as of March 17, 2016.
 
2. The ECB’s Policy Announcement May Lead to a Weaker Euro: Even though the first week after the announcement hasn’t seen this occur, that doesn’t mean that over a more medium- to long-term time frame it won’t—especially if the Fed raises the Fed Funds interest rate in June 2016 or beyond. Here, the WisdomTree Europe Hedged Equity Fund (HEDJ) could be a feasible strategy, as it tracks the returns (after fees) of the WisdomTree Europe Hedged Equity Index, which has a requirement of all constituents to generate at least 50% of their revenues from outside Europe.
 
3. European Consumers May Increase Their Aggregate Demand: The importance of this outcome cannot be overstated. In addition to EZR, which tracks (after fees) the performance of the WisdomTree Europe Local Recovery Index—an Index that requires eligible constituents to derive at least 50% of their revenues from inside Europe—the focus would be on small-cap stocks, via either the WisdomTree Europe Hedged SmallCap Equity Fund (EUSC) or the WisdomTree Europe SmallCap Dividend Fund (DFE).
 
4. Uncertainty as to Exactly How the ECB Announcement Will Impact European Equities or the Euro: The prior three thoughts represent different tilts that correspond to different viewpoints, but they’re not the only answers. The WisdomTree Dynamic Currency Hedged Europe Equity Fund (DDEZ) owns dividend-paying stocks of Europe, weighted by the dividends paid. Additionally, DDEZ tracks (after fees) the returns of an Index that implements a dynamic hedge for the movements of the euro versus the U.S. dollar, which will adjust monthly based on changes in market conditions.
 
Central Bank Actions Are Here to Stay

What we saw on March 10 from the ECB and earlier this year from the BOJ is that global central banks are doing whatever they can to influence markets. It is truly amazing to see that both are employing negative deposit rates. Over time, we will have to see how market dynamics are influenced, and we hope that the fiscal side of the equation can ultimately make its appropriate contribution, taking some of the pressure off monetary policies to carry the full load.

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing their investments on certain sectors, regions and/or smaller companies may be more vulnerable to any single economic or regulatory development. This may result in greater share price volatility.  

The Funds invest in the securities included in, or representative of, their Indexes regardless of their investment merit, and the Funds do not attempt to outperform their Indexes or take defensive positions in declining markets. 

As some of these Funds can have a high concentration in some issuers, the Funds can be adversely impacted by changes affecting those issuers. Due to the investment strategy of some of these Funds, they may make higher capital gain distributions than other ETFs. 

HEDJ and EUSC use various strategies to attempt to minimize the impact of changes in the value of the euro against the U.S. dollar, and these strategies may not be successful. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. DDEZ invests in derivatives in seeking to obtain a dynamic currency hedge exposure. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. 

Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile.

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