French Election Round 1: How Did European Equities Respond?

It has been difficult to turn on any investment media in 2017 without hearing at least something about European elections—particularly the French presidential election. Going into April 23, the first round of the process, we as an industry waited with baited breath, given the apparent tightening of polls.

Few (If Any) Were Allocating to European Equities Prior to This Event

In speaking to industry professionals over the course of the first four months of 2017, a common conversational framework tended to ensue:

1. Broad Agreement That U.S. Equities¹ Were Either Close to Fairly Valued or Even Expensive: The only logical argument we tended to hear supporting U.S. valuations was that interest rates² remain near historic lows, and therefore bonds are still quite expensive compared to stocks.
2. Awakening to Emerging Market Equities³, which Have Been Performing Strongly for More Than 12 Months: We remember trying to discuss emerging market equities at the end of 2015 (largely to no avail), but now that the benchmark index is more than 25%⁴ above those levels, there seems to be greater interest. 
3. Disconnected Reality of European Equity Performance vs. European Equity Sentiment: Growth and inflation dynamics in Europe, not to mention corporate earnings, were far from a disaster scenario. While the S&P 500 Index and the Russell 2000 Index delivered 6.07% and 2.47%, respectively, European large caps and small caps⁵ outperformed. 

Home country bias—even in the face of many saying outwardly that they didn’t love the current levels of the U.S. equity markets—remained the majority action, we think predominantly due to the feeling of being “burned” by 1) the Brexit referendum surprise and 2) Donald Trump’s surprise election victory.

The European Equity Opportunity Became a Coiled Spring

Europe is a major world market—if one includes the UK and the eurozone, the exposure in the MSCI ACWI is approximately 17%.⁶ With the election concerns, a divide occurred among sentiment, fundamentals, and ultimate allocations. Any catalysts for shifts in sentiment (such as more positive election results than expected) could therefore lead to significant rebalancing or reallocation back into the region. 

Average Annual Returns

Broad-Based Measures of European Equities Responded Strongly in Initial Reaction

Summarizing some of the critical takeaways, in our view:⁷

• EDOM: The WisdomTree Europe Domestic Economy Fund, built to track the price and yield performance of the WisdomTree Europe Domestic Economy Index before fees and expenses, reacted very strongly to the initial results from the first round of the French presidential election. In looking at underlying drivers, what stands out is that EDOM had slightly more than 30% of its exposure in the Financials sector. This sector responded very strongly on April 24, 2017, with French and Italian banks delivering in many cases double-digit returns. Looking beyond the single-day reaction, we find it instructive to consider the fact that the European Financials sector may have among the highest betas to shifts in European sentiment, so if things continue to “surprise to the positive,” this strategy may be particularly sensitive. 

• DFE: The WisdomTree Europe SmallCap Dividend Fund, built to track the price and yield performance of the WisdomTree Europe SmallCap Dividend Index before fees and expenses, also responded strongly. We wrote about this Index on April 5, 2017, as a way to think about expressing a view that the election results might not conform to the most dire of predicted scenarios. While EDOM is tracking an Index that requires constituents to derive at least 50% of their revenues from inside Europe, DFE is tracking an Index that merely focuses on small caps to get a similar exposure to locally driven revenues of Europe. While Financials in DFE also led the way in the April 24 market reaction, we’d make an important distinction: EDOM’s constituents include some of the largest, most well-known (for better or worse) banks throughout Europe. DFE’s constituents are small caps, lending the potential to gain exposure to a completely different, lesser-followed slice of Europe’s equities.

• HEDJ: The WisdomTree Europe Hedged Equity Fund, built to track the price and yield performance of the WisdomTree Europe Hedged Equity Index before fees and expenses, also responded strongly. It’s important for investors to see the completely different positioning compared to EDOM and DFE, since the case can be made that both of those strategies tap into improvements in Europe’s local picture and rising domestic demand. HEDJ’s Index requires constituents to derive at least 50% of their revenues from outside Europe, so the Fund is really generating exposure to the performance of global companies. It’s also important to note that HEDJ’s Index is hedging the exposure to the movements of the euro versus the U.S. dollar. The euro appreciated by approximately 1.30% on April 24 (benefitting the returns of EDOM and DFE, which do not track the returns of hedged indexes and do include euro exposure), but as we look forward, we question how much euro appreciation may make sense, given the not-realized divergence in monetary policy between the European Central Bank (ECB) and the U.S. Federal Reserve.

Ready for the Next Chapter of the Story

While the market seems to be thinking Emmanuel Macron will be victorious (at least as of this writing), the past few years have led us to remember that it ain’t over till it’s over. We’ll continue to monitor how different types of European equity strategies respond to new developments. 

¹Refers to S&P 500 Index universe, as of 4/24/17.
²Refers to both short-term interest rates, like the U.S. Federal Funds Rate, and more long-term rates, like the U.S. 10-Year Treasury note interest rate, as of 4/24/17.
³Refers to the MSCI Emerging Markets Index universe, with performance from 12/31/15 to 4/24/17.
⁴Refers to the MSCI Emerging Markets Index universe, with performance from 12/31/15 to 4/24/17.
⁵Refers to the Euro Stoxx 50 Index and the MSCI EMU Small Cap Index from 12/31/16 to 4/24/17.
⁶Source: Bloomberg, with data as of 4/24/17.