U.S. investors in international equities have fought a headwind in recent years, as the weakening of international currencies relative to the U.S. dollar has eroded dollar-denominated investment returns.
This headwind emerged in 2014, when the euro and many other currencies tumbled relative to the dollar. The primary catalyst was a divergence in monetary policies, as the U.S. Federal Reserve (Fed) began to move toward incrementally tightening its policy while central banks in other developed markets became more accommodative in hopes of stimulating their stagnant economies. Currency movements had a big impact on investments; for the three-year period ended December 31, 2016, a hypothetical investment in the MSCI Europe Index generated an annualized loss of 3.17% as measured in U.S. dollars, while the same investment held in the euro and other local currencies posted a 5.59% annualized return—for U.S. investors, a currency headwind of 8.76% on an unhedged basis.1
2017: a turning point
So far this year, however, we’ve seen a reversal, as international currencies have appreciated relative to the dollar. In the course of the regular conversations that we hold with the asset managers in our network, currency specialists have recently expressed the view that the current period represents a critical juncture for global currencies. These specialists are monitoring two key factors: international economic strength and the extent to which central bank policies will converge relative to market expectations.
Economic trends can be a key driver because currencies often reflect the underlying conditions within their respective countries. The stronger a country’s growth prospects, the more likely it will be that its currency strengthens; economic weakness would suggest a weaker currency, all else being equal. In the first half of 2017, we saw a relatively broad-based economic recovery across international markets, and the consensus view across our asset management network is that this positive momentum will extend through the rest of the year and, therefore, may continue to provide a support for non-U.S. currencies generally.
From a monetary policy perspective, the currency specialists in our network generally believe that the market’s expectations about growing policy divergence between the Fed and the European Central Bank (ECB) had become stretched earlier this year; many investors appeared to expect that the Fed would accelerate its pace of interest-rate increases, while the ECB would remain ultra-accommodative for the extended future. However, the past few months have yielded weak U.S. inflation readings—an unexpected development that suggests the Fed may tighten policy more gradually than had been expected. As for the ECB, it increasingly appears that it could pull back in 2018 from its accommodative stance as Europe’s economic growth accelerates. As the degree of policy divergence between the Fed and the ECB eases relative to earlier expectations, the euro—the largest trade-weighted currency versus the U.S. dollar—could stand to benefit.
As we outlined in the outlook section of our third-quarter edition of Market Intelligence, our network sees several positive catalysts for international equities, including attractive valuations, solid economic growth prospects, and improving corporate fundamentals. While currency headwinds had until recently weighed on U.S. investors’ international equity returns, currency factors appear to be reversing to the point that they’ll become favorable. The currency specialists in our network generally expect that international currencies will remain on strong footing through the rest of 2017.
1 FactSet, 2017.
The MSCI Europe Index tracks the performance of publicly traded large- and mid-cap stocks across 15 developed countries in Europe. It is not possible to invest directly in an index. Past performance does not guarantee future results.