Time To Rethink Currency Hedged ETF Use

U.S. expanding, Europe tamed, Japan voting: Whither the dollar?

Yesterday’s surprisingly strong GDP numbers—third-quarter annualized growth was revised up to 3.9 percent—has many investors scratching their heads. To say we’re in a world of conflicting economic news would be an understatement.

Just to wrap a few data points:

1. We have the strong GDP, suggesting basic economic growth for the U.S., but with a backdrop of flagging consumer confidence.
2. The European Central Bank seems ready to keep stimulating the euro, pulling it off the two-year lows.
3. Japan seems to be poised for more gains on ongoing stimulus and a likely positive election for Prime Minister Shinzo Abe in December.
4. Bond guru Jeff Gundlach is predicting the yield curve will flatten even more, with yields on long bonds falling for the next year—not rising.

In my mind, these all point to rethinking the currency hedge in both Japan and Europe. Any answer to the question, “What should I do, with this kind of backdrop?” is entirely personal and inherently speculative, and that’s always frustrating to me.

Frequently flip-flopping between hedged equities and unhedged equities is just another type of market timing—something I’m generally pretty sure doesn’t work.

But at the same time, any international investment bakes in a currency choice whether you want it to or not. You really can’t say, “I don’t have an opinion on the euro” and then invest in European stocks. If you go in unhedged, by definition, you’re bullish on the euro. If you hedge, you’re bearish.

So how do I parse that choice right now?

The Heat Is Off Europe

It’s clear Europe is now following in the policy footsteps of the U.S., and there’s a real opportunity to capture a European recovery. As Don Luskin put it in our “Alpha Think Tank” newsletter:

“There's a combination of reality and sentiment that has conspired to hold Europe back in the second half of the year …[Draghi] cooked up this deflation emergency in order to do these purchase programs that he wanted to do. Now everybody is just in fearful trembling about deflation in Europe. So you add that on top of the export uncertainty, and you've got just the right amount of facts to support the sentiment.”

It’s hard to look at the disparity between the Vanguard FTSE Europe ETF (VGK | B-97) and the U.S. market and not get at least an itch to call a bottom.

It’s also hard to look at the bottom line there, which is the return of the euro versus the U.S. dollar so far this year, and wonder how much further it could possibly fall, now that Mario seems back in control.

Japan With The Yen?

It’s easy to make a similar case for Japan. Here’s a similar chart with the iShares MSCI Japan ETF (EWJ | B-98):

At least with the yen (again, the bottom line) it’s hard to love the technical look-see here, but how much further can the yen really go? It’s at 117 to the dollar right now, up from the mid-70s a few years ago.

Sure, it could theoretically go to precrisis levels (it was in the 130s in 2007), but I don’t really hear anyone calling for a full-on 1980s-style collapse that sends the yen doubling.

Taking The Hedge Off?

On the other hand, the impetus for a flood of money into the dollar also seems a bit off the boil.

The “tax cut” effect of cheap oil doesn’t just help U.S. consumers, it helps all economies. And if Jeff Gundlach is right and the yield curve flattens despite a potential increase in rates next year, that makes U.S. bonds even less attractive than they already are.

Less money flowing into safe-haven Treasurys means less upward pressure on the dollar, which means the euro and the yen may stabilize.

For a lot of ETF investors, the hedged versions of Japanese and European equities have become the default over the last few years, and for good reason: The data shows that removing the currency risk reduces the volatility of your international investments in all markets, and the case for a strong dollar has been pretty clear.

If you do make the decision to take the hedge off your exposure, recognize you’re making an inherent bet against the U.S. dollar and adding that volatility back into your exposure. But at some point, every investor needs to look at the data and decide whether a particular theme has been “played out.”

That may or may not be the case with the yen and the euro, but I do think the easy money is gone.

At the time this article was written, the author held a position in VGK. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.