European equity investors have started to reassess their portfolio positioning as an increasingly strong euro casts a shadow over the earnings outlook for certain stocks.
Improving fundamentals and diminishing political risks have buoyed European shares this year, making it the most successful developed market of 2017. For a sterling investor, the FTSE Europe ex UK has delivered 16.6 per cent year to date, according to FE, outstripping returns from major UK, US and Japanese benchmarks.
This has had some unfavourable consequences. The more positive environment, alongside uncertainty elsewhere, has seen the euro appreciate against the US dollar and sterling, creating a headwind for the region’s exporters.
Kevin O’Nolan, a multi-asset investor for Fidelity, said market gains had fallen back since May’s French election as a result of the currency’s rise.
“A lot of the gains achieved have retraced. I would put almost all of that down to the euro strength,” he said.
This headwind could gain further momentum should the ill-effects of a stronger currency feed into company earnings.
James Rutherford, who works on the Hermes Europe ex UK Equity fund, acknowledged the continent had just been through a “good reporting season”, but said certain European companies could be hit hard as currency hedges rolled off.
“We are at a juncture where we are starting to see cracks in the earnings outlook,” he said.
“For most companies who [currency] hedge, policies normally work on a rolling six-month basis. It takes time for that appreciation to start affecting results.”
Jitters for sterling and the dollar have seen the euro make significant gains on a relative basis. In the year to date, the currency has risen by 7.2 per cent versus sterling, hitting an eight-year high last month, and 11.4 per cent versus the US dollar. Given this backdrop, asset allocators have been mulling over whether to back domestically oriented European firms rather than exporters as a way to negotiate the environment.
“For the last quarter, in terms of earnings the domestic-focused companies outperformed the exporters on a sales and earnings basis,” said James de Bunsen, a multi-asset manager for Janus Henderson.
“They have been more optimistic about results going forward, having stronger revisions to year end. It has been a good idea to have been skewed towards domestic plays rather than exporters.”
The extent of the currency gains complicates the task of predicting the performance of European equities. While a stronger currency dents Europe’s exporting revenues, it could delay any monetary tightening from the European Central Bank, aiding stocks. Capital Economics suggested currency appreciation was likely to push back any tapering of quantitative easing.
Investors are examining the extent to which dollar weakness – and relative euro strength – can remain at current levels. Frances Hudson, a strategist at Standard Life Investments, questioned the sustainability of the shift. Some portfolio moves reflect the anticipation of a correction. Mr O’Nolan said he had started to remove a euro long position, expressed using derivatives, as well as “deepening” European equity exposure.