By Sabrina Callin, CFA

March 16, 2015

With the U.S. stock market hovering near the top of its six-year bull run, it’s not surprising that many investors have been looking to diversify beyond U.S. borders. Last year, international equity funds experienced the strongest inflows of the broad categories tracked by Morningstar, taking in more than $140 billion in assets from U.S.-based investors.

Whether or not that allocation decision has paid off to date has a lot to do with currency exposure. Recent dollar strength has weighed on the returns of international equity funds that do not hedge against currency fluctuations. Consider that the MSCI EAFE Unhedged Index fell 4.90% in 2014, while the MSCI EAFE USD Hedged Index gained 5.67%. (MSCI EAFE provides exposure to 21 developed markets excluding the U.S. and Canada. The largest regional exposures are approximately 30% exposure to the eurozone and 21% exposure to Japan.)

Is this trend likely to continue? PIMCO believes it is. Based on our outlook, we believe the return opportunities from equities are likely to be greater in regions outside the U.S. – particularly in Europe – and that hedged strategies should continue to outperform. Here are three reasons why.

Reason 1: Diverging central bank policies are creating opportunities – and a stronger dollar

While the Fed is poised to raise rates later this year, other central banks are on a different path. Disinflationary forces and slow growth in Europe and Japan and decelerating growth in China are likely to keep central bank policies loose in these regions. Yet bad news could ultimately be good news for their respective equity markets: aggressive quantitative easing (QE) measures should keep interest rates ultra-low and could help boost economic growth, providing a potential tailwind for earnings. The last round of QE in the U.S. which concluded last year, helped push equity markets to new nominal highs. In the eurozone, PIMCO expects QE could add about 0.5% to GDP in both 2015 and 2016.

This diverging policy environment has also bolstered the U.S. dollar. The dollar has appreciated strongly over the past couple of years, leading some market observers to wonder if the rally has run its course. PIMCO doesn’t think so. Rather, we believe it is the beginning of a bigger, long-lasting upward trend, though there is likely to be some volatility along the way.

Normally, when the dollar appreciates, it is part of a multi-year trend, and as Figure 1 shows, previous strengthening cycles have seen significant increases. What is different about this cycle, however, is that the dollar started its ascent from relatively cheap levels: its value relative to other currencies hit a multi-decade low in 2011. With the U.S. expected to remain the growth leader in the developed world, and QE likely to weaken the euro and yen, we think that the dollar has room for further appreciation. It’s also important to note that this dynamic should boost Euro-area earnings, particularly for companies that export to a stronger U.S. end market.