With a synchronised recovery in economic activity underway, memories of the 2015-2016 deflation shock fading and a slew of benign election results (Dutch, French and German), confidence in the euro area has improved markedly since the beginning of the year and has propelled equities higher.

Although the near-term economic outlook is positive, we warn of a potential hidden risk to equities in the form of a reduction in FX hedging by foreign investors. The chart below shows the cumulative flow of capital into eurozone ETFs on both a currency-hedged and unhedged basis.

Following the net selling of equities through most of 2016, foreign flows into eurozone stocks have surged since the beginning of this year. These flows are overwhelmingly unhedged.

Given that the cost of hedging has not materially increased this likely reflects a similarly bullish assessment for the euro, which has rallied 14% YTD against the dollar and seen multi-year high speculator net long positions. This leaves equities exposed if euro momentum subsides, particularly on the back of a dovish tilt at the ECB.

(Click on image to enlarge.)

Source: Bloomberg, Macrobond and Variant Perception