BoA: Long-term asset rotation is quietly underway, you only know the dollar is naked when the tide goes out!

In a strategy report on April 14, Bank of America estimated that European investors have left 73% of their exposure to US stocks unhedged, equivalent to approximately $6.5 trillion in unhedged stock exposure. In other words, according to these estimates, a 1% permanent increase in hedging would be equivalent to approximately $650 billion in Euro to US Dollar hedging. As US stocks and the US dollar weaken this year following the Covid-19 pandemic, there has been a significant reversal in capital flows. European investors may need to significantly increase their hedging levels. Investors are less likely to hedge their exposure to US stocks compared to US fixed income securities. Foreign investors tend to fully or almost fully hedge their exposure to US fixed income securities, while they employ more flexible hedging mechanisms for US stocks. Key conclusions: 1. Sharp increase in foreign exposure to US stocks post Covid-19 pandemic. 2. Europe is engaging in stock rotation through passive exchange-traded funds (ETFs). 3. Estimation of European hedging scenarios. 4. Quarterly hedging framework for US stocks. 5. Urgent need for hedging. 6. Data from some European asset management companies. The main points of the report include: - Investors are less likely to hedge their exposure to US stocks compared to US fixed income securities. - Foreign investors tend to fully hedge their exposure to US fixed income assets, while employing more flexible hedging mechanisms for US stocks. - The exposure of foreign investors to US stocks has significantly increased post Covid-19 pandemic. - European investors may need to significantly increase their hedging as the US dollar weakens. In summary, the report highlights the need for European investors to increase their hedging levels as they face increased exposure to US stocks amidst a weakening US dollar and shifting capital flows.Country's stock investment in the United States and Eurozone (4-week fund flow as a percentage of assets under management)Focused on Eurozone investment in the US, EPFR data shows that since the pandemic, capital has flowed significantly towards US stocks, with the EPFR index rising from around 0 to over 20,000 (Chart 4). In the previous years, Eurozone investments in US bonds and stocks were relatively balanced. However, in the post-pandemic period, this balance has shifted significantly towards stock investments. Chart 4: Since the pandemic, capital inflows from the Eurozone to the US have significantly shifted towards stocks (Eurozone inflows to US stock funds - bond fund index) Chart 5: A significant shift towards US stocks indicates a sharp increase in the Eurozone's unhedged exposure to US assets (index of Eurozone's unhedged exposure to US assets) This shift towards stock investments itself indicates a sharp increase in Eurozone investors' unhedged exposure to the US dollar, with EPFR data showing the index rising from around 0 to over 59,000 (Chart 5). Of course, this is just indicative data, as EPFR data is just a subset of total exposure. However, as we will discuss in more detail below, these trends provide interesting insights into potential exposures (we assume that 80% of bond investments flowing into the US are hedged, while only 20% of stock investments flowing into the US are hedged). Europe rotating stocks through passive trading open-end index funds (ETFs) Details of the capital flows into US stocks in recent years also suggest a lower hedging rate. The significant increase in Eurozone investments in US stocks in recent years was driven almost entirely by passive investments (about $700 billion since 2012), primarily through ETFs (about $600 billion since 2012, see more details in Chart 6 and Chart 7). Compared to active funds, these fund flows are less likely to be hedged. Chart 6: Capital flows into US stocks are mainly driven by passive investments (Eurozone investor purchases of US stocks by fund type, in billions of USD) Chart 7: Capital flows into US stocks are mainly through ETFs (Eurozone investor purchases of US stocks by fund type, in billions of USD) From the end of 2022 to the fourth quarter of 2024, and up to the beginning of this year, the steady growth of Eurozone investments in US stocks may provide strong support for the US dollar (Chart 8). Similarly, as the Euro has recently strengthened against the US dollar, purchases of US stocks by Eurozone investors have also stalled. Chart 8: Since the end of 2022, Eurozone investors have turned to investing in US stocks (Eurozone investor purchases of US stocks, 4-week fund flows as a percentage of assets under management) In the first quarter of 2025, US stocks underperformed European stocks, while there were outflows from passive and trading open-end index funds (ETFs) (Chart 9). Considering the lower likelihood of hedging for passive ETF funds, if investors continue to reduce their holdings of US stocks through passive ETFs, we expect the Euro to US dollar exchange rate to further strengthen. Chart 9: ETF and active fund inflows may be behind recent stock performance (Eurozone country investor purchases of US stocks by fund type, 4-week fund flows as a percentage of assets under management) Estimating Europe's hedging scenario Using international capital flow data and hedging rate estimates, we can measure how much of the US dollar-denominated securities currently held by foreign investors are hedged or unhedged. This helps us understand the potential magnitude if foreign investors reduce their holdings of US assets or adjust the hedging rate of their US assets. While it is difficult to determine the actual hedging rate applied at any given time, we can use various frameworks (our own framework and frameworks in academic literature) to estimate existing unhedged exposures. Chart 10 shows the total holdings of all US long-term securities held by non-US residents, while Chart 11 focuses on regional ownership of US stocks. Here, we specifically focus on European investors as they are a key focus of the emerging theme of potential long-term asset rotation and hold about half of the foreign holdings of US stocks, valued at around $8.9 trillion. This is in line with our recent analysis of global imbalances, indicating that Europe has become a major creditor to the global economy, especially the US. Chart 10: Since the COVID-19 pandemic, non-US residents' holdings of US stocks have grown significantly (US long-term securities held by non-US residents, in trillions of USD) Chart 11: European investors hold about half of the foreign holdings of US stocks (US stock holdings by region, in trillions of USD) Chart 12 draws on estimates from a Harvard Business School study on hedging behavior of non-US investors (labeled as "A" and "B" in the table). Based on these estimates, this means that 73% of European investors' stock holdings are unhedged, while only 4% of their fixed income holdings are unhedged. Other studies have reached similar results (such as Wenxin Du and Amy Wang Huber, 2023). Chart 12: Stock investments face significantly higher currency risk exposure (estimated hedging rates for European investors holding US stocks and fixed income) In USD terms, this equates to approximately $6.5 trillion of unhedged stock exposure. In other words, based on these estimates, for every 1% permanent increase in the hedging ratio, it is equivalent to about $650 billion of Euro to US dollar hedging exposure. Note: 1. Based on US Treasury International Capital System (TIC) data. 2. In this report, we primarily focus on European investors as they are a significant group holding Eurozone assets.Quantity measurement is the most important. Future reports may further investigate the holdings of non-European foreign investors.3. For the proportion of funds hedging, we use estimated data from Table 3 and Table 4 in a Harvard Business School study. The specific funds used were not disclosed, but the study report stated: "After the above screening, we obtained 2,483,437 mutual fund - currency - monthly observations, with 916,806 observations of hedgers." 4. We combine the estimated data from Harvard Business School with the Treasury International Capital (TIC) data. The Harvard Business School study did not include TIC data.