As multi-asset global investors, movements in currency markets can have a big impact on returns. This was particularly evident in 2016, an eventful period for currency markets to say the least.
Amid expectations of fiscal expansion and rising interest rates, the U.S. dollar was the currency of choice, rising 10% on a trade-weighted basis. The yen was initially strong but then fell by 18% against the dollar. Sterling has cratered against all comers, and the euro is down 10% versus the dollar.
These movements have been driven by political and economic uncertainty, which appears likely to continue. Furthermore, the tide of quantitative easing, which has helped drive so many currency movements over the past eight years, may be about to go out. Amid such a global maelstrom, it can be very challenging to assess the true value of a currency when making an investment decision.
A good starting point could be the Economist’s “Big Mac index.” This well-known gauge of global prices assesses the cost of the famous American staple in different countries and converts this price into dollars.
The index is grounded in the purchasing power parity theory, which suggests that over time, exchange rates should adjust in order that a dollar buys the same amount of goods (in this case a Big Mac) or service anywhere. If the tasty meal looks like a bargain in one currency, that currency may be undervalued. The Big Mac is chosen because it is one of the few products that is identical everywhere and hence universally comparable.
This index is a useful tool for taking a longer-term view, given that currency strategists often look shorter-term when making forecasts and have a tendency to follow trends. The Big Mac index can provide a useful frame of reference when assessing if the currency in which a potential investment is priced is cheap or expensive.
So what does the index tell us today? First, the most expensive of the major currencies is the Swiss franc. This will not be a surprise to anyone who has had tried to purchase a Big Mac and pommes frites in Europe’s most prosperous nation.
It may also reflect a feeling that, amid the tumultuous environment mentioned above, Switzerland feels like an oasis of calm. The cheapest currency? The Egyptian pound – a currency that has suffered from the abandonment of the dollar peg in a country reeling from civil unrest.
The overarching theme in the current index is that the U.S. dollar is expensive against all major currencies…
The overarching theme in the current index is that the U.S. dollar is expensive against all major currencies, bar the aforementioned Swiss franc. There may be good reason for this – such as rising interest rates (and as importantly, rising interest rate differentials versus others), upgrades to economic growth expectations, and inflows into dollar-denominated assets. However, if an investment strategy is predicated on a strong dollar, it is worth bearing in mind that the strategy may be predicated on an expensive thing getting even more expensive.
The flipside of this view of an expensive dollar is that other currency blocs may offer good longer-term value. In the midst of the current gloomy mood relating to the sterling or the euro, both currencies appear to be around 20% undervalued versus the dollar. Both regions obviously have their issues, but this valuation may make it a good deal for some. The yen offers even more potential value. However, it is worth bearing in mind that strength in the Japanese market remains umbilically linked to weakness in the yen because of the predominance of Japan’s exporters. Two of the most undervalued currencies would appear to be the Chinese renminbi and the Mexican peso, reflecting investors’ concerns about U.S. trade.
The best-performing currency of last year, and one not included in the Big Mac index, is one that may have problems persuading the cashier in McDonalds to accept – the Bitcoin. The virtual currency more than doubled in value versus the dollar (albeit it has fallen by almost 20% at the start of the year).
Investors might be right to be slightly skeptical of this electronic creation, and its strong performance may only reflect the fact that it is not a tool of any central government’s monetary policy or at the mercy of any election or referendum (and may be navigating waters away from these particular storms).
It is also worth noting that one of the other facets of currencies is that they can, and do, overshoot fair value. In these times of unconventional monetary policy, uncertain politics and significant currency consensus, it is a reminder to, at least, be aware of what you’re buying.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and currency exchange rate, political and economic risks.