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 US 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, in my experience, is 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? Firstly, 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 mit pommes frites in Europe’s most prosperous nation. It may also reflect a feeling that, amid the tumultuous environment mentioned above, little Switzerland feels an oasis of calm. And 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 US dollar is expensive against all major currencies.
The overarching theme, in the current index, is that the 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. Hence, in the midst of the current ‘gloomfest’ relating to 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 offer some comfort to investors considering buying assets in these regions. 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 due to the predominance of Japan’s exporters. Be careful.
Two of the most undervalued currencies would appear to be the Chinese renminbi and the Mexican peso, reflecting investors’ concerns about US trade.
But the best-performing currency of last year, and one not included in the Big Mac index, is one that you might have problems persuading the assistant 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 sceptical 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 hence may be navigating waters away from these particular storms. For the right answers I will leave it to those with greater knowledge of the currency and of the corners of the internet in which it is normally used.
It is also worth noting that one of the other facets of currencies is that they can, and do, overshoot ‘fair value’. You can be a long time waiting for (and considerably poorer) the mean-reversion that this analysis predicts. But it is nevertheless a timely reminder in these times of ‘unconventional’ monetary policy and uncertain politics and in a time of significant currency consensus to, at least, be aware of what you’re buying.