Undervalued Currencies & The Big Mac Index in 2014

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It is that time of the year again, and Britain’s Economist magazine has just published its annual “Big Mac Index.”

Since 1986, the “Big Mac Index” has provided a tongue-in-cheek but surprisingly useful way of measuring purchasing power parity (PPP) — that is, the relative over and undervaluation of the world’s currencies compared to the U.S. dollar.

According to the theory of purchasing power parity, a dollar should buy the same amount of the same good across all countries.

The “Big Mac” Index compares the cost of Big Macs — an identical item sold in about 120 countries — and calculates the exchange rate (the Big Mac PPP) that would result in hamburgers costing the same in the United States as they do abroad.

Compare the Big Mac PPP to the market exchange rates, and you instantly see which currencies are under or overvalued.

Not that the Big Mac index is perfect. In Argentina, ground zero of this week’s emerging markets sell-off, McDonald’s doesn’t really sell the Big Mac anymore because the government decided it didn’t want to be included in the Economist surveys and regulated the hamburger’s price. And the inclusion of price of a “Big Mac” in India — the cheapest in the world at $1.54 — is problematic because in India, Big Macs are made of chicken. Hindus don’t eat beef.

Finally, with several emerging markets’ currencies plummeting in the past few days — most notably Turkey — the Economist’s data is already out of date.

Global Currencies: The Current State of Play

Over the past few years, each time I looked at the Big Mac Index, I was struck by how many currencies got back in line with what PPP would suggest.

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Let’s take the example of Europe. Five years ago, the euro was overvalued by a massive 50%, compared to the U.S. dollar. Today, the European currency has settled at being a mere 7.8% overvalued.

The Big Mac Index once had the United Kingdom pegged as one of the most expensive places on the planet for much of the past decade. Back in 2007, the British pound hit 2.10 GBP to the U.S. dollar. After the Great Recession, the GBP tumbled to about $1.35. In the current survey, a Big Mac actually costs the same in the United Kingdom — $4.63 — as it does in the United States, where a Big Mac sells for $4.62. (By the way, the cost of a Big Mac in the United States has risen 5.72% over the past year — higher than the headline inflation numbers would suggest.)

This past year, currencies have jostled around more than usual, thanks mostly to two factors.

First, governments have discovered that devaluing currencies is another tool for policy makers to kick-start moribund economies. This is the explicit strategy of the Japanese government, which has devalued the Japanese yen by around 25% since November 2012. Sure enough, that triggered both a rally in the Japanese stock market, and maybe — just maybe — a sustainable economic recovery.

Second, as the global economic recovery takes hold, developed, non-commodities-based economies are doing better than expected, while formerly red-hot emerging markets founder. And that is causing emerging-markets’ currencies to plummet.

The Big Mac Index: Overvalued Currencies

As a group, the Scandinavian currencies have always been the most overvalued ones in the world. A Big Mac in Oslo today is 68.6% more expensive than in the United States. Sweden and Denmark come in at 36% and 12% overvalued, respectively. The safe haven Swiss franc is overvalued by 54.5%. All of these figures are down over the past few years.

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Brazil’s currency — the real — has suffered a big fall. Three years ago, the Brazilian real was 52% overvalued on the Big Mac Index. Today, the real is 13% overvalued compared to the U.S. dollar. And I bet it has further to go.

The Big Mac Index: Undervalued Currencies

The biggest changes in the past year have been the devaluation in emerging markets’ currencies.

For as long as I can recall, the Chinese yuan has been consistently the most undervalued currency in the world. Today, it is far from that. But that has nothing to do with the Chinese. The Chinese yuan remains remarkably stable, still trading 40.7% below its PPP rate, pretty much where it has stood for the past five years.

The 2014 “Big Mac Index” marks the first year that a whole slew of emerging markets’ currencies are now cheaper than the Chinese Yuan. Russia, Hong Kong, Indonesia, South Africa and India are all top emerging markets that have currencies that are cheaper when measured by PPP than the yuan.

The Mexican peso and Chinese yuan are now valued roughly equally — which is part of the reason that so many U.S. and global manufacturers are “re-shoring” to Mexico, and why you’ll be seeing a lot fewer “Made in China” labels in your local Wal-Mart over the coming years.

The Big Mac Index: What You’d Trade Today

So, if you were running a currency hedge fund, and if you were using the principle of buying undervalued currencies — and selling the overvalued ones — here is what you’d do.

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Among the “big six” currencies traded by foreign-exchange traders, you’d sell the Swiss franc (FXF) — the only major currency that is massively overvalued. You’d ignore the British pound sterling (FXB), euro (FXE) and the Canadian dollar (FXC), which are roughly within 10% of their PPP values. The Japanese yen (FXY) is undervalued by 35.7%. But with the Japanese central bank committed to driving the yen down further, I would not go long on the yen.

You could also bet on some less mainstream currencies, as well. Looking purely at the original Big Mac Index, you’d sell the Swedish Krona Trust (FXS) and the Brazilian Real (BZF).

You’d buy the Chinese yuan (CYB) (40.7% undervalued), the Russian ruble (FXR) (43.3% undervalued), the South African rand (SZR) (53.3% undervalued), the Mexican peso (FXM) (40% undervalued) and the Indian Rupee (ICN) (66.8% undervalued).

In case you missed it, I encourage you to read my e-letter column from last week about why small caps are the best investment. I also invite you to comment in the space provided below.

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