Why You Should Pay Attention to Global Currencies

The relevance of global currency movements is tough for most American investors to get their heads around.

Looking to make the difficult and remote even more philosophically complex, currency speculator extraordinaire George Soros once opined that investing in currencies is an “existential choice.”

Now before you reach your well-thumbed copy of existential philosopher Jean-Paul Sartre’s “Being and Nothingness,” understand that Soros’s point has nothing to do with the thinking of this Gauloises cigarette-smoking, womanizing French rake.

Jean-Paul Sartre: “Me, long the U.S. Dollar? Never!”

Soros’ point is that no matter what you invest in, you are always also betting on a currency — whether you know it or not.

So when you buy a share of Facebook (FB), this U.S.-dollar denominated stock carries U.S. dollar risk with it. You just don’t think about it because the U.S. government does not have a history of announcing an overnight currency devaluation — as governments elsewhere in the world have done in the past.

Throw in the fact that Facebook gets a growing percentage of its revenues from overseas in non-dollar denominated currencies, and you start to see why currencies matter. And that’s even if you are comfortably ensconced far afield on the beach in Naples, Florida.

Enter The “Big Mac” Index

Britain’s Economist magazine has just updated its measure of global currencies — the “Big Mac Index.”

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

The Big Mac Index is useful tool for assessing the relative over- and undervaluation of the U.S. dollar — according to the textbook measures of “purchasing power parity.”

According to the theory of purchasing power parity, a U.S. 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.

Once you compare the Big Mac PPP to the market exchange rates, you see which currencies are under- or overvalued.

I like to think of purchasing power parity as the “fundamentals” of a currency.

But as with stock prices, exchange rates can often diverge substantially from their fundamentals.

The Economist highlighted the following example:

A Big Mac costs 48 kroner ($7.77) in Norway but only $4.80 in the United States. That makes the kroner overvalued by 61.8% and makes it the most overvalued currency in the index. In contrast, the Big Mac costs just $1.62 in Ukraine, making its currency the weakest looked at by the Economist. Ukraine beat out long-time cheapest “Big Mac” champion India — though because Hindus don’t eat beef, Big Macs in India are made of chicken.

One Way to Think About Currencies

Another good intellectual shorthand is to think of a currency as the “stock” of a country.

Much like stocks, overvalued currencies become overvalued for reasons that have little to do with their fundamentals.

These include a country’s future prospects, its perceived “safe haven” status or, as in the case of Brazil, just plain investment fashion.

About four years ago, the Brazilian real was 52% overvalued based on the Big Mac Index. That was because Brazil was perceived to be (yet again) the “country of the future.” But as Brazil’s economic growth has tumbled as the government introduced populist policies, the reputation of Brazil’s currency has suffered a big fall.

Today, the real is “only” 22.1% overvalued compared to the U.S. dollar. But on the Economist’s scale adjusted for gross domestic product (GDP), the real today is still overvalued by an eye-popping 86.8%.

Over the past few years, savvy Brazilians have been quick to convert their overvalued Brazilian reals into Miami condominiums. Based on the current “Big Mac” Index, they would be wise to continue to do so.

Puzzling also is the continued “safe haven” status of the Swiss franc, as well as the still-remaining Scandinavian currencies, the Norwegian Krona and Swedish crown. These currencies have been consistently the most overvalued currencies in the world over the past decade. Today, according to the Big Mac index, each is overvalued by 42.4%, 61.8% and 24.2%, respectively.

Here is one possible explanation.

Deep-pocketed investors don’t think of these currencies like they do others.

Much like central London property, they hold these currencies simply as a way to store value.

When you have too much money, your “existential choice” is about keeping what you have safe.

And these currencies offer the opportunity to do just that.

The ‘Exorbitant Privilege’ of the U.S. Dollar

Just last week, French Finance Minister Michel Sapin launched into a rant about the U.S. dollar’s unfairly dominant position in the international financial system.

He’s not the first Frenchman to do so.

Almost 50 years since Valéry Giscard d’Estaing did the same complaining about the U.S. dollar’s “exorbitant privilege.”

Much to the consternation of the “doom and gloom” crowd, the U.S. dollar has maintained its exorbitant privilege as the world’s safe-haven currency.

And looking at the “Big Mac Index,” the editors of the Economist conclude that the U.S. dollar is faring quite well, thank you.

Despite predictions of the “death of the dollar,” the U.S. dollar has gained ground on its emerging markets rivals since the global financial crisis.

The average valuation of the emerging-market currencies in the Economist’s GDP-weighted index has moved from roughly neutral in 2009 to about 15% undervalued against the dollar this year.

It turns out that the recovering U.S. economy and the Federal Reserve’s gradual reduction of quantitative easing is making the U.S. dollar ever more attractive.

So there you have it…

Currencies add an extra, complex dimension to the investment process.

But understanding how to think about currencies can give you just the extra edge you need to make better and more profitable global investments in the future.

In case you missed it, I encourage you to read my e-letter column from last week about why investing in Russia may not be a crazy idea. I also invite you to comment in the space provided below.