No Comprehensive Currency Theory
I don’t think we have a really good, comprehensive theory of how currencies interact. Maybe this is because currencies haven’t been floating for that long. But today’s commercial world is also radically different from what it was a generation ago. Countries around the globe have been pretty consistently promoting free trade and trying to coordinate interest rate and other macroeconomic policies. At least partly as a result, the past twenty or thirty years have seen immense growth in international trade, and the rise of large global firms in Asia, Latin America and Europe, to match the scope of their US counterparts. Of course, trade in services, where incremental manufacturing costs may be negligible, has risen dramatically as well.
Stocks vs. Bonds–Different Rules
Currency movements can be a crucial issue for investors to plan for. The picture most investors have, I think , is modelled on how the international bond market works. But currency issues for government bonds are radically different from those for stocks.
An international (100% foreign) or global (US + international) bond manager almost always places a derivative overlay on top of his bond positions. He does this partly to try to exploit inefficiencies in the foreign exchange markets. He also wants to bring his results back into the reference currency in which his performance is judged. Most important, he wants to protect his portfolio from possible future currency losses that he may anticipate but which are not yet expressed in today’s prices. After all, when you get down to it, government bonds are just streams of future payments in nominal terms over a set time frame in a specified currency. Bonds don’t have a life of their own. They can’t act to ward off the adverse effects of currency shifts by developing new products, the way companies can. or by shifting procurement to lower-cost countries, or doing currency hedging themselves.
A (highly simplified) example. Imagine that you buy a government bond yielding 10% issued by a country with a large trade deficit (the value of what it imports is greater than the value of what it sells to the rest of the world–an unsustainable condition). One day, investors wake up and start to worry about the fact that this country has to continually borrow money to pay for imports and maybe that it can’t generate enough foreign exchange to make its interest payments. This is sort of like the way the credit rating agencies start to worry about a consumer who continues to run up credit card debt. Now, the world may tolerate a trade deficit for a longer time if it’s to finance purchases of industrial machinery that will be used to make stuff for the export market, but in this case let’s assume the imports are all consumer goods, like flat screen TVs.
Investors express their worry by selling the currency, pushing it down 5%. The country’s government realizes it will be hard to continue borrowing from the rest of the world if the currency is weak, so it tries to defend the currency by raising interest rates to 11%.
An investor in this country’s government bonds has lost in two ways. Since rates are now 11%, his 10% bond is worth less than par. And, if he is unhedged, he has likely suffered a bigger loss from the currency decline.
Mexico as an Example
For stocks, the situation can be substantially different. The most startling instance I can think of is Mexico after the country came near to collapse in 1982. During the following decade, the peso lost about 99% of its value and local interest rates reached well above the 50% level (I’ve looked in a haphazard way on the internet for the actual numbers, without success. But I figure they’re not so important). Yet stock investors made more money in dollars in the Mexican market during that period than in virtually any other market in the world.
Mexico is admittedly an extreme case. It started in 1982 from a position of near government bankruptcy, due toheavy reliance on oil and excessive borrowing to finance consumption rather than investment. But its citizens had an heroic commitment to transforming the country’s economy. They continued a reform agenda despite eight years in a row of falling real wages. In addition, the government made it illegal for a period for people to transfer money out of the country. So local investors gravitated to stocks to try to preserve the purchasing power of their pesos. The general point is still valid, though–that a stock investor can prosper in a weak currency environment, even without going into the currency futures markets to hedge, as long as he selects stocks correctly.
Currency Effects on Economic Activity
Speaking in the simplest terms, a drop in a country’s currency has two short-term effects: it acts like a decline in interest rates by stimulating overall economic activity; and at the same time it shifts economic energy among sectors, rearranging the relative winners and losers within the economy. In the long term, at least in theory, things settle back to where they were before. The only lasting effect is a higher level of inflation.
As the local currency falls, imported goods become more expensive. Buyers look to local alternatives, so import-competing businesses get a boost. So, too, export-oriented firms, because locally produced goods are now cheaper on the world markets. Local vacationers stay home, because overseas trips are now more expensive; foreigners flock to the local vacation spots in larger numbers. Foreigners may find property and other asset values more attractive and buy, as well.
On the other side of the coin, anyone who uses now higher-cost foreign materials in his products is a loser. So too are importers of foreign finished goods, and the foreign firms who supply anything to the local market.
Rules for Stocks
1. Therefore, all other things being equal, you want to hold a company that has its costs in weak currency countries and its revenues in hard currency countries. This will produce the widest margins. It also explains why the furniture industry has shifted from Europe and the southern US to China and the higher end of the clothing industry is quickly following along.
2. You have to think things out from the perspective of an investor in the company’s home market. Imagine two chocolate companies, each with half its business in the US and half in continental Europe. One is listed in the US, the other in France. Let’s assume the euro is a stronger currency than the dollar. The US one is likely to be an outperformer on Wall Street, the French one is likely to be a relative loser in Paris.
3. Most large companies hedge at least some of their foreign exchange exposure through currency derivatives all the time. Most companies highlight this fact only when they have currency losses, not when they have gains. It’s human nature, but it gives investors an overly optimistic idea of margins.
4. Sometimes, all things aren’t equal. Sometimes, a company can have a unique set of desirable products, or some other reason to be experiencing an extended period of super-strong growth, and currency effects aren’t big enough to destroy the investment case. Example: if you were a euro- (or Dmark-) based investor in the late Eighties, would you buy Microsoft? True, you would have had a currency loss by holding a dollar-denominated asset, but between 1986 and 1999, MSFT went up more than 500x in dollars.
5. I’ve always found the currency derivative market to be tough to make money in. It’s dominated by very sophisticated large banks, who spend 100% of their time thinking about currency and who always seem to be one or two steps ahead of me. So except in extreme cases of misvaluation, mostly with yen, I’ve tended to avoid it. In the example in rule #4, I realize that I would have maybe 30% more if I hedged the currency exposure. But I have no edge in currency. And worrying about currency would take away from time thinking about stocks–thus lessening the chances of finding a MSFT. So I’d have to be content with 500x rather than 650x, but would have a greater chance of making the “smaller” amount of money.
6. Currencies move quickly, stocks usually follow more slowly. I’m not sure why this is the case, or that it will continue to be so in the future. But I’ve found that there’s usually time to position yourself more favorable, even after a currency move has begun. The other side of the coin is that you may have to wait for a month or so for the equity markets to price in the effects of a currency change.
7. The “all other things being equal” works best in emerging markets and with commodity-like products. Big multinationals in developed economies typically can choose among multiple sources of supply in different countries, so they can try to mitigate negative effects of currency by shifts in procurement. Also, they tend to have more complex products, where customers may have no choice but to accept higher prices. They can hedge, as well, by locating assembly plants close to customers, and through the currencies in which they denominate their debt.
8. Note: emerging markets can have other serious pitfalls. It’s important to learn the local rules of the game before starting to play. Stay tuned for a post on this.