The J-curve: sort of useful What it implies for US stocks

What the J-curve is

In economics, the J-curve theory is a (very, overly: take your pick) simple attempt to explain or describe what happens to trade between two countries when the currency of one trading partner declines vs. the other’s.  The theory takes its name from the shape of a graph of the balance of trade, assuming the explanation is correct.  The graph initially bulges in one direction before moving gently and gradually in the other; that is, it looks like a “J” lying on its side.

Like most academic stuff, it rises or falls on the simplifying assumptions the theorist makes.  In the basic form of the theory, they are:

1.  there are only two countries trading.  Let’s call them A and US.

2.  all exports are priced in the currency of the country where they are produced.   Let’s say the currencies are ¥ and $.

3.  prices change immediately, but the quantities imported only gradually respond to the new prices.

An example

If the ¥ rises against the $ by 10%, then everything the US imports from A suddenly costs 10% more in dollars.  The cost in ¥ of imports from A is, correspondingly, 10% lower.

Step 1. Because the prices change right away, the price of imports jumps by 10% immediately and the current account of the US deteriorates on day one.

This makes some intuitive sense:

for unique products, people are stuck paying higher prices;

for other things, it takes consumers time to find less costly substitute products; and

industrial companies, either because they see their currency weakness coming or it’s their normal policy, will have hedged at least part of their ¥ exposure, so they’re not under immediate pressure to act.

Step 2. As time passes, US buyers of imported  goods rethink their purchasing habits.  Some people will do without a certain imported good entirely or buy fewer, say, one a month instead of one a week.  Others will find locally-produced substitutes.  Most will do a combination.  The net result, however, will be that the dollar value of imports will actually decline from the level before the currency weakness.

In country A, the opposite will occur.  The ¥ value of imports will drop initially.  But as consumers adjust to the new prices, they will buy more of the imports they’ve always used, because they’re cheaper, and will substitute away from other locally produced items in favor of equivalents made in the US.

When/where the explanation works

The J-curve is a good first approximation for most situations.

It works best, however, when dealing with unique items, for which there are no substitutes, or for commodity-like items for which there are plenty of substitutes.

It works well when dealing with small countries, where their impact on a global corporation’s profits will be negligible.

It works better with industrial inputs than with consumer items.

More importantly, where/when it doesn’t

Let’s get a minor case out of the way first.  Years ago, Porsche, a company with all its production costs in euros, worried that the euro strength it foresaw against the dollar would undermine its sales in large parts of the world.  So it hedged its anticipated dollar exposure for three years.  It was correct.  It didn’t have to raise prices a lot in its dollar markets.   Both its unit volumes and euro-denominated profits were insulated from dollar weakness for a long time. This is highly unusual–and risky–behavior, though.  It’s the only instance I know of.  Most companies hedge only a part of their currency exposure and for between six months and a year.

The main problem with the J-curve:  consumer companies and major markets for their products.

Take automobiles, the quintessential traded good, as an example.

The yen has risen against the dollar by about 15% over the past year.  Toyota would have to be crazy to raise its prices by that much in the US.   The risks are too high.  Not only would an extra $4,000-$5,000 on the price tag send customers who have bought nothing but Toyotas for a generation running from the showroom., but that would put the thought in their heads, perhaps for the first time ever, to give Ford or Hyundai a try.

In other words, in the US Toyota prices its output in dollars, not in yen.  Failure to understand this is the key flaw in the J-curve explanation.

Sony and Nintendo are another case in point.  Despite the rise in the yen over the past year, they are lowering the dollar price of their game machines, in order to stimulate demand.

What does a strong-currency company in this situation do?

1.  The company realizes that market share slowly and expensively built over many years is more important than short-term profits and suffers a falloff in home-currency results.

2.  It focuses on cost-cutting and on innovation to try to rebuild profits.

3. It slowly begins to raise prices, to the extent that the competition allows it to.  As a general rule, prices can rise only in line with inflation (that is, the overall increase in the price level) in the weak-currency country.

Implications for stocks

1.  The J-curve doesn’t work that well as an explanation of competitive behavior in a large market with global companies like the US.

2.  In the United States stock market, look for exporters, or for companies with large presence in strong-currency markets.  Currency effects may not be much of a help to import-competing firms.

3.  For a Japanese buyer, US assets are now 15% cheaper than they were a year ago–and 25% less than they were five years ago.  Urban real estate purchases and vacations here must seem particularly attractive–at the same time similar purchases abroad must appear daunting to Americans.  My guess is that these two areas will be hot spots of profit growth over the next few years.

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