What's Up with Currencies?
Volatile currencies add a level of complexity to international investing.
We all know about the drop in stock markets worldwide. What hasn't been discussed as much is the additional damage weak currencies have inflicted on many international markets. I have written a bit about currencies in past newsletters, but with the significant declines in many currencies in the past three months (the volatility has continued since I originally wrote this article) I wanted to spend time exploring what factors can drive currency movements and how they are affecting how I think about the stocks in the Passport Portfolio.
Purchasing Power Parity
Theoretically currencies find equilibrium based on what is known as "purchasing power parity" (PPP). Basically what this means is a basket of goods should cost the same amount in different countries. As goods change in price due to factors such as wage differentials and inflation, the currencies will adjust to keep the baskets in alignment. Over the long run PPP is a pretty accurate reflection of reality, but in the short term many items can swing currencies far out of alignment, and this can last for years.
One of the problems with PPP in reality versus theory is having an equal basket worldwide. To solve this, The Economist for many years has taken that most ubiquitous of foodstuffs, the McDonald's (MCD) Big Mac, and used the price of Big Macs worldwide to compare currencies. This is a very simplified methodology, but it has been surprisingly accurate over the long term. Please visit visit www.economist.com for the most recent results. Per the last results, most European currencies appear significantly overvalued. Due to currency weakness since then, the British pound is now trading below its Big Mac theoretical value and other European currencies are less overvalued. Asian currencies remain undervalued according to the table; I'll talk about them more later. Now let's look at some reasons why PPP doesn't work in the short term and what drives currency movements.
Allan C. Nichols does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.