What's Up with Currencies?

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.

Interest Rates
Generally the biggest issue in currency movements is different interest rates in the various countries and the expectation of where interest rates are headed. The U.S. started cutting interest rates one and a half years ago, which exacerbated the weakness that already existed in the dollar. The U.S. has been aware for some time that its economy was struggling due to the housing bubble and then the subprime crisis. Interest-rate cuts are intended to boost economic activity by reducing borrowing costs. Lower interest rates make it cheaper to fund investments. For corporations this lowers the hurdle rate a new investment needs to generate in order for the firm to go ahead with the new project. For individuals, lower rates make it cheaper to borrow for additional consumption and for housing. Because part of the subprime mess resulted from adjustable-rate mortgages resetting to higher rates that homebuyers couldn't afford, reducing rates helps bring many mortgages back into affordability.

But while lower rates help the economy, their downside has been that credit markets have frozen up. So, even though projects may be feasible now, companies can't get the funding to invest. Likewise, individuals' credit limits have been pulled on credit cards and second mortgages, and standards have tightened for new loans, which has reduced the consumer's ability to continue to spend or move houses. Because a significant amount of GDP is dependent on consumption, the consumer's inability to spend is adding to the weak economy.

As Europe and other areas of the world realized economic problems were a world phenomenon and not just a U.S. one, they began to aggressively cut rates in the second half of 2008. These European interest-rate cuts and expectations that more would follow were a major factor in the reversal of currency movements from August through December. While there have been many cases of minor currencies having sudden collapses, to have major currencies move as dramatically as the euro and pound have against the dollar in such a short space of time is quite rare. The current drop is even greater than when the pound was forced out of the European mechanism (the precursor to the euro) in 1992.

Unwinding the Carry Trade
However, interest rates and expectations of future interest rates alone aren't sufficient to explain all of the recent currency movements. Hungary and Iceland have jacked up interest rates trying to salvage their currencies, but to no avail. Brazil has possibly the highest real interest rate (the rate above the local inflation rate) in the world, yet its currency has weakened significantly. And Japan has possibly the lowest interest rates in the world, yet its currency has appreciated against the dollar. These unusual moves are related. In the past couple of years many investors, especially hedge funds, have been involved in what has been known as the carry trade. Here an investor borrows cheaply in yen and invests in the higher yields of bonds in Hungary, Iceland, or Brazil. This is very profitable as long as currency movements are benign. In Brazil you actually had the additional benefit of the currency strengthening. However, as currencies have started to gyrate, investors have unwound this trade, usually at a huge loss, but this has meant selling the currency of the high-yield country, which pushes that currency down further, and buying yen, which pushes the yen up further.

Current Account Deficits
One of the major reasons the currencies of Hungary, Iceland, and some other Eastern European countries began to drop in the first place was because of their large current account deficits. (This has been exacerbated in the past couple of weeks.) Historically, when a country has had a current account deficit (the difference between what it generates in GDP and what it consumes, or the amount it needs to borrow from other countries to sustain its standard of living) near 5% of GDP the currency has become vulnerable. The current account deficit was 5% or greater in Asia in 1997, in Russia in 1998, in Turkey in 2000, in Brazil in 2001, and in Argentina in 2002. However, with the world economy growing nicely in the past several years, financing has been very abundant and lenders have been willing to finance significantly larger current account balances. As investors realized the slowdown was going global, suddenly financing disappeared for these highly leveraged countries and their currencies began to swoon. Hungary and Iceland had previously had some short-term problems with their currencies, but they didn't last long and investors became even more sanguine. However, this time they weren't so lucky.

Current Sentiment
In the short term currencies ultimately move because of sentiment. The dollar remains the world's reserve currency. By far the majority of reserves held by central banks remain in U.S. dollars. Many commodities, including oil, are priced in dollars. This generates a certain natural demand for dollars and makes it the most liquid currency in the world. In uncertain times many investors flee to the perceived safety of the U.S. currency. Sentiment is also dependent on a country's foreign exchange reserves. Here many countries are in much better shape than during past crises as they hold significant reserves, especially China and Russia (although Russia has burned through a lot of reserves since I originally wrote this trying to defend the ruble).

However, in the long term the dollar has the same problems it had two years ago, which had caused it to steadily decline against Western European currencies. By the time all the bailouts and the cost of the Iraq War are calculated, the U.S. could be running a current account deficit of close to 7% of GDP (even higher with the recently approved stimulus package). Investors aren't going to be willing to finance that deficit at low interest rates for long. Eventually, the dollar will need to weaken again or interest rates will need to climb, possibly significantly. This concern leads me to believe that inflation will rear its ugly head again, though probably not for at least another year. This concern is one of the reasons for buying  Royal Dutch Shell (RDS.A). I'm also looking at other commodity producers, such as  BHP Billiton (BHP),  Rio Tinto , and  Vale (RIO).

Commodities Influence
The weakness in commodity prices has also influenced the currencies of countries whose GDP is heavily dependent on commodities. Long-term charts of commodities against the Australian dollar and the Canadian dollar show significant correlation. These currencies have rolled over against the U.S. dollar as commodity prices have declined, causing a double whammy for those already invested, but they will provide a double positive if commodity pricing increases again in the long term.

Currency Manipulation
I have written before about many of the Asian countries manipulating their currencies to keep them artificially low against the dollar and the euro in order to increase exports. I expect the global economic slowdown to hurt exports from many of these countries. Without the continued significant inflows of new dollars and euros I think it will become much more difficult for the countries to continue this manipulation. China has the reserves to continue if it wants to, but other countries don't have the reserves China does. I expect to see many Southeast Asian currencies appreciate going forward.

What Does This Mean for Investing?
One of the reasons investing internationally outperformed investing in the U.S. from 2003-07 was the dollar weakening against many currencies. As the dollar weakens, the gains in stocks in those other currencies are amplified when converted back into dollars. In 2008 and so far in 2009, however, the reverse has happened: As the dollar has strengthened, the returns in weaker currencies take an additional hit, causing international returns to be worse. This has been particularly acute in the past six months. I had expected the British pound to weaken due to the U.K. having its own housing bubble, but I certainly hadn't expected it to be this severe this fast. And while I thought the euro had strengthened too far against the dollar, I had expected only minor adjustments over time.

Morningstar is not designed to make currency calls, and although I have opinions that have been fairly good, I want to pick stocks not currencies. Because of that I want to diversify the portfolio with lots of different currencies. While I think Asian currencies will appreciate, I think many Asian economies are only beginning to feel the pain that is coming. This keeps me from rushing to invest there. Ultimately, I am looking for high-quality companies with good balance sheets, trading with a large margin of safety. Because of the volatility in exchange rates I'm looking for a wider margin of safety than usual. I want to make sure currencies don't hurt me too badly in the short term. Longer term, I think the dollar has overshot to the strong side and we will again see currency gains from the dollar weakening, but that may not occur until 2010.

The Bottom Line
The rapid movement in currencies is adding an additional level of complexity to international investing, and I'm looking for an extra margin of safety in order to compensate. One important factor to remember, however, is investing internationally provides opportunities to invest in countries growing much faster than the U.S., and over time that faster growth should provide outsized returns. Although current returns are depressing, I expect for those willing to hold on, long-term returns will make it worthwhile.

This is an updated version of an article that originally appeared in the December issue of theMorningstar InternationalInvestornewsletter. To learn more about theInternationalInvestornewsletter please see information below.