What drives the value of a currency?
Interest rates used to be considered the main driver – the higher the rate (after inflation), the higher the currency. And it makes sense. Investors will invest where cash earns most interest. And that demand should move the price (exchange rate) up.
But in recent times this theory seems to have been lost on the investoriat.
These days we see many of the strongest currencies in the world paying precious little to investors. In many ways this is a product of the flight to safety – the Swiss franc for instance. We’ve even seen the pound bounce despite economic policies that would normally prove fatal.
It’s not just interest rates that determine relative currency valuations. Prices do too. Economists call the theory 'purchase power parity' (PPP). And I’d like to explain how we can use it to spot undervalued currencies. In fact I’ll point to one deeply undervalued currency today.
The importance of the Big Mac
It’s based on the idea that a similar basket of goods should cost the same amount of money wherever you go. If the goods are cheaper in one country, then that country should be able to export the goods to other countries at a profit. Thus demand for its currency goes up... and so the price of its basket of goods gets dearer. Indeed, over the long-run, prices tend towards parity.
Though the theory bears the typical hallmarks of an economist’s illusion, there’s undoubtedly some basic sense to it.
My favourite PPP currency indicator is the Big Mac index (BMI). Quite an appropriate acronym for a burger index I think you’ll agree!
The Economist magazine publishes the figures annually. It shows the $US value of a Big Mac across the globe. And to my mind, it’s an important, as well as fascinating indicator.
The good thing about a Big Mac is its uniformity – no need for a committee to assess what an international shopping basket might look like. Just look at Big Macs!
The following chart shows the index. You should just about make out the price of the Big Mac on the right hand side of the chart (in blue). The further down the chart you go, the cheaper you’ll get a Big Mac – and – perhaps, the more undervalued the currency...
The Big Mac Index (BMI)
This year, the Economist has put together quite a useful graphic. You’ll notice the lollipop layout. Basically, the light blue blob shows the pre financial crisis (2007) price of a Big Mac. And the dark blob shows us its price today. It shows – in Big Mac terms – how the currencies have fared during these post-crisis years.
Just to put things in context, the red line running through the centre is the price of a Big Mac in the USA... $4.33.
The index suggests that currencies to the right of the red line are overvalued, while those on the left are undervalued.
An exclusive report from The Right Side
Twice the growth at half the price
The first interesting point to note is that back in 2007, the index told us that the euro was about 20% overvalued. If you’d have used burgers as a basis for shorting the euro, you’d have done well. For those of you looking for the euro to fall to parity with the dollar, I can tell you it already has. Well, in terms of Big Macs it has!
The next thing of note is that many of the emerging market currencies have strengthened. Just look at Brazil – a Big Mac will cost you around 15% more than in the States. The currencies of Indonesia, China and Hong Kong are moving closer to parity with the dollar. This is in line with my long term view. In fact, I expect things to accelerate as soon as dollar concerns come back after the presidential election.
But there’s an exception that I want to home in on. And that is the Russian rouble.
Pre crisis, the rouble looked undervalued. And today it looks even more undervalued. I think it’s fair to say that Russia is pretty much unloved. Few investors have the stomach to put their money into Russia. Russian equities are trading on a price/earnings (PE) ratio of around five or six times, yet you’ll find European markets on double that. And that’s despite the fact that Europe is stagnating... and here’s Russia putting in a very respectable 3.5% rise in GDP this year.
When you think about it, much of the West is buckling under the crushing weight of an untenable welfare state. Yet Russia has made far fewer promises to its electorate.
A cheap way to buy Russian
I am still a believer in Russia. I think the political risks are overstated, while in the West they’re considerably understated.
I previously tipped a cost-effective way of getting exposure to Russian equities. And that was via the JP Morgan Russia investment trust. Unfortunately, the trust hasn’t performed well since I mentioned it. The price has drifted from £6.72 to just under £5 today. I guess we were a little early into that one.
But to me, this looks like a bargain. You’re getting twice the growth of Europe at half the price. And what’s more, there’s a nice hedge against socio-political fall-out from a crumbling West.
With the price of a Russian Big Mac coming in at around half its American equivalent, there’s good reason to suspect the rouble is undervalued. If you buy Russian stocks today, you’ll not only get the benefit of a rising Russian market, you’ll also get the boost from any currency gain.
Of course Russia could remain unloved – its stocks as well as its currency. But surely not forever!
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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