The New Zealand kiwi is nearing an all-time high against the
That's great news for any U.S. exporters looking to sell goods
into that country, as U.S. made products become relatively less
expensive. On the flip side, the surging kiwi makes New Zealand a
costlier destination for U.S. travelers.
Yet for investors, this currency move represents a completely
different set of issues. And currency moves may be the single
most important factor when you are trading in and out of foreign
Apologies to advanced investors, but a few basic explanations
are in order. When you buy shares of a foreign stock (likely
through an American depositary receipt), mutual fund or
exchange-traded fund (
), your dollars must be converted into the local currency. And if
that currency rises in value, as the New Zealand kiwi just has,
then your investment rises in value by an identical amount, as
you own kiwi-denominated assets, not dollar-denominated assets.
(This notion mostly applies to stocks as most foreign bonds are
mostly denominated in dollars or euros.)
We saw the impact of a surging currency in recent quarters, as
the Indian rupee staged a remarkable rebound against the U.S.
dollar last fall and winter.
As I noted last week
, India's SENSEX index rose an impressive 35% over the past 10
months, but many India ETFs rose by a significantly higher
amount, thanks to currency gains.
Of course, it works both ways. Last summer, the Indian rupee
was in freefall, and those same ETFs fell at a much sharper rate
than that India index. Back then, investors were abandoning
emerging markets on concerns that key currencies were plunging,
which were magnifying losses. That episode unfortunately spooked
many investors, leading them to conclude that emerging markets
simply carry too much risk. And that's a shame, because as we saw
with India, what a currency taketh away, it also giveth.
How to Gauge a Currency
At first blush, it may seem impossible to know which direction a
currency will move in any given period. But foreign exchange
traders make such assessments and prediction all the time. George
Soros made the trade of a lifetime in 1992, correctly predicting
an imminent plunge for the British pound. But you don't have to
be Soros to develop an informed view of currencies. You just have
to do a little digging.
Let's pivot back to that emerging market swoon last summer. At
the time, the financial press was buzzing about the "
," which were a group of countries (Brazil, Indonesia, South
Africa, Turkey and India) that were running unsustainable trade
Indeed, for a variety of reasons, you should avoid countries
that consistently import a lot more goods than they export. It
creates massive economic imbalances in those countries that can
cripple growth and send foreign investors fleeing. The fact that
such trade deficits invariably end up driving down local
currencies is just one more reason to avoid them.
Ironically, when such countries begin the process of
addressing their economic problems, they can hold great appeal to
investors. India's game plan regarding its economic woes has
emerged as the most robust of those Fragile Five, which is why
the Indian stock market -- and the Indian currency -- have
rebounded in such dramatic fashion.
Currency movements aren't based solely on trade balances. They
are also tied to the amount of foreign currency reserves that a
country holds. Before you invest in any emerging market, check to
see that the country has billions of dollars and euros socked
away in its central bank, and check to see that this balance is
remaining constant or growing. If you spot falling foreign
country reserves, there's a good chance its currency will soon
weaken as global investors grow scared.
Lastly, pay attention to interest rate differentials. The New
Zealand kiwi is surging because New Zealand's central bank is
raising rates -- and the U.S. Fed is not. Global funds flow
toward countries with rising rates and away from countries with
flat or falling rates.
There's one final thing you need to know about currencies:
They always revert to the mean.
The Indian rupee's plunge last summer led to huge strains on
that economy, and it became increasingly clear that actions were
needed to strengthen the currency. Conversely, the Brazilian real
had grown so strong in 2010 and 2011 against the dollar
(magnifying gains for U.S. investors in the process), that the
Brazilian economy grew less competitive. The Brazilian government
eventually took steps to weaken its currency (bad for U.S.
investors), though that effort has been somewhat blunted by
stubbornly high inflation. Once the Brazilian central bank
decides that inflation is less of a threat, then it will lower
interest rates, which will likely weaken the currency further.
Translation: U.S. investors may want to avoid Brazilian stocks
and ETFs until that process has played out.
Risks to Consider:
The U.S. dollar, seen as a safe haven, somewhat dilutes the
natural mechanisms of currency movements. In times of economic
crisis, global investors flock to the dollar, blunting the
returns of any emerging market investments as local currencies
Action to Take -->
Currency issues aren't the only consideration for emerging
markets. Economic growth rates, inflation trends, government
policies and many other factors also go into the mix in deciding
the winners and losers in emerging markets. But if you ignore the
currency issue, you could be in for a rude surprise (or in
examples like India, an unexpected tailwind).
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