The International Monetary Fund (IMF) recently asked central banks how they want to change the composition of their currency reserves. Their answer? They want to stock up on emerging-market currencies – in particular, the Chinese yuan.
I’m not surprised. I’m preparing for the day when the current US dollar hegemony fades away. I increasingly take the long view when I think about investing, and as a result, I find myself buying emerging-market (EM) assets. As the relative value of Western currency wanes, I can’t help but think that exposure to emerging markets will be key.
A Big Mac in every city and every town
When I talk about currency exposure, I’m not talking about holding cold, hard cash – be it in Thai baht, Indonesian rupiah, or Vietnamese dong. What I’m really talking about is stocks or bonds denominated in EM currencies.
It’s sometimes forgotten that currency exposure often represents half of the performance of these EM investments.
And though the currencies can be volatile, there’s every reason to suspect they’ll continue to give EM positions a decent fillip over the long run. Here’s why.
Purchasing power parity (PPP) is a simple theory to help understand how to value different currencies. The idea is that a basket of goods should cost about the same across currency borders. If you price a broadly similar basket of goods in two different currencies, you’ll be able to work out the exchange rate simply by comparing what each basket cost you.
That’s why the Economist publishes its Big Mac index. The price of this very identifiable and broadly similar product is compared across different currencies to see which currencies are over or undervalued. Though it’s just a bit of fun, it is very much an exercise in PPP.
PPP is theoretical, so it’s a bit limited. Like so many economic theories it ignores things like transaction costs and trade barriers, so it can’t be fully relied upon in the real world. And that’s great news. I mean, one of the joys of travel is exploiting relative price differences in different countries.
But the idea is nonetheless a very useful one, and it explains why, over time, emerging-market currencies should continue to rise.
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As a gap-year student, I spent several months travelling in Romania, a country that had only just opened its borders to a curious West. This was an economic disaster zone. The currency (lei) was pretty much worthless. I could change a tenner on the black market and get in return a massive wodge of tatty local notes. In fact, to look at the state of them, you already had suspicions about its inherent value.
The initial excitement of becoming an instantly rich lei-man waned as I realised there was nothing to spend this paper on. Well, next to nothing: at the time, cheap beer was still an exciting prospect!
The point is to try to work out the value of lei in terms of PPP was all but impossible. You simply wouldn’t be able to fill a shopping basket remotely comparable to one in the UK. In terms of international trade, the lei was, to all intents and purposes, worthless.
As I went about my business, it became clear that the only place I could get hold of essentials was at the unofficial black markets. Only thing was, these were hard currency markets, operating in sterling, deutschmarks, or dollars. I was an instant pauper, once again!
Fast forward to today and clearly it’s a very different story. Slowly but surely, liberalisation and globalisation has dragged up purchasing power around the emerging world. As the locals create more and more stuff of value and international appeal, EM currencies tend to appreciate.
My thesis is that this process is set to continue – the guys that are working hard to achieve prosperity will be rewarded with a rising currency. This has important implications for your investments.
How to invest overseas
For me, the long-term direction of EM currencies is clear. But of course, the short term is a very different story.
As I said, these currencies are volatile. International speculators drive them up and down on a whim. And right now, that whim has pushed most EM currencies to multi-month, or even multi-year lows.
Basically, it’s all this talk of ‘tapering’ in the US. The international financiers have got it in their collective head that the US is in strong recovery mode. They say the dollar is set to strengthen as quantitative easing (QE) stalls and rates rise. The idea is that the dollar is a much safer bet than any EM currencies.
Well, I have my suspicions about all of that; especially over the long run.
But for me, I’ll take all the negativity surrounding the EM markets as an opportunity.
Lars Henriksson is something of an EM expert. He lives in Malaysia and works day and night to find the hottest emerging-market companies for his subscribers. Lars finds exciting companies, and then enjoys the tailwind from appreciating EM currencies. He’s good at it too.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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