There seems to be a strange order that prevails in the relationship between currencies and global stock indexes. Over the long term (in this case, since the end of Bretton Woods), the strength of a given currency gives very little information about how well its equity index will perform. But, the tendency of that index to correlate with its exchange rate over time does.
Specifically, the more an index measured in terms of a base stock index (and in a common currency, of course) correlates with its exchange rate (that is, negatively correlates with currency strength), the more likely it is to outperform other indexes that more negatively correlate with their exchange rates (positively correlate with currency strength).
I interpret that to mean that among high-performing stock markets, countries with weaker currencies (rising exchange rates) outperform those with stronger currencies (falling exchange rates). Among weaker stock markets, I am less sure of the order of performance. The way I have gone about the analysis suggests that among the losers, those with weaker currencies should perform worse, but as I have been preparing this article, I am less sure than I was before. It is possible that stock markets with weak currencies perform better than markets with strong currencies.
So, there seems to be either a "sandwich effect" or a "cake effect," when it comes to the relationship between stocks and currencies.
The sandwich effect would look like this:
|Order of long-term performance of global indexes?|
|1. strong markets/weak currencies|
|2. strong markets/strong currencies|
|3. weak markets/strong currencies|
|4. weak markets/weak currencies|
The cake effect would invert "3" and "4."
|Order of long-term performance of global indexes?|
|1. strong markets/weak currencies|
|2. strong markets/strong currencies|
|3. weak markets/weak currencies|
|4. weak markets/strong currencies|
Although in this article I am going to focus on the relationship between exchange rates and stock indexes, the same can be said for the relationship between inflation and stock indexes. The more a stock index measured in terms of a base stock index (I am using the US as a base reference) correlates with its CPI (measured in its domestic currency) relative to American CPI (measured in dollars), the more likely it is to have outperformed other stock indexes.
Since thinking about exchange rates and currency strength and negative correlations and the contrast between long- and short-term tendencies within global equity markets can get pretty confusing (I promise), I am going to try to break this argument up into digestible pieces as best I can.
In Part I, my aim is to map the contours of the problem that I have found. In Part II (and if necessary, a Part III), I am going to try to analyze whether this is a permanent feature of the post-Bretton Woods order or if it is a fluke peculiar to the period ending in 2013 (or the period beginning in 1971), or something in between. In Part I, the focus will be cross-country comparisons, and in Part II, I will focus on incremental changes across time. In the 1994-1998 period, for example, which concluded with the dramatic East Asian currency crisis, currency strength was, unsurprisingly, a good predictor of which stock indices would perform best, but this layering effect that I will try to describe was undiminished: among the winning markets, those that depreciated their currencies and inflated (on a relative basis) outperformed their strong-currency counterparts. And, on the lower end of the markets I have looked at, the nation with the worst-performing stock market (again, in dollar terms), had a stronger currency than did other losers.
That raises a problem with this analysis, however. Because I am focusing on long-term results since 1971, I am restricted to the seventeen markets for which I have stock market data. It is possible that with the inclusion of a greater degree of smaller, developing markets, these effects will not hold up. Including those markets in the discussion might be a worthwhile endeavor for a Part III.
As I glance at the broader set of 1994-1998 data while preparing this article, however, I notice that among the OECD and the BRICS (stock market data for all of these countries can be found conveniently at the OECD website), the country that had the worst performing currency, Turkey (by far, with an 800% increase in its exchange rate), had a much better stock market performance compared to Japan, whose currency weakened only slightly relative to the dollar. Thailand, which is not included in the data provided by the OECD, had a 90% decline in its stock market in dollar terms in 1994-1998, having only doubled its exchange rate.
The other big problem is that I am using stock index performance rather than total return data. I just do not have enough long-run return data to conduct a useful analysis. Dividend growth is a huge part of investment returns over the long haul. Thailand's performance relative to the US has held up primarily because of its high, if unstable, earnings growth. Having said that, my first thought is that total return data might actually support my case. If, as a rule, poor countries experience higher rates of growth, inflation, and currency depreciation, they may also have higher dividend growth and therefore higher returns than otherwise suggested by stock index performance.
But, let's save all that for another installment.
For now, here is the comparison between inflation, currency performance, and stock index performance for the seventeen countries since 1971. The US market will often get lost in the shuffle here, because I used it as the base country, although I hope to try to apply some of this analysis to the US in Part II.
|Country||Stock performance ($) % change 1971-2013||Exchange Rate % change 1971-2013 (positive change means depreciation)||CPI % change 1971-2013|
|Correlation w/ stock performance||1.0||-0.15||-0.23|
As you can see, assuming that we had already known in 1971 where CPI and exchange rates would stand in 2013 for those seventeen countries, that would not have told us anything about where their stock indexes would stand relative to one another last year.
If you go on a country-by-country basis, though, you will find that on average, a country's stock market ratio (its dollar-denominated index price divided by the US index) tends to inversely correlate with its exchange rate (i.e., positively correlate with currency strength). The average correlation was -0.32. In other words, for the average stock market boom or bust (defined here as a rise or fall relative to the US index), its domestic currency was more likely to strengthen or weaken, respectively, than not, which is about what would be expected.
Austria is a fairly representative example of this.
Over the course of those 43 years, Austria's stock market ratio tended to inversely correlate with its exchange rate and CPI ratio (Austrian CPI in euros divided by American CPI in dollars). Exchange rates and CPI ratios tend to be highly correlated across all countries (i.e., among all the OECD + BRICS + Indonesia). (Somewhat unexpectedly, exchange rates were more highly correlated with CPI ratios than they were real exchange rates).
For Austria, the correlation between the stock market ratio and the exchange rate was -0.35.
A more extreme example of this relationship can be found in South Africa.
The correlation between South Africa's stock market ratio and its exchange rate was -0.74. And, this is what you would expect to see: a big fall in South Africa's relative stock performance matched by a big rise in its exchange rate (a fall in the value of the rand).
On the other end is Finland.
The correlation between the Finnish stock ratio and its exchange rate is 0.2, meaning that there was a slight tendency for equity strength to coincide with currency weakness and/or equity weakness to coincide with currency strength.
Instead of going country by country, we can plot all of those on a scatter chart like the one below. It shows that -- no surprise -- some countries' stock ratios correlate with their exchange rates and CPI ratios more than others.
But, when we overlay long-term stock performance, an interesting pattern shows up. The more positive the correlation with the exchange rate or CPI ratio, the better its long-term performance tended to be.
There may be a simple explanation for this: South Africa. I do not mean South Africa alone, but those countries that have seen weak stock markets and rising exchange rates (weakening currencies). They will, one would think, inevitably tend to produce strong negative correlations, and so those negative correlations would then predict weak returns. Viola! Problem solved!
But, I do not think that would explain the upper end, the "Finlands." Look at the charts below, which compare long-term stock performance with the correlation between stock ratios and currencies. Among the highest performers, with the exception of Switzerland, superior stock index performance goes almost hand-in-hand with a tendency towards positive correlations with the exchange rate, meaning that there was a fairly considerable tendency for currency weakness to coincide with higher stock performance in dollar terms.
I am not a statistician, so I am sure this is not the most sophisticated way of going about the analysis, but it seemed like the best way for a rank amateur to determine how much of the effect is due to effects on the lower end of the scale was to run the correlations again, this time chopping off the weakest performers one by one. And, again, by chopping off the winners one by one.
What I found was that by chopping off the weakest performers, the correlations did not change, but chopping off the strongest performers had a strong impact, which if I am not mistaken, means that the effect is not caused by the weak markets correlating with weak currencies.
A simpler way of going about it is dividing the sixteen countries (if you remember, the US market is being used as a base) into the eight worst and eight best performers. Among the best eight performers, the correlation is 0.62. Among the eight worst, it is 0.32. Again, the effect is stronger among high performers than low performers, meaning that it is unlikely that correlations predict returns due to very weak markets.
I suspect that the reason that the correlation is low among low performers is because that depreciation is boosting weak performers just as it is "boosting" strong performers (although I am not getting into causation just yet). At this stage, however, that is more of a hunch than anything else.
To wrap things up, let me attempt to describe the general problem of the relationship between currencies and stocks once again, as I see it.
1. Currency strength is only weakly correlated with stock market strength over the long term.
2. Over the short-term, however, in an average market, stock market (ratios) are more likely to correlate with currency strength (inversely correlate with exchange rates) than not.
3. But, the more likely a market (ratio) is to correlate with currency strength (negatively correlate with its exchange rate), the worse its long-term performance has been.
4. This relationship is more distinct in high-performing stock markets than low.
5. Therefore, if you had known in 1971 which currencies would have appreciated the most, this would not have been very helpful in picking which global market to invest in, but if you had been told which countries were the least likely to correlate with their exchange rates, this would have been very profitable.
So, the next question is, assuming this is not a statistical fluke or a spreadsheet mishap, is it an historical accident? I mean, is this a real long-term relationship, or is there something about the ending in 2013 or beginning in 1971 that produces this? And, if it is real, why?
I am going to take those questions up in Part II, but my tentative answer is that this condition seems to be strongest during periods of "deflationary shocks," such as during the crises of the early 1980s and late 1990s. But, it also seems to be an increasingly chronic condition since the early 1990s, presumably beginning with the collapse of Japan and the end of the high inflation of the 1980s in many developing markets.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.