Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
As if investors in the developed world do not have enough to worry about, with weak domestic economies and lost credit ratings, they must also come to terms with a loss of purchasing power given currency depreciation relative to emerging markets. The dollar’s slide is nothing new, but purchasing power has been supported with imported deflation in consumer goods. This may come to an end as prices rise in emerging markets and the dollar continues its downward trend. Dollar weakness is just fine for exporters, but if you want to be rocking a Playstation in your retirement you had better protect your portfolio.
Since 2003, the dollar has fallen 21%, 7%, and 57% against the currencies of China, India, and Brazil respectively. Data from the Federal Reserve for a broad index of currencies shows a similar picture. Given fiscal and economic weaknesses in the developed world relative to emerging markets, this trend is not expected to reverse over the long-term. As Standard & Poor’s showed a couple of weeks ago, the health of the U.S. economy is no longer sacrosanct. S&P is not alone, Fitch recently warned that it would also downgrade U.S. debt if the government missed any bond payments or failed to address its fiscal problems. In the near term, interest rate differentials and a promise by the Fed to leave rates at near zero until 2013 bodes well for capital inflows into emerging markets and currency strength. This all means that investors with their portfolios largely invested in dollar-based companies will see declines in returns, over the long-term, relative to more internationally-diversified portfolios.
In the past, economic growth and currency appreciation in emerging markets has been short-lived. As soon as the capital flows reversed, of which emerging markets were dependent on, their economies crashed and currencies plummeted. This may not be the case going forward. Emerging markets have rebounded from the financial crisis of 2008 faster than the developed world for two reasons. One, the emerging world is much more dependent on China’s growth and commodity needs. While much of the world’s exports are still destined for the United States, the growth in the emerging markets is also partly due to a developing consumer base. When the U.S. sneezes, the rest of the world does not necessarily catch a cold anymore, but instead simply reaches for a tissue and moves on. Additionally, the emerging market has been much more fiscally responsible this time around. The BRICs alone hold 40% of the world’s reserve currencies. While the dollar’s status as the world’s reserve currency lends some support, the trend is toward greater diversification of reserves.
The popular strategy to date has been to invest in companies with significant international revenues. This may offer the investor the opportunity to benefit from the emerging world’s economic growth, but these companies must eventually repatriate their profits. While these profits offer a currency gain from the dollar’s depreciation, they will not help the investor going forward. Despite the familiarity offered the investor by domestic companies and their financial statements, investors must address the issue.
There are several options available to investors to diversify their currency exposure. The most direct would be investment in the equities of foreign companies through ADRs or in their respective foreign markets. While many of these stocks are great buys, investing in a specific company simply to achieve currency diversification is not recommended. Investors should do their own due diligence to find stocks that will provide currency protection as well as growth. Several funds offer exposure to emerging markets. The iShares MSCI Emerging Markets Index Fund (EEM) is by far the most popular. Its regional exposure includes 21.4% in the Americas, 59.4% in greater Asia, and 19.2% in emerging Europe and has returned 15.9% in the last year. The fund holds only 17.5% of its total holdings in non-cyclical sectors, so investors should make sure their macroeconomic outlook will support the shares as well. The leading price-to-earnings ratio, according to Morningstar is 11.56 making it fairly attractive on a valuation. The fund pays a dividend yield of 2.8% making it a good addition to a dividend portfolio. Investors should note that 26.5% of the fund is exposed to South Korea and Taiwan, two countries where investors differ on inclusion in emerging markets. Overall, a good long-term buy but investors should be ready to accept some short-term losses do to macroeconomic weakness.
The iShares MSCI BRIC Index Fund (BKF) holds 39.1%, 30.6%, 15.1%, and 14.7% of assets in China, Brazil, India, and Russia respectively. There is significant overlap in holdings between the EEM and the BKF, so diversification would be limited if holding both funds. Sector exposure is similar to that of the EEM as well, so global growth will play a significant role in fund performance. On a valuation basis, the fund is slightly cheaper than the EEM with a leading P/E of 10.5 times and the dividend yield is significantly higher at 3.65 percent. I prefer the BKF relative to the EEM for the exclusion of nominal emerging markets like South Korea and Taiwan.
Investors can also invest in currency ETFs. The WisdomTree Dreyfus Emerging Currency Fund (CEW) invests in short-term securities and instruments designed to provide exposure to currencies and money market rates of selected emerging markets. The fund has returned 10.3% in the last twelve months. Currency exposure includes: Mexican Peso, Brazilian Real, Chilean Peso, South African Rand, Polish Zloty, Israeli Shekel, Turkish New Lira, Chinese Yuan, South Korean Won, Taiwanese Dollar, and the Indian Rupee. Three factors concern me with the fund. While the theme of the article is that developed country investors must diversify their portfolio to guard against loss of value due to domestic currency depreciation, I would rather invest in companies with revenues in foreign currencies rather than the currencies themselves. While the long-term trend in the currencies may be appreciation, investment in currency funds could sit idle for periods longer than many investors are willing to wait. By investing in companies headquartered overseas, the investor benefits from appreciation in the value of the company as well as in the currency itself. Additionally, the fund itself holds currencies from countries that may not be considered emerging by many investors such as the Shekel, the Taiwanese Dollar, and the South Korean Won. Finally, those countries truly emerging have often showed a preference to short-term currency manipulation or intervention to correct imbalances. Overall, a good fund for a pure play in foreign currencies but investment requires analysis of the monetary policies and intervention within each country.