Foreign Stocks: Currency Moves Determine Actual Profits

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Includes: BZF, CYB, FXA, FXB, FXC, FXE, FXF, FXS, FXSG, FXY, ICN, NOKS, NZDS
by: Daryl Montgomery

Summary

Stock returns on investments in foreign countries are determined by both changes in stock prices and currencies.

Investors only get the stock market return if the currency exchange rate is flat.

If a currency goes down the same amount as the stock market goes up, there is no return.

Investors need to search out countries where both stocks and the currency are increasing in value.

On August 9th, the FTSE 100 notched its fourth straight gain and was up over 10% on the year. Supporters of Brexit felt vindicated that the collapse that opponents predicted after the June 2016 vote not only didn't take place, but investors were profiting handsomely. In reality, this was not the situation at all. The British pound went down by roughly the same amount as the stock market went up, and the combined changes left investors no better or worse off. Meanwhile, on the continent, the euro was up only slightly on the year, so it was effectively close to unchanged. This meant stock returns for foreign investors were roughly what they seemed to be. Across the Atlantic, however, Brazilian investors had a lot more to celebrate than just the Olympics.

Investors who buy stocks priced in foreign currency need to consider both the change in stock price (or the index price, if they are buying the overall market) and the change in the foreign currency versus their own. If the value of the foreign currency is going down, this will subtract from their stock returns. If the currency exchange rate is flat, the return on stocks will be unaffected. If the foreign currency gains value versus their own, they will be getting even higher returns than just what they're making on their stocks.

The current British stock market is an example of the first case. The market is rising, and nominal returns are impressive. However, the value of the British pound is falling by approximately the same amount. If you are a dollar (or any other foreign currency) holder, when your gains are translated back into your home currency, they will disappear. In general, this type of action is common when a currency is devalued. Stock prices will go up, so their new price maintains the same total value (if the currency devaluation is overnight, stocks will also adjust their prices overnight). The chart below shows the FTSE 100 in black and the British pound in gold. While stocks are up about 12%, the currency is down about 12%.

UK Stocks and the British Pound, 2016 Year to Date

Stocks trading in euros in August 2016 were examples of what happens when a currency's exchange rate is relatively unchanged. At least this was true if your native currency was the U.S. dollar. The euro was even totally flat compared to the dollar at several points early in 2016. It was up only a couple of percent in mid-August. So, the returns investors got on stocks in all the eurozone countries were essentially unaffected by currency. The chart below shows German stocks versus the euro. The black line is the German market and the gold line the euro.

German Stocks and the Euro, 2016 Year to Date

The situation every investor would like to find himself in is when both a stock market and the currency of a country both go up together. This supercharges stock returns. Brazil was a glowing example of this pattern in 2016. Its main stock index, the Bovespa, was up around 37%, and its currency, the real, was up around 35% by mid-August. In the chart below, the black line is the Bovespa and the gold line is the real.

Brazilian Stocks and the Real, 2016 Year to Date

There is, of course, a fourth possibility for stock and currency movements - both could go down. This would be the worst of all possible worlds, making losses from stocks even bigger. This situation must be avoided at all costs.

When investors are putting money overseas, they need to analyze both stock and currency markets. In 2016, the big winners in this regard have been in South America. The industrially advanced countries of Europe, Japan and North America are relatively moribund compared to a number of emerging markets. More about the outperformance of emerging markets in 2016 can be found here. For information about currencies outperforming the U.S. dollar, go here.

In order to make comparisons, investors can use currency and ETPs (exchange-traded products). In the U.S., these include: the Australian dollar (NYSEARCA:FXA), the British pound (NYSEARCA:FXB), the Canadian dollar (NYSEARCA:FXC), the euro (NYSEARCA:FXE), the Swiss franc (NYSEARCA:FXF), the Swedish krona (NYSEARCA:FXS), the Singapore dollar (NYSEARCA:FXSG), the Japanese yen (NYSEARCA:FXY), the Brazilian real (NYSEARCA:BZF), the Chinese yuan (NYSEARCA:CYB) and the Indian rupee (NYSEARCA:ICN). There are also additional currency ETPs that trade in the UK, including the New Zealand dollar (UK:LNZD) and the Norwegian krone (UK:LNOK). If there isn't a currency ETP, then a chart needs to be found by some other means to make sure it's heading up versus the dollar (or the investor's home currency). If it isn't, an investor should reconsider their stock strategy.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.