Currency Risk To Push U.S. And European Stocks Higher

Includes: EWG, EWL, EWU, SPY, VGK
by: Morgan Myrmo

The current fuss over a potential U.S. stock market correction is likely unwarranted when putting the current state of global currency into context.

Using the current Fed taper as a backdrop, investors have began a stampede out of emerging market and commodity currencies this month. Extreme examples include the Turkish lira, the South African rand and the Argentinean peso, which are down 5.8%, 7.5% and 22.5% against the U.S. dollar, respectively, over the past month.

Leading the currency outflow is Argentina's peso, which has lost 22.5% versus the U.S. dollar this month.

Depreciating 7.5% in one month is also very severe, as noted in the U.S. dollar's appreciation versus the South African rand.

The strong dollar has also impacted commodity currencies, with the Australian dollar down 2%, the New Zealand dollar down 1.3% and the Canadian dollar (loonie) down 5.1% versus the U.S. dollar over the past month.

The Russian ruble, which is both an emerging and commodity currency, is down 7.3% versus the U.S. dollar over the past month.

When risk is on, the safe-haven U.S. treasuries generally do well. As investors flee emerging markets, the 10-year bond yield has come under pressure, for a reduction of 36 basis points on the year. After rising last year to close out at 3.03%, the yield quickly dropped in January 2014 to 2.67%.

It's also important to note that the U.S. dollar has been stable in terms of the euro, the Great Britain pound and the Swiss franc this year, with very minor depreciation observed over the past two years.

The EUR/USD has been flat in 2014, with the dollar down ~4% over two years.

The GBP/USD has also been stable over the past month, with the dollar down ~5.4% over the past two years.

The CHF/USD (franc/dollar) has been flat on the year, with the dollar losing ~2.8% over the past two years.

What is important to note here is that the leading three of the four most important global reserve currencies (USD, EUR and GBP), as well as the Swiss franc have all traded closely over the last two years and 2014-to-date, while developing markets and commodity markets have been under pressure.

Note: The yen is also an important reserve currency, however is left out of this analysis. The yen has dropped over 30% versus the U.S. dollar in the past two years, for reasons not applicable to this research.

The New Paradigm: Currency Risk

With markets setting the stage in the first month of 2014 by crushing emerging market currencies and punishing resource currencies versus the U.S. dollar, the euro, the Great Britain pound and the Swiss franc, a tone has been sent that reflects anti-emerging market sentiment.

The strong dollar is bad for gold and other natural resources, as the cost is reduced in dollar terms versus the global weakening currencies of emerging markets such as Brazil, South Africa, Australia and New Zealand.

With increased demand for the U.S. dollar seen in both currency prices and treasury yields, the 2013 "rising rates" investment theme has given way to the new threat of currency risk.

Capitalizing on Currency Risk

Currency risk is translated into the value of stocks translated into domestic currency. For example, a U.S. investor owns an index fund of European equities valued at $10,000. If the European equity index goes up 10% in one year, the value becomes $11,000 in terms of the Euro.

When translated into the U.S. dollar, currency risk takes place. If the dollar has weakened 5%, then the value becomes $11,579 ($11,000/0.95), for an enhanced 15.79% return. If the dollar strengthens 5% however, the value drops to $10,476 ($11,000/1.05), for a muted dollar return of 4.76%.

Now imagine the emerging market currencies that are dropping over 5% this month to start out 2014, such as the Turkish lira, Russian ruble, Argentinean peso and the South African rand. If this trend is to persist, emerging market stocks are going to suffer this year.

Developed markets that are focused on commodities, such as the Australian and New Zealand dollars and the loonie are coming under pressure as well.

The only currencies left, excluding the Japanese yen, are the developed country, non-commodity based currencies that are primarily represented by the U.S. dollar, the euro, the Great Britain pound and the Swiss franc.

The 2014 Currency Risk Bandwagon Plays

For those looking to jump on the bandwagon early, the play is to buy large-cap stocks that are part of indexes based in the ex-yen developed market currency basket.

For starters, the SPDR S&P 500 Index ETF (NYSEARCA:SPY) is a low-cost fund that tracks the S&P 500 index. The trading volume is very large and the ETF gives blanket exposure to the U.S. stock market.

In Europe, one of the best options is the Vanguard FTSE Europe ETF (NYSEARCA:VGK), a low-cost index fund that tracks the European developed market with large-cap holdings. VGK holds 497 stocks in 17 countries that include the UK, France, Switzerland and Germany. For simplicity's sake, the FTSE Developed Index that VGK tracks could be thought of as the EURO S&P 500 Index.

For those looking for specific European country plays, the iShares MSCI Switzerland Capped Index ETF (NYSEARCA:EWL), the iShares MSCI United Kingdom ETF (NYSEARCA:EWU) and the iShares MSCI Germany ETF (NYSEARCA:EWG) are all excellent options for those looking to own a direct holding in Switzerland, the UK and/or Germany.

Here is a chart of these five options over the past 52-week time period.

SPY Chart

With the current global sell-off, these five index plays are down on the year, thus offering attractive entry-points after last year's large gains.

SPY Chart

For investors based in both developed and emerging markets that are looking maintain equity exposure while hedging against currency risk, the U.S./euro large-caps are a great starting point.

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

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