Are Currencies Cheap Or Dear? Look To The REER

| About: PowerShares DB (UUP)
This article is now exclusive for PRO subscribers.

Exchange rates reflect the relative value of one currency to another, and can greatly impact the value of an investment that is denominated in a currency other than an investor's home currency. Take, for example, the case of a U.S.-based investor holding a bond denominated in Mexican pesos. Although the price of the bond in Mexican pesos is a determinant of the investor's total return, what ultimately matters more to that investor is the value of the bond once converted into U.S. dollars.

Given the importance of exchange rates in determining investment returns, how can investors assess the value of a foreign currency and its potential impact on returns?

Exchange rates are often expressed as a currency's value relative to U.S. dollars. For one U.S. dollar, how many units of the foreign currency can be purchased (or vice versa)? This is referred to as the nominal exchange rate.

Looking Beyond the Nominal Exchange Rate

The nominal exchange rate, however, may not be the best measure of a currency's underlying value because it does not reflect the true purchasing power between two currencies. We feel a better measure to use is the real exchange rate which adjusts the nominal exchange rate for differences in price levels.

Let's assume that someone holding Mexican pesos can buy a specified basket of goods and services in Mexico for a given price. If that person converted their pesos to U.S. dollars at the nominal exchange rate and could buy the same amount of that basket in the United States, then there is purchasing power parity, meaning one U.S. basket costs the same amount as one Mexican basket after taking into account the exchange rate. However, if the price of the U.S. basket increased by 20% and there was no change in the nominal exchange rate, then for a given amount of Mexican pesos, a larger amount of the Mexican basket can be purchased. The U.S. basket of goods and services is more expensive, and therefore less competitive, versus Mexico. An appreciation of the Mexican peso would reduce this advantage.

An Introduction to REER

Additionally, the exchange rates described above (both nominal and real) only reflect the foreign currency's value against one other currency (e.g., the U.S. dollar). It may be more informative to compare a currency against all of a country's trading partners in order to assess overall value. One measure that practitioners often look to is the real effective exchange rate (REER). The REER takes inflation into account, and is a more comprehensive measure of a country's whole economy as it is a weighted average of bilateral exchange rates. REER is expressed as an index, and represents changes in price rather than absolute prices.

The interpretation of changes in REERs is not necessarily straightforward, because changes in the value of a currency can be caused by both long-term fundamental changes within an economy as well as shorter-term factors. For example, does a declining REER indicate value or structural changes that have fundamentally reduced competitiveness? Further, price competitiveness of a country can be both a cause and effect of economic conditions, so linking movements in the REER to economic performance can be challenging. Additionally, several assumptions go into the calculation, including the measure of inflation that is used.

We believe REERs do, however, convey important information and are a good place to start when examining a currency, and movements may signal changes in fundamental or relative value. All else being equal, a rising REER means that a country's goods are becoming more expensive, and therefore less competitive, relative to its trading partners. As a result, a country's imports would be expected to increase which could lead to a wider current account deficit. A very rapid increase might precede balance of payments difficulties. On the other hand, a declining REER means a country's goods are less expensive, and exports would be expected to increase.

REER Case Studies: Mexico and the U.S.

Market participants and researchers often attempt to estimate an equilibrium REER based on fundamental value. That analysis is beyond the scope of this post, but as a starting point, we'll look at the REERs of two countries, Mexico and the United States, within a historical context (see charts below). If one assumes that the long-term factors that determine equilibrium are reflected in long-term average observed REERs, then historical averages may be a good starting point. It can be seen that the Mexican peso is currently below historical averages, after a sharp decrease following the 2013 taper tantrum and more recent weakness this year. On the other hand, the U.S. dollar is above its historical averages, and reached a recent peak at the beginning of 2016.

Mexico Real Effective Exchange Rate
January 1994 - August 2016

Source: Bloomberg.

United States Real Effective Exchange Rate
January 1994 - August 2016

Source: Bloomberg.

Emerging Markets Local Currencies Still Cheap?

To get a better sense of emerging markets more broadly, the chart below represents a weighted average of the countries currently represented in the J.P. Morgan GBI-EM Core Index (the "Index"), using country weights of the Index as of August 31, 2016. Despite recent strength beginning in February of this year, emerging markets' REERs are still well below the levels experienced in the past decade and are still approximately at the level following the financial crisis in 2009. One possible conclusion is that emerging markets local currencies were, on average, oversold following the taper tantrum and the collapse in commodity prices and may still have room to appreciate before trading at more normalized levels. Rate hikes in the U.S. may provide a headwind, but lower rates for longer still appear likely and the U.S. dollar has already strengthened significantly over the past three years. Additionally, improving fundamentals, generally low inflation, and a stabilization in commodity prices may continue to be a tailwind to emerging markets local currency appreciation.

Emerging Markets Real Effective Exchange Rate Average
January 1994 - August 2016

Source: Bloomberg.

Emerging markets local currency bonds provide investors with two distinct sources of return: local bond yields and potential currency appreciation. Investors can access bonds issued by emerging markets governments and denominated in local currencies with VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSEARCA:EMLC).

Important Definitions And Disclosures

J.P. Morgan GBI-EMG Core Index (GBIEMCOR), is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer.

The indices listed are unmanaged indices and do not reflect the payment of transaction costs, advisory fees, or expenses that are associated with an investment in any underlying exchange-traded funds. Historical performance is not indicative of future results; current data may differ from data quoted. Indexes are unmanaged and are not securities in which an investment can be made.

This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

An investment in the EMLC may be subject to risk which include, among others, credit risk, call risk, interest rate risk, and sovereign defaults, all of which may adversely affect the Fund. High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities. International investing involves additional risks which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity and political instability. Changes in currency exchange rates may negatively impact the Fund's return. Investments in emerging markets securities are subject to elevated risks which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict and social instability. The Fund's assets may be concentrated in a particular sector and may be subject to more risk than investments in a diverse group of sectors.

VanEck Vectors™ J.P. Morgan EM Local Currency Bond ETF (EMLC) is not sponsored, endorsed, sold or promoted by J.P. Morgan and J.P. Morgan makes no representation regarding the advisability of investing in EMLC. J.P. Morgan does not warrant the completeness or accuracy of the J.P. Morgan GBI-EMG Core Index. "J.P. Morgan" is a registered service mark of JPMorgan Chase & Co. © 2016. JPMorgan Chase & Co. All rights reserved.

Investing involves substantial risk and high volatility, including possible loss of principal. Bonds and bond funds will generally decrease in value as interest rates rise. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.