Getting bang for your buck
From the Hungarian forint to the Chilean peso, currencies can be a valuable partner in managing investments.
Currencies offer a source of diversification. The oil-heavy Norwegian krone, for instance, behaves differently to the industry-based Swiss franc; and they each behave differently to the US dollar. When things are tough in energy-based Norway, things could be fine in pharmaceutical-exporting Switzerland; and your “drugs and oil” portfolio will earn in dollars as the global default currency. As with other asset classes, combining non-correlated assets into a portfolio creates diversification which means you can achieve the same investment outcome with lower volatility. In this way, currency, as a diversifier, reduces portfolio risk.
Currencies can also be a source of return in at least two ways. Either by buying a currency when it is attractively priced and selling when it appreciates – for example the currently inexpensive and appealing Canadian dollar, or Loonie. Or returns can come though owning a currency that is structurally sturdy and likely to strengthen steadily over long stretches of time, meaning you can buy it and hold it forever (Buffett’s favourite holding period). The Swiss franc, or Swissie, is a good example, given Switzerland’s geopolitical advantages, and its strong economic and financial systems. Thus, adding such currencies to a portfolio could be a good way to add to investment returns whilst lowering risk.
Currencies can also be a source of risk with dangerous implications for returns. So, rushing from one currency in a moment of weakness into another that is strong often produces painful results, certainly in the near term. Selling the rand at R19 to buy the greenback in April 2020 produced a three-month loss of 10% – and slightly more if we consider dollar balances earned 0% interest versus the opportunity cost of interest earnings on rand investments.
Of course, in five or ten years’ time this rand recovery might be seen as a mere blip if the rand were to reach R30 or R50 to the dollar, should the ZAR buckle under the weight of South Africa’s crumpling economy. Or it could be that, in fashion with its multi-decade habit, the rand will recover 30, 40 or 50 percent as after the Rubicon speech, global financial crisis and Nenegate.
In a third scenario, the rand could collapse in a Venezuelan heap where that currency has seen a cumulative devaluation of 100,000,000 to one since 2008, meaning an investment of $1 million in 2008 would be worth 1 cent in 2020. Zimbabweans know the devastation of currency collapse (2008), as do Germans (1923) and Brazilians (1985).
If nothing else, this emphasises that currencies can be volatile. If managed well, volatility can be a blessing; if not, volatility is a source of risk or even destruction. However, simply buying other currencies is not good diversification – rather, acquiring other currencies at good valuations makes for good diversification.
This raises at least two questions. In a world rocked by Covid-19 and shrouded in uncertainty, which currencies possess structural strength? And based on this assessment, on what valuations are they currently trading?
We assess currency stature by using 12 different measures of strength and stability to score all major currencies and many smaller ones across three pillars:
- external strength and international dependency;
- effectiveness of economic management and country vulnerability; and
- ability of the system to absorb currency shocks.
Chart 1 shows the results for key and interesting currencies. Lower scores mean stronger currency structures. Unsurprisingly, the Swissie is strong and investible with evidently low risk; the Sudanese pound and Cuban peso exist closer to a world of “uncertainty and unknowability” than to risk. The latter are not the places to put investment capital, no matter how compelling the “valuation”. The South African rand is in the company of the Vietnamese dong and Argentinian peso.
Chart 1: Strength of currency structure
Source: Cannon Asset Managers (2020)
The second question asks about fair value. Benjamin Graham’s comment “In the short run, the market is a voting machine but in the long run, it is a weighing machine,” is seldom truer than in the case of currency, where weight comes in the form of purchasing power parity. It is almost impossible to predict near-term currency moves, but its fair value can be weighed with the robust tool of purchasing power parity (effectively an economy-wide “Big Mac” index).
Chart 2 shows the currency structure score plotted against purchasing power parity relative to the dollar. A few things leap out. In a world awash with dollars, almost every currency is attractive in valuation compared to the dollar. Only two currencies are “expensive”: the Swiss franc and Swedish krona. If you are investing, the sweet spot sits in the world of structurally strong and attractively priced: South Korea, Singapore, Israel and Japan, stand out. In which case your currency could be buying Samsung, Singtel, Shufersal or Softbank.
Chart 2: Currency valuation vs structural strength
Source: Cannon Asset Managers (2020)
Investing sits on two core pillars: buying good assets at good prices. Adding a currency lens allows enhanced investment performance via even greater quality at even better prices. As Sid Cottle said “Investment is the discipline of relative selection.”