PPP provides active approach to currency value management

But it would be a mistake for long-term investors to simply ignore currencies altogether as these seemingly random short-term movements can have an enormous impact over the long run. 

For example, over the past 10 years the FTSE World index has gained 4.4 per cent per year when measured in US dollars. But for a sterling-based investor, the same basket of equities would have returned twice as much in the same period. This puts investors in a difficult position in the sense that currencies are very difficult to predict, yet too important to ignore. 

When faced with this predicament, many investors simply accept the currency exposure that comes with their investments. Others may decide to hedge their portfolios to match benchmark weights. For instance, if Japan represents 10 per cent of the global equity market, an investor could tweak their currency holdings to ensure that the yen is also roughly 10 per cent of their overall currency exposure.

The problem with this approach is similar to that of passive equity investing in that it takes no account of value. In this example, having a 10 per cent exposure to the yen may or may not be a good decision, but that will ultimately depend on the currency’s underlying fundamentals, rather than an arbitrary weight decided by a benchmark provider. 

In extreme cases – such as the bubble era in the late 1980s when Japan accounted for an unusually large portion of the global benchmark – a currency’s weight may be so distorted that it is neither sensible nor feasible for most investors to replicate. 

In the same way that active stockpickers can assess the valuations of individual companies, an active approach to currency management can also be value-oriented. One way to do this is by looking at purchasing power parity (PPP). This can be done on either an absolute basis, which compares actual prices, or relative basis, which compares inflation-adjusted prices against their own histories. In theory, PPP should tell you whether a particular currency is over- or undervalued at the current exchange rate.

In practice, both absolute and relative PPP models are far from perfect, but they can provide a decent starting point for further analysis. For example, the US-China comparison is especially problematic because the Chinese currency has not floated freely over its history and so relative PPP probably overstates its overvaluation relative to the dollar.  

At best, models such as PPP can only act as a guide to currencies likely to be good long-term stores of purchasing power. How well these models reflect the economic reality of the country and its ability to support the value of its currency also needs to be considered. At a time when many countries apparently prefer weaker currencies as a policy tool, it is a challenge to find ones that can be relied on.

Meanwhile, as the impact of the Brexit vote has been acute, our focus is on identifying good, long-term stores of purchasing power. With the UK’s reliance on capital inflows, the pound had clear risk for several years, but it now appears undervalued on PPP measures versus the dollar and moderately so versus the euro – although the risks remain. Hence, while the pound appears cheap, which is a positive sign for the long term, it is important to consider if it has the margin of safety that we would prefer to see as active currency investors. 

The real risk that matters in investing is of permanent loss of capital. Currency volatility itself isn’t necessarily bad – in fact, it can create buying opportunities. The real danger is when a currency collapses, which can permanently impair the investor’s purchasing power. 

In the absence of extreme views, we believe the prudent course of action is to avoid making large currency bets and resisting the temptation to make short-term predictions. As Pascal noted: “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” That’s not the worst advice for currency traders either.

Nick Purser is a currency analyst at Orbis Investments

KEY FIGURES

$4.22

UK price for McDonald’s Big Mac, as per the Economist’s PPP-measuring Big Mac Index

$4

Price for a Big Mac in the eurozone

$5

Price in the US

8.7%

MSCI World’s current exposure to the Japanese yen