Don’t Invest In Emerging Markets Until You Read This

The New Zealand kiwi is nearing an all-time high against the dollar.

#-ad_banner-#‚ÄčThat’s great news for any U.S. exporters looking to sell goods into that country, as U.S. made products become relatively less expensive. On the flip side, the surging kiwi makes New Zealand a costlier destination for U.S. travelers. 

Yet for investors, this currency move represents a completely different set of issues. And currency moves may be the single most important factor when you are trading in and out of foreign investments.

Apologies to advanced investors, but a few basic explanations are in order. When you buy shares of a foreign stock (likely through an American depositary receipt), mutual fund or exchange-traded fund (ETF), your dollars must be converted into the local currency. And if that currency rises in value, as the New Zealand kiwi just has, then your investment rises in value by an identical amount, as you own kiwi-denominated assets, not dollar-denominated assets. (This notion mostly applies to stocks as most foreign bonds are mostly denominated in dollars or euros.)

We saw the impact of a surging currency in recent quarters, as the Indian rupee staged a remarkable rebound against the U.S. dollar last fall and winter. As I noted last week, India’s SENSEX index rose an impressive 35% over the past 10 months, but many India ETFs rose by a significantly higher amount, thanks to currency gains.

Of course, it works both ways. Last summer, the Indian rupee was in freefall, and those same ETFs fell at a much sharper rate than that India index. Back then, investors were abandoning emerging markets on concerns that key currencies were plunging, which were magnifying losses. That episode unfortunately spooked many investors, leading them to conclude that emerging markets simply carry too much risk. And that’s a shame, because as we saw with India, what a currency taketh away, it also giveth. 

How to Gauge a Currency
At first blush, it may seem impossible to know which direction a currency will move in any given period. But foreign exchange traders make such assessments and prediction all the time. George Soros made the trade of a lifetime in 1992, correctly predicting an imminent plunge for the British pound. But you don’t have to be Soros to develop an informed view of currencies. You just have to do a little digging.

Let’s pivot back to that emerging market swoon last summer. At the time, the financial press was buzzing about the “Fragile Five,” which were a group of countries (Brazil, Indonesia, South Africa, Turkey and India) that were running unsustainable trade deficits.

Indeed, for a variety of reasons, you should avoid countries that consistently import a lot more goods than they export. It creates massive economic imbalances in those countries that can cripple growth and send foreign investors fleeing. The fact that such trade deficits invariably end up driving down local currencies is just one more reason to avoid them.

Ironically, when such countries begin the process of addressing their economic problems, they can hold great appeal to investors. India’s game plan regarding its economic woes has emerged as the most robust of those Fragile Five, which is why the Indian stock market — and the Indian currency — have rebounded in such dramatic fashion.

Currency movements aren’t based solely on trade balances. They are also tied to the amount of foreign currency reserves that a country holds. Before you invest in any emerging market, check to see that the country has billions of dollars and euros socked away in its central bank, and check to see that this balance is remaining constant or growing. If you spot falling foreign country reserves, there’s a good chance its currency will soon weaken as global investors grow scared.

Lastly, pay attention to interest rate differentials. The New Zealand kiwi is surging because New Zealand’s central bank is raising rates — and the U.S. Fed is not. Global funds flow toward countries with rising rates and away from countries with flat or falling rates.

There’s one final thing you need to know about currencies: They always revert to the mean.

The Indian rupee’s plunge last summer led to huge strains on that economy, and it became increasingly clear that actions were needed to strengthen the currency. Conversely, the Brazilian real had grown so strong in 2010 and 2011 against the dollar (magnifying gains for U.S. investors in the process), that the Brazilian economy grew less competitive. The Brazilian government eventually took steps to weaken its currency (bad for U.S. investors), though that effort has been somewhat blunted by stubbornly high inflation. Once the Brazilian central bank decides that inflation is less of a threat, then it will lower interest rates, which will likely weaken the currency further. Translation: U.S. investors may want to avoid Brazilian stocks and ETFs until that process has played out. 

Risks to Consider: The U.S. dollar, seen as a safe haven, somewhat dilutes the natural mechanisms of currency movements. In times of economic crisis, global investors flock to the dollar, blunting the returns of any emerging market investments as local currencies weaken.

Action to Take –> Currency issues aren’t the only consideration for emerging markets. Economic growth rates, inflation trends, government policies and many other factors also go into the mix in deciding the winners and losers in emerging markets. But if you ignore the currency issue, you could be in for a rude surprise (or in examples like India, an unexpected tailwind).