Emerging Currencies: Is Purchasing Power Parity Broken?

fixed-income
harper1
Head of Fixed Income & Currency
08/21/2013

Frequently quoted by international economists as a means of assessing the value of currencies against one another, the basic notion of purchasing power parity (PPP) states that if currencies are in equilibrium (or fairly priced), then converting one currency into another should buy the equivalent amount of goods in another country. Taking a real world example, a Big Mac in the United States should cost the same as in Poland after converting your dollars to zloty. Indeed, the Economist newspaper popularized this way of thinking through their “Big Mac Index,” in which they use the menu of the world’s largest fast food chain to compare the relative purchasing power of foreign currencies against the U.S. dollar. But with global growth being revised down around the world and concerns about rising interest rates in the U.S., most foreign currencies have depreciated against the dollar in the last few months. As this has occurred, discounts in many emerging market currencies have actually increased versus their long-term target of appreciation. So what role does PPP play in how investors should think about currency risk in their portfolios? Valuation Relative to Purchasing Power Parity using Exchange Rates Sources: International Monetary Fund, Bloomberg, WisdomTree As shown in the chart above, for many investors, an attractive element of emerging market currencies versus their developed market counterparts is the fact that they are trading at (sometimes significant) discounts to their long-term purchasing power. The thinking goes that as their economies develop and become more efficient, the prices of similar goods will eventually converge via the exchange rate. However, there is no market guarantee that these discounts can’t increase in the short term, should these currencies depreciate, as we’ve seen in recent risk-off periods. Essentially, PPP represents a basic valuation of comparative exchange rates. In many ways, PPP is similar to the notion of the price/earnings ratio in the equity market. While their valuations appear “cheap” relative to other assets, there is no guarantee that the price will increase, which would lead to investment gains. However, just as in equities, “cheap” valuations can become even “cheaper” during periods of market stress. Indeed, the most recent period has been particularly difficult, as many investors have shunned nearly all emerging market assets in 2013. Absent investment flows, increases in economic growth or a general change in sentiment, foreign currencies and asset prices have remained weak against a domestic equity market that has recently touched all-time highs. So what will ultimately reverse the recent period of weakness in foreign currencies? While no silver bullet exists, it is interesting that the vast majority of emerging market countries with “undervalued” currencies are predominantly export-based economies. Therefore, as their currencies depreciate, their goods actually become cheaper to foreign buyers. On the other hand, the price of imported goods increases, which leads to the potential for an increase in inflation. It has long been said that it is important for a larger economy such as China to move up the value chain and transition to a more domestic-consumption-focused economy. While an appreciating currency may make China’s exports comparatively more expensive, it will gradually increase the foreign purchasing power of Chinese consumers. If appreciation occurs in a gradual way, a strengthening currency can be a positive factor for foreign investors and local consumers at the same time. Although the recent period of volatility has proven difficult for many investors, we believe there is potential for long-term value in diversifying the currency risk of their portfolios. At current levels, investors might consider learning more about different ways of altering the currency risk profile of their portfolios through foreign-currency exchange-traded funds.

Important Risks Related to this Article

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.

About the Contributor
harper1
Head of Fixed Income & Currency
Rick Harper serves as the Head of Fixed Income and Currency for WisdomTree Asset Management, where he oversees the firm’s suite of fixed income and currency exchange-traded funds.  Rick has over 22 years investment experience in strategy and portfolio management positions at prominent investment firms. Prior to joining WisdomTree in 2007, Rick held senior level strategist roles with RBC Dain Rauscher, Bank One Capital Markets, ETF Advisors, and Nuveen Investments. At ETF Advisors, he was the portfolio manager and developer of some of the first fixed income exchange-traded funds. His research has been featured in leading periodicals including the Journal of Portfolio Management and the Journal of Indexes. He graduated from Emory University and earned his MBA at Indiana University.