As the US dollar continues to make substantial gains on global currencies, Jacques Plaut, portfolio manager, discusses the factors investors typically consider when evaluating currencies and determining which are a good store of value.
If you are an investor in currency, you may know that the US dollar has made significant gains this year – the rand has lost 13% of its value against the US dollar year to date, the British pound has lost 21%, and the Turkish lira has given up 40%. Why?
On the one hand, currency is just a medium of exchange. The intrinsic value is in the underlying assets – property, goods, companies – and the paper money that you use in exchange for these goods is arbitrary. On the other hand, ask anyone in Zimbabwe, Lebanon or Venezuela what they think of this theory, and you will get a different view.
But how does one decide which currency is a good store of value? Like valuing anything, this is not an exact science. Investors typically consider:
- The quality and track record of the issuing central bank. Can it be trusted to limit the supply of money?
- The amount a country has in foreign reserves. Can the country pay for imports using foreign money it already owns, or does it have to buy foreign money?
- The fundamentals of the sovereign. Countries with stable laws and growing economies are more likely to have currencies that are increasing in value.
- Some measure of purchasing power parity, like the Big Mac index. Purchasing power parity is a rough indication of how cheap things are in a country compared to others.
Sentiment vs fundamentals
One can’t deny that sentiment plays a large role in currency moves, even over long periods of time. The dollar and Swiss franc are traditionally considered safe havens in times of trouble, and this expectation has not disappointed so far in 2022. Very few assets have outperformed the dollar over this period. What does this mean for investors?
The dollar’s fundamentals are good compared with many other currencies but not that good in absolute terms. US inflation is running at 8.3%, which means that investors holding dollars are able to buy fewer baskets of goods every year, even when taking the interest earned on their cash into account.
The US Federal Reserve has not done a very good job of controlling the money supply and has been far behind the curve in fighting inflation. The US political landscape (and society) is becoming more fractured and unstable, citizens and the government are heavily indebted, and Big Macs are cheaper in almost every other country than in the US. Sceptical investors see signs of a loss of confidence in the dollar in things like meme stocks and non-fungible tokens (NFTs).
Investors are fickle, and sentiment can change quickly. One doesn’t need to know in advance what will cause the change – it could be a new law or a diplomatic incident – but if your investment is underpinned by sentiment and not by fundamentals, the risk of permanent capital loss is always there.