Japanese Markets Tumble Again

After a decent sized gain yesterday, the Nikkei is down over 2% again as of the time of this posting. As bad as the news is regarding the nuclear situation there, I am surprised it is not worse. I'm not sure that this is the market reflecting better information than we are getting out of the press or if it is simply that, after some serious declines earlier in the week, the market is as low as it will go. I'm not prepared to test that particular proposition yet, but I think it bears watching.

One thing that has surprised me in all of this is that the yen has actually strengthened and not weakened. I saw a couple of articles suggesting that Japanese residents and institutions would start repatriating funds rather than seeking to park their money oversees because they need those funds to pay for damages. Apparently that is at work here. It is what I would call a secondary effect where the primary effect of market weakness pushing the yen down gave way to the actual mechanical action of domestic Japanese investors redeeming oversees assets.

The real economic effects are still being assessed at this point and they are difficult to fully quantify. Obviously, there are the losses to insurers, which are being quoted at around $25 billion. Disruptions for various electronic component manufacturers are another source of significant strain. Of course, Japanese consumer confidence is going to be seriously depressed, and rightfully so, after seeing such horrors unleashed on them by a merciless earth. Similarly, the already clammed up Japanese business community is unlikely to unleash its purchasing power either. Those are all in the short term and are unavoidable. However, I would generally say that nations tend to recover from these sorts of incidents more rapidly and more vigorously than most predict. The one caveat here is that serious nuclear contamination is a different animal and it is very difficult to quantify those economic effects. As long as the situation remains (relatively) contained, it will not seriously hamper the recovery. At this point, all we can do is pray for those working in and near the reactor to subdue the situation there. Those workers are the bravest individuals in the entire world at the moment.

On Germany, China, and Currencies

A little light reading on Bloomberg today: http://www.bloomberg.com/news/2010-08-17/germany-ignores-soros-as-exports-drive-record-growth-at-consumers-expense.html

One of the principal things that concerns me going forward is that there was no effort made to bring the global current account disparities into better alignment. You can't have three or four really big exporting countries (China, Germany, at times Russia) and have a few big importing countries (U.S., Italy, Spain) and expect there to be stability in foreign exchange markets or evenly distributed global prosperity.

Given the U.S.'s return to large current account deficits with the onset of economic expansion, I think we can say with some degree of certainty that the dollar is likely to be quite weak in the medium term. In the short run, it may have some loft from transitory crises, but the dollar's trajectory is more likely than not to be down, interest rate signals not withstanding. According to the interest rate theories, we can expect a stronger dollar ten years from now than we have today, which may be true, but from an investment standpoint that's not relevant.

Currency Risk: How exactly does it work?

This issue has come up about 1,200 times in the last five years for me, so I suppose it warrants at a minimum a brief discussion. Ideally, I should like to give it a little more justice than this, but once you go down this road, it can be endless unless you cut it off at a certain point.

Without discussing the finer points of how changes in foreign exchange rates impact your investments, let's use a simple example. In this fictional example, you buy 100 shares of Petrobras (PBR) in Brazil at $35 a share. The Brazilian currency, the real, is trading at 2.00 to the dollar. Whether you bought it on the Sao Paulo exchange or as a New York listed ADR (American Depository Receipt), it is still effectively denominated in the real. So long as the real remains at 2.00 to the dollar, changes in the underlying price of Petrobras should still have a 1-1 translation in dollar terms. In other words, if Petrobras rises by $1 in Sao Paulo, you shares, either there or here, should rise by that same $1 (or 2 reals). There is some break in the link with ADRs from time to time, but over the long run they correlate pretty well. ADRs are supposed to incorporate changes in foreign exchange rates in their valuations, but some times things go slightly awry.

However, what happens if the Brazilian central bank cuts interest rates, making in the interest rate differential between the U.S. and Brazil look less attractive so investors start selling real denominated assets? Well, here you can get a double whammy. Because there is a general flight from Brazilian assets, Petrobras may decline from $35 to $30. In other words, your asset fell from $3,500 to $3,000 or from 7,000 to 6,000 in real terms. However, the liquidation of Brazilian assets put pressure on the real too. Let's say the real weakens from 2.00 to 2.25 to the dollar.What does this do to your assets now? Well, they're still worth the 6,000 in real terms, but in dollar terms they are worth 6,000/2.25 or $2,667 (rounded). You lost $500 on the actual decline and $333 on the decline in the currency.

While this seems like a stylized example, it really actually isn't. Moves of greater magnitudes than this happened in Brazilian assets for much the same reason in mid-2006 because of nearly the same cause(the Fed was raising rates while Brazil was cutting and the real routed for a brief period as a result). Currencies move for a variety of reasons, but interest rate differentials, or rather the prospect for changes in differentials, are one of the major short term reasons. Of course, in the long run, current account deficits, the relative attractiveness of all forms of investment, political stability, and so on are major contributors. Economists have their own views on the subject as well relating to interest rate parity, which actually has the opposite conclusions of what we often observe over the short term in the markets.

Whatever the possible causes, which we can all discuss later, these are the effects and they bear watching. If an investor is blind to moves in the foreign exchange markets while investing in foreign denominated assets, they can get burned. Of course, if you are a U.S. investor and the dollar seems set to weaken for years to come, overseas investments are more attractive that ever. You get the superior profit growth of emerging markets plus the weakening of the dollar which automatically raises the value of your foreign investments. Of course, if you bet wrong, then your returns get clipped.

Will China End the Peg?

We'll see if this latest signal turns out to be anything. There are those that have been buying Chinese ADRs for months and even years on this proposition because as the dollar weakens, Yuan denominated assets rise in value automatically. On a related matter, I hope to write a short piece on exchange rates and their effects on investment decisions tomorrow.