Wednesday, August 06, 2008

A Stronger Dollar and Your Portfolio

The Economist magazine published its annual Big Mac index in its July 24 issue. The Big Mac index lists the price of a McDonald's Big Mac in numerous countries around the world, in Dollar terms. Since the ingredients in a Big Mac are supposedly identical in all geographies, the index tells you something about the cost of living AND about the strength of the local currency. Theoretically, if each foreign currency is valued "correctly", the purchasing power of a Dollar - when taking into account the exchage rate - should be the same wherever you go. This theory is known as Purchasing Power Parity.

Without wasting more time discussing the economic theory - which I am not qualified to do anyway - The Economist came to some interesting conclusions regarding the strength of the Dollar based on this most recent edition of the Index: the Euro is over valued by about 50% (with a Big Mac costing $5.34 compared to $3.57 in the U.S.); the British Pound, Canadian Dollar and Swiss Frank are also over valued. However, the Japanese Yen is under valued by about 27% ($2.62 for one of them healthy burgers), and although The Economist gives some caveats with respect to the Chinese currency, that too may be substantially under valued. The Argentinian and Australian currencies appear to be about fairly valued according to this measure.

If you accept the Big Mac Index as a valid piece of economic data, there are some interesting implications for your optimal investment strategy. As the Euro soared in recent years, returns on investments in European companies were helped by the swing in exchange rates towards the Euro. However, if the Euro really is this over valued, this trend may reverse sharply in the future. For the opposite reason, investments in Japan and China might not be a bad idea.

The Economist also points out that while Turkey and Brazil offer high interest rates to investors (16.75% and 13%, respectively) the Big Mac Index suggests that such high interest rates are not sufficient to off-set the exchange rate risk of these potentially over valued currencies.

Me? I just enjoy talking about these things and reading about world economics. I don't intend to make any adjustments to our portfolio strategy. However, given the recent declines in U.S. markets, I will be investing in U.S. stocks for the next few months to put our portfolio back into balance. If exchange rates play in our favor, all the better.

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