Sep

28

In 1920, Gustav Cassel developed the theory of Purchasing Power Parity. PPP argues that currencies are in equilibrium when their purchasing power is identical in each country. Also known as the "Law of One Price," this means that the exchange rate between two currencies should equal the ratio of price levels based on identical goods and services. Put simply, a pound of dirt in Tyler, Texas should cost $1.50 when the same pound of dirt in Metz, France costs Euro 1.00 provided the exchange rate at the time is 1.5 to 1.

I believe dollar and other US asset bears are wrong thinking dollar weakness will cause panic and dumping of US Equities. Rather, US stocks will be snapped up like never before:

1. As we are now in a global economic landscape, you cannot tell me Citibank is suddenly going to be worth less than Deutsche Bank or HSBC because of the dollar's decline. The same can be said of Verizon versus Vodafone or Merck versus Novartis. If the dollar continues to decline on interest rate differentials and economic fears, then US stocks will ultimately have to be re-adjusted higher to keep valuations across geographic lines consistent.

2. The obvious: US Exports might get a boost — bullish for US stocks. Foreign earnings components should increase — bullish for US stocks.

3. European shares will likely feel the pain in comparison.

The Fed's actions last week were brilliant. Yes, they needed to create an environment that would continue to support asset prices as bank balance sheets have ballooned to extreme levels. But more so, the Fed's choice to drop the dollar just might be the action required to finally get our current account back in line over the long term.

Riz Din comments:

The relationship between exchange rates and equities has also been playing on my mind of late. Two thoughts on the topic:

1. The counterpoint to (2) is that while exporters may get a fillip from a lower dollar, US consumers are effectively being taxed by way of higher import prices. We may find consolation in a recent Fed study that suggests that inflationary pass through from a weaker currency is relatively limited, but with a weaker dollar playing a driving role behind rocketing global commodity prices and with China revaluing their currency over time, inflationary pressures may be in the wings yet, and it is probably worth keeping an eye on US import prices.

2. As James points out, recent US equity gains could be a purely monetary effect, in the sense that foreign investors can now buy more US shares with each euro, GBP, yen etc., so they will bid up the share prices until their values are restored in local currency terms (the Law of One Price). Furthermore, foreign investors will likely demand a higher US equity risk premium in order to compensate for the risk of further USD depreciation, so perhaps domestic investors can look forward to further price gains. This paper from the ECB discusses what it calls the 'Uncovered Equity Return Parity' condition (URP), where the described parity condition is used to explain the variability in exchange rates (although in our example the causality runs in the other direction, from exchange rates to equities).

Building on the above, I am led to wonder whether equities are a good hedge for a weaker currency, and indeed whether there is a profitable trade in there somewhere (if I was in Zimbabwe right now, I'd be asking for my wages to be paid in stocks!). In developed countries such as the UK and US, the theory says that a 5% currency depreciation should produce 5% inflation, but we know this doesn't seem to happen in reality. So, while foreigners may end up bidding up domestic equity prices to maintain prior purchasing powers, domestic investors can buy local stocks and arbitrague the fact that the 5% inflation is not going to arrive for a long while, if at all.

Andrea Ravano adds:

I think the main problem of an extreme dollar weakness, could be a sharp interest rate rise. The bondholders of the world could use the ultimate hedge and get out of the free falling buck by selling their holdings, which should cause higher interest rates.

In the end though, the real problem of a weak currency is not in the short term but the long. In weak currency economies products become more valuable than competing peers because they are cheaper; not because of increased productivity or industrial design, but simply for the devaluation of one of the cost components.

Take Italy as an example. Italy has used the competitive devaluation strategy for the Italian lira since the early '70s. By doing so the system has prospered , but only to discover, after the introduction of the euro and the subsequent forex stability, that the economic system as a whole had productivity and price competitiveness which had been left behind during the ephemeral times of currency devaluations.

The pattern at the time was that before devaluations interest rates would rise sharply and drop sharply thereafter.We must consider the fact that we had a fixed currency system which made adjustments much more abrupt. 


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