Cheap Currency Not Always Equal To Undervalued Equity Assets

``A disordered currency is one of the greatest of evils. It wars against industry, frugality, and economy. And it fosters the evil spirits of extravagance and speculation. Of all the contrivances for cheating the laboring classes of mankind, none has been more effectual than that which deludes them with paper money. This is one of the most effectual of inventions to fertilize the rich man’s field by the sweat of the poor man’s brow. Ordinary tyranny, oppression, excessive taxation: These bear lightly the happiness of the mass of the community, compared with fraudulent currencies and robberies committed with depreciated paper.”-Sen. Daniel Webster, during the debate over the reauthorization of the Second National Bank of the U.S. in 1832

Attractiveness of corporate equity asset based on currency changes is relative. It doesn’t automatically mean that foreigners will be attracted to an asset simply because of the singular notion of a depreciating currency. If such is the case then foreign money should be stampeding into Zimbabwe since its currency is losing ground by the minute due to rampaging inflation. Maybe sometime in the future, but perhaps not under a Mugabe regime.

On the contrary, a declining currency usually means higher prices of goods and services or consumer inflation which adversely impacts economic growth or corporate earnings. Perhaps foreigners could be attracted once they anticipate an inflection point following a massive devaluation and or a selloff or both. Think the Philippines in 1985/86, Argentina 1990, Peru and Brazil in 1990.

Dr. Marc Faber in Tomorrow’s Gold (highlight mine) makes an important case where falling currencies proffer great investment opportunities, ``Most investors believe that inflation is bad for financial assets and good for real assets such as gold, silver, diamonds and real estate. However what is usually overlooked is that, in very high inflation economies, at some point, stocks become ridiculously undervalued in real terms and therefore provide outstanding buying opportunities. I call this phenomenon the paradox of inflation: instead of producing high price levels, hyperinflation tend to create extremely low prices as currency depreciation (due to massive capital flight) over compensates for domestic inflation.”

Figure 5: Yardeni.com: Foreign Buying of US Equities

But out of the ordinary we don’t see any strong correlation of falling currencies and rising instances of foreign buying seen in the context of the US markets as an example.

The US dollar index strongly rose from 1995-2002, yet foreign purchases of corporate equities as shown in Figure 5 courtesy of Yardeni.com continued to rise. The US dollar likewise rallied in 2005, yet has seen positive inflows from overseas investors in corporate equities.

On the other hand, the declining US dollar has seen a mixed output. The initial phase consisted of a decline (2002-2004) while the succeeding phase has shown a reversal. In short, many other factors determine the attractiveness of an asset.

For the Philippines whose financials markets is hobbled by high transaction costs, high risk premium, low liquidity, unsophisticated and undeveloped market platforms as major disadvantages among other known risks, we have been quite fortunate –the emerging distaste for the US dollar has prompted for a worldwide search for alternative non-US dollar markets, diminishing global “home” bias supported by real time technological innovation and deepening trade and financial integration (a.k.a globalization), aside from the growing need to improve on the region’s financial markets as conduit to absorb savings and forex surpluses to mobilize capital-has buoyed the attraction of our assets to international investors.

We just hope we don’t shoot ourselves in the foot.