Financial Insights

Big Mac Attack on the US Dollar?

The Economist recently published its Big Mac Index to provide its latest view on which major currencies are under- and overvalued relative to the U.S. dollar.  According to the July Index, the U.S. dollar is “overvalued” against all currencies examined, except those of Norway, Sweden, and Switzerland:  it’s cheaper to convert dollars into foreign currency and buy a Big Mac in all those other countries than it is to buy a Big Mac in the U.S.  If the dollar is overvalued, it could depreciate.  On the one hand, U.S. multinationals may stand to benefit from a decline in the dollar, but on the other, domestic firms importing large quantities of inputs would suffer rising costs.  So, should portfolios be realigned in advance of a substantial dollar depreciation?

Purchasing Power Parity is the theory behind the Index and roughly states that arbitrage enabled by free trade in goods (like hamburger meat) ought to equate prices (expressed in a single currency) across countries.  Here in the States, for example, you’d pay $5.30 (on average) for a Big Mac, while in Europe you’d pay €3.92—which translates to $4.47. If you’re in Europe this summer, be sure to take advantage of cheap Big Macs while you can! By that measure, the dollar is 19% overvalued relative to the euro.

Many of you may (correctly) take the Big Mac Index with a large grain of salt, but the consequences of dollar depreciation or appreciation is nothing to sneeze at. As the dollar appreciated from mid-2014 through mid-2015, one estimate by researchers at the Board of Governors of the Federal Reserve, showed that returns in shares of firms with a high degree of foreign sales were 20% below those with a low degree of foreign sales (excluding energy, utilities, and financial sectors).*  Exporters receive fewer dollars for every sale in euros when the dollar appreciates.

The value of the dollar versus the euro remains high today as compared to its 10-year average. This partly reflects the fact that the U.S. recovery has occurred ahead of that in many European countries in the wake of the global financial crisis. More promising investing opportunities in the U.S. have drawn European (and other foreign) investors to place their money in U.S. assets, and those investors need to use their euros to buy dollars to make those investments. For consumers and travelers from the U.S., euros—and Parisian Big Macs—have become relatively inexpensive, but this has been a headwind for U.S. exporters. Europe is now enjoying a stronger recovery, and as yields and returns there rise, should we expect the dollar to depreciate as the Big Mac Index suggests? Possibly, but other factors will be at work.

As Europe recovers further, wages and consumer spending there will increase, and some of that spending should push up demand for U.S. exports. That would tend to strengthen the dollar further. As emerging markets also continue to recover and grow, they too should buy more capital equipment and consumer products made by U.S. firms, creating another force to drive the U.S. dollar higher. And if the Trump administration’s push to buy “Made in America” products takes hold (the official theme of last week), that too would redirect demand from imports to U.S. products, reducing demand for euros.

This just scratches the surface of all the forces at work behind exchange rate dynamics (inflation is a big one to add to the equation). As you can see, these forces can work in opposing directions at the same time. Historically, the U.S. dollar’s exchange rate has roughly followed a random walk ever since the flexible exchange rate system was adopted in the early 1970s. And so statistically, the best forecast of the dollar-euro exchange rate one year from now is simply that rate of exchange today. Frustrating, no? It’s all those countervailing forces briefly mentioned above.

The Big Mac Index is telling us to expect dollar depreciation, but should we believe it? Well, Big Macs are pretty tough to trade, once they are cooked and served, and this reveals the flaw in that arbitrage argument behind exchange rate movements. Substantial components of the cost of a Big Mac, and many imported goods we buy, include the local transportation to bring ingredients to the franchise, the labor to make the Mac, the cost of real estate under your feet when at McDonald’s, and local taxes.  In short, the Big Mac’s price mostly reflects nontraded inputs, and so we should expect to pay more for them in places like Switzerland and the U.S., where wages are high, and less in places like Egypt and China, where wages are low.  So enjoy a Big Mac wherever you are, but don’t expect it to be a useful forecaster of the dollar’s value.

* https://www.federalreserve.gov/econresdata/notes/ifdp-notes/2015/how-much-has-dollar-appreciation-affected-us-corporate-profits-20150717.html

 

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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