The Mighty Dollar

With tax cuts and tax returns on everyone’s minds, we think it is a good time to look closely at our favorite currency!  We might call it “dough”, “bread” or “cheddar”, we have “bean”-counters to keep track of it and we use simple, gastronomic valuations, like the Big Mac Index, to compare it to its peers.  Thinking about the US dollar and its’ value might just make you hungry!   The dollars’ worth is determined by the foreign exchange market, but investors and economists alike are always looking for ways to value the currencies and look for explanations or even monetary conspiracies, to explain currency fluctuations.

In 1986, The Economist came out with the Big Mac Index as a simple way to discuss exchange rates and purchasing-power parity (PPP), which compares the amount of currency needed to buy the same item in different countries, in this case a Big Mac. The Wall Street Journal came up with their own modernized version of this same idea with their Latte Index, which compares the price of a Starbucks tall latte in cities around the world.  For example, in New York City, the WSJ reporter could buy a tall latte at Starbucks for $3.45.  Other WSJ reporters would need to spend $5.76 in Zurich, $4.22 in Shanghai, $3.40 in Berlin (almost the same as the U.S.), $2.84 in London and $1.53 in Cairo.  These simple comparisons of the price of a good that is available in many countries can be an indicator of whether foreign currencies are over-valued or under-valued relative to the US dollar.

There are some criticisms of these simple tools.  Costs of these products can depend on local wages or rents, which are generally more expensive in richer countries and can add to the cost of the product.  The price for a Starbucks Latte can even fluctuate amongst American cities or specific locations, like airports, which may have higher rents.  And adjusting these indices for GDP will change the data and perhaps improve their accuracy.  Some also have pointed to the ingredients in these particular items as causing value differences.  McDonald’s, for example, must use strictly British beef in the U.K.  Starbucks can be a little more consistent, as coffee beans are not generally grown in most of the countries they operate in, so the imported price is pretty standard.

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What these indices don’t tell us about the currency market is why fluctuations occur.  For example, why has the U.S. dollar hit a recent three-year low?  According to an article in yesterday’s WSJ, one simple explanation for a weakened dollar is that “the economies in the rest of the world are finally growing again, so their currencies are strengthening. The U.S. economy isn’t improving as fast—because it was stronger to start with—so the dollar’s falling.”  The Chinese yuan has gained 3.8% so far in January after gaining 6.7% in 2017, which has the officials at the People’s Bank of China concerned about their exports.  President Trump and the U.S. have been critical of any Chinese central bank policies that would devalue the Chinese currency and cheapen goods coming into the U.S.  This trade friction complicates China’s management of their currency, particularly as they attempt to make the yuan a more market-driven currency.

Adding to the currency gap with China and the drop in US currency values overall were comments made last week by the U.S. Treasury Secretary signaling Administration support for a weaker U.S. dollar as being “good for trade.”   Such overt comments are traditionally avoided by the Treasury Department, but may spotlight the Administration goals to reduce the trade deficit and allow currencies to float freely.  President Trump reiterated his stance on trade imbalances in his State of the Union address, pledging to “fix bad trade deals” and that he expects trade deals to be “fair” and “reciprocal”.  Another factor that may weaken the dollar is the belief that 2018 will bring a tightening of monetary policy by the international banks.  Some banks, like the Bank of Canada and Bank of England, have already raised rates.

A weaker dollar makes U.S. goods cheaper to foreign markets, but there is a risk of undermining confidence in an array of U.S. assets, like the U.S. Treasury market.  As the WSJ article explained, as the new tax law expands the federal budget deficit, the government will look to sell the debt to foreign investors.  Those investors may demand higher rates to compensate for the risks of a weaker currency and those costs could fall onto the U.S. taxpayers.

So, we should think about our American dollar today and perhaps look at our paychecks or tax returns to see what has changed.  At DWM, we are always careful to think about each and every one of your dollars – the ones you invest, the ones you save, the ones you spend and the ones you pay in tax.  Using the simple Big Mac or Starbucks Latte indices might help us remember all the factors that go into the value of a dollar around the world.  For me, I certainly prefer to imagine buying a tall latte in Zurich over a Big Mac!

 

 

Big Macs and Donald Trump

Big Macs are becoming a real bargain everywhere in the world… except for the United States. This is because most emerging market currencies have taken a big hit since the election of Donald Trump, whereas, the dollar is as strong as it has been in almost 20 years. Not only has Trump raised expectations of an increased strength of the dollar, but many foreign countries have had problems of their own as well, leaving emerging markets lagging behind.  The Turkish Lira, for example, is one of the worst performing currencies so far this year due to terrorist bombings, economic slowdowns, and a central bank reluctant to raise interest rates to defend the currency (The Economist, Big Mac Index of Global Currencies). Emerging market struggles paired with a surging US dollar has led the Lira to be undervalued by 45.7% according to the Big Max Index.

You may be asking yourself “what on Earth is the ‘Big Mac Index?’” At least that’s what I asked myself the first time I heard it. You may be surprised to hear the Big Mac index is exactly what it sounds like: the cost comparison of a McDonalds Big Mac burger from one country to another. It is a fun, educational, and interesting way to learn how the world is valuing cost of goods on a country by country basis. The Big Mac index is built on the idea of purchase-power parity, meaning in the long run currencies will converge and rates should move towards equalization of an identical basket of goods & services.

In the United States a Big Mac costs $5.06 versus 10.75 Lira, or $2.75, in Turkey. The Mexican peso is even more undervalued at 55.9% versus the US dollar, meaning, a Big Mac only costs $2.23 in Mexico as of January 15th, 2017. The Big Mac index allows us to take complicated subjects, such as international commerce, and make it relatable and understandable.

One drawback of the Big Mac index is it does not take account of labor costs. Of course, a Big Mac will cost less in a country like Mexico because workers earn lower wages than workers in the US. So, in a slightly more sophisticated version of the Big Mac index, labor is included. This typically devalues the US Dollar (USD) compared to other countries around the world because our income is higher. For example, in the traditional Big Mac index, the Chinese yuan is 44% undervalued to the greenback, but after labor adjustments, it is only 7% undervalued. When this adjustment of labor cost is made, it makes it nearly impossible for the USD to trade at a premium against the Euro. This is because Europeans have a higher cost of living and lower incomes than Americans (The Economist, Big Mac Index of Global Currencies). Typically, the Euro trades around a 25% premium against the USD according to the Big Mac index. However, since the election of Donald Trump, even with the labor cost adjustment, the Big Mac index currently finds the Euro UNDERVALUED to the dollar. The US dollar is so strong, it is currently trading at a 14 year high in trade-weighted terms.

 A strong dollar may sound great, but it has many disadvantages. In the United States specifically, a strengthening USD can lead to a widening trade deficit with decreased exports and increased imports. This has a negative result on domestic businesses that operate in foreign countries as well as anyone servicing debts tied to the US dollar. President Trump has publically stated he feels international commerce is rigged against the United States. Whether he is right or wrong, as the trade deficit grows, so does the likelihood of him imposing tariffs on imports from China and Mexico in hopes of bringing balance to trade. If we put a tax on imports, it will lead to something called “protectionism,” or the practice of shielding the United States’ domestic industries from foreign competition. Some feel this is a strong policy because it will keep businesses in the United States and, according to Trump, will prevent us from being taken advantage of. However, it is fairly accepted in macroeconomics that protectionism is a poor/outdated policy because corporate globalization has led to international supply networks that promote convergence and integration throughout the world. Simply put, the countries that are the best at developing goods, develop them, and other countries benefit from the best products at the lowest prices. When something like protectionism takes place, it disintegrates these networks and adversely affects trade-dependent states and the domestic country itself (in this case the United States). The import tax will ultimately drive up prices for domestic consumers who would otherwise benefit from world prices that are significantly lower. This will lead to an increase in trade of intermediate goods and inward investing into value chain niches.

The reason the Big Mac index is so interesting is because it can explain a complex subject like macroeconomics with something as simple as the cost of a hamburger. By knowing the price of a Big Mac on a country by country basis, we are able to understand a significant amount about the world economy and the repercussions the US will face based on the actions we take moving forward.

The Big Mac index is telling us one thing for certain: the US dollar is abnormally strong, which makes the near future uncertain. It is important to have a well-diversified portfolio with an appropriate asset allocation and a competent, experienced fiduciary like DWM to help guide you through times like this. 

Big Macs, Gold, and Sugar

biggestBigMacBig Macs are a real bargain in China. On average, only $2.74 versus $4.79 in America. In Switzerland it will cost you $6.82, Norway $5.65, Euro area $4.02, Chile $3.27, Russia $1.88, and India $1.83. These values are from The Economist’s Big Mac Index, their annual survey to provide information on exchange rates.

The Big Mac Index was started in 1986 to provide a guide as to whether currencies are at their “correct level.” It is based on the theory of Purchasing Power Parity (PPP) which holds that in the long run exchange rates should move towards equalization of an identical basket of goods and services. Therefore, the Big Mac “raw” Index would suggest that the Chinese yuan was undervalued 43% to the dollar currently and will likely rise in the future.

However, the rise will likely be much less than 43%. This is because you would expect that a burger would be cheaper in poorer countries than in rich ones because labor costs are less. Hence, the Economist also compares the Big Mac price to GDP per person to get an adjusted index. When we use the adjusted index, the yuan is calculated to be 9% undervalued. India is estimated to be 34% undervalued and Switzerland 13% overvalued using the adjusted index.

The stronger U.S. dollar (USD) is very apparent in the raw and adjusted Big Mac Index. Over the last 12 months, the WSJ Dollar Index has risen 22%, mostly in anticipation of an interest rate increase by the Fed. The dollar’s gains are a burden for commodities, which are priced in USD and become more expensive for overseas buyers when the dollar gains in value. Gold and sugar are two commodities that have been dramatically impacted by the strong USD.

Gold hit a 5 year low last week propelled by a stronger USD, improving economic conditions, investor sentiment, and expectations the Fed will raise rates. Gold does well in response to unexpected crises (such as the financial crisis in 2008/2009), but not so for long-simmering troubles like the Greece situation. Furthermore, a diversified stock portfolio, as measured by a world index, has gone sideways (unchanged) for the last twelve months. And, with interest rates expected to rise and gold not paying any interest or dividends, investors have been moving out of gold. Furthermore, China and its citizens who have been big buyers of gold have tapered off their purchases. First, investors wanted to get into the roaring Chinese stock market instead, but as that market keeps sliding there is little liquidity to buy gold.

Of course, we think of gold as a kind of insurance policy. There’s a cost when things are good (markets are moving up) or moving sideways because gold is holding or losing value. But, when a crisis develops then this insurance helps mitigate the damage. A few percentage points of gold in your portfolio helps. Gold was up 2% in 2008 when stocks were down 35% or more.

In a similar way, sugar fell to a six year low last week. In the past year, sugar prices have fallen by 25%. Brazil has been supplying one quarter of the world’s 180 tons of sugar annually. The value of the Brazilian real has fallen 17% against the USD this year. As the value of the currency falls, it encourages producers and exporters to sell supplies on global markets, because it becomes more profitable for them when they convert the USD sales back into local currency.

Last week, Brazil’s cane growers announced they are in for an unusually large crop, increasing the worldwide supply. In addition, artificial sweetener production, including China’s Sucralose is expanding rapidly. As alternatives to natural sugar flood the global market, prices for real sugar declines.

I always look forward to the Big Mac Index. It is both fun and educational. The Big Mac Index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. It helps explain, in part, why gold and sugar hit 5 and 6 year lows last week. And the Big Mac Index lesson is much more easily digested than many of the economics lectures and papers many of us have had to endure. Here’s to McD’s, In n’ Out Burger, Five Guys, Shake Shack, and more. Keep ‘em coming.

The Big Mac Index: Tracking Worldwide Standards of Living

Big Mac indexA Big Mac has 540 calories and 29 grams of fat. It also contains important economic information that The Economist and others use to compare international prices and wages.

In January, a Big Mac cost $6.81 in Switzerland, $4.20 in the U.S., $2.44 in China, and $1.96 in India. The hourly wage at a McDonald’s (“McWages”) in each of those countries was $15.00, $9.24, $1.46 and 78 cents, respectively. Economists divide the cost of the Big Mac by the McWage to get “Big Macs per Hour” or BMPH in comparing countries. In the U.S., Canada and Western Europe, our BMPH is 2.2 (hourly earnings at a McDonald’s are 2.2 times the cost of Big Mac). In China the BMPH is .6 and in India only .4. So, in India, McDonald workers would have to work 2 ½ hours just to be able to buy a Maharaja Mac (made of chicken, not beef.) These numbers change over time and that’s what the economists are tracking.

The Big Mac Index was started in 1986 to attempt to track “purchasing power parity (“PPP”)” used to evaluate market exchange rates, currency valuations and cost of living changes across the globe. Mc Wages and Big Macs were selected because they are uniform and ubiquitous. Sandwiches are produced worldwide according to a rigidly uniform process detailed in a 600 page manual. Identical burgers are produced in every city. This produces an ideal environment for global productivity comparisons. BMPH represents a PPP-like calculation of the real wage, taking account the local cost of goods.

The Big Mac Index demonstrates the vast gulfs in worldwide productivity and standards of living. The gaps are in fact shrinking. In the U.S., our BMPH was 2.4 in 2007. Now, the McWage is up 26% in four years, but the cost of the Big Mac is up 38%, partially due to increases in food prices. The net 9% drop in our BMPH is one sign of a reduced overall standard of living. In Russia, the BMPH increased an astounding 152% from 2000 to 2007 and has increased another 42% from 2007 to 2011. China has had increases of 60% from 2000 to 2007 and another 22% from 2007 to 2011. India saw a large increase of 53% from 2000 to 2007 but their BMPH declined by 10% from 2007 to 2011. It’s no surprise that more progress in standards of living was made by the BRICs and other developing countries from 2000 to 2007 than from 2007 to 2011.

Yes, our BMPH has gone down slightly here in the U.S. over the last decade. Even so, we’re still the envy of the entire world, by far. Time to celebrate- with a Big Mac and fries.