Economics and Woman Empowerment

One says if you teach a parrot to repeat the words - supply and demand- there you go, you can produce an economist. I find it very witty and funny but economics is more than that. One funny analogy is to say that pop music is all about Justin Bieber. Ok here's a better analogy. To say economics is about supply demand is equivalent to say Cambodia is all about Angkor Wat and temples. Yes, Angkor Wat is an indispensable wonder which puts Cambodia on the world map, but Cambodia has more things to offer besides the beautiful Angkor Wat. Similarly, we can use the basic concept of supply and demand as a framework for our analysis on many social phenomenon. 

The mind-boggling thing about economics is that you can see economics everywhere you go. (Credit to our friend at Economind for the inspiration.) Should you use your last $10 on drinking with your friends or $10 phone card to call your bae? That is an economic question related with cost and benefit and which alternatives produce the higher level of satisfaction and happiness or what economists like to call “utility”. (The term utility is a bit vague and I’m pretty confident that it is very very similar to satisfaction and happiness. I hope our friend at Economind would share the same understanding) Should you send a girl to school or force her to help family at home? Yes, it’s more about gender equality and education but I can assure you that it has everything to do with economics. You see, an educated woman can participate in the labor force and labor is a scarce resource to the economy. We don’t have an infinite amount labor to produce goods and service, so we have to be clever in allocating the labor in a way that produce the most output “as many and fast as possible”. Economists also have a term for that. It’s called “efficiency”. Making a woman stay at home may not be the most efficient way to utilize her labor. She may be able to be involved in other activities that generate more social or personal benefit, be it a manager, a teacher, a salesperson, a factory worker and so on. An educated woman produces more than just income for household. A study found that a child born to an educated mother is “50%” more likely to survive past the age of 5. An economist can even monetize the social return/benefit of child mortality reduction and of educating a woman all thanks to our brilliant mind.

Our friend at Economind made a very interesting point and I'll add his whole quote. "Economics is indeed everywhere. A failure to recognize this is a failure to see solution to many problems. Gender empowerment is in every bit and piece economics as it is about gender equality. On top of what you just said, allowing women in labour force will also raise tax revenue and increase marginal productivity of capital, meaning capital investment will yield more return due to larger base of labour force. This boosts economic growth significantly."

Now you understand the massive scope of econ. Well, similar to M&M chocolate candy which comes with many colors, economists can be separated into many kinds as well such as trade economist, financial economist, health economist, agricultural economist, other development economist and so forth. The point is when it comes to allocating scarce resource to its most efficient use, superman has nothing on economists and they are just one call away to save the day. (Congrats to you if you get the Charlie Puth’s reference. Give yourself some kind of reward because you have a good taste, my friends.)

Find our friend Economind athttps://www.facebook.com/economind/?fref=ts

Brands and The Economics of Information

We would like to touch on a subject that is ubiquitous to everyone - brand - which comes to my mind today when we talked about which cinema we should go to watch Finding Dory from my favorite animation studio: Pixar. Some of my favorite Pixar films are “Up, Toy Story 3, Wall-E, Ratatouille and many more. Enough of my praise for Pixar and I will focus instead on coffee, since it’s something that many people know and relish.

The common misconception for many people is that they consider “brand” as something that is of high value and high value and it is a label on a product. While it’s true to a certain extent, it doesn’t completely cover what brand really is. When you think that your co-worker is very genuine and helpful, that’s a brand you attach to your co-worker. Perhaps you think that your co-worker is a hypocrite and manipulative, that’s also brand with which you associate your co-worker. You see, brand goes beyond the label on the product. Brand can extend toward a person, service, a religion and a country. Brand is more than the label per se. Brand basically is the “perception” or “image” you have representing a certain product/service and everything. Even my country Cambodia is putting a lot effort in “rebranding” our country’s image.

Source: https://d.ibtimes.co.uk/en/full/1455968/finding-dory-movie.jpg?w=400 http://funnyand.com/wp-content/uploads/2014/12/Starbucks-Coffee.jpg

There is a reason why a market researcher asks a respondent to tell the researcher the words that come to the mind of the respondent immediately after hearing the name of a product. It goes something like this “What three words come to your mind when you think of Starbucks?” Take 30 seconds to answer this very question yourself. Well, some internet users would comment “Overpriced, Overrated, Overhyped”. Some might say “Quality, Hip/Cool, Cozy/Relax”.

But what brand has anything to do with economics? Well, as I told you in the previous post, you can feel the force of economics almost everywhere you go. Brand has many things to do with the economics of information. Let’s say you drive to a faraway place and you are in need of some caffeine and your favorite drink is hot latte. You have two choices: you can buy your latte at a local coffee shop or at your well-known Starbucks. More often than not, you would get your latte at Starbucks. But why is that? It doesn’t necessarily mean that Starbucks latte is always highly superior to the local shop’s, but you know what to expect of Starbucks latte and service. The local shop’s coffee might be a lot better than the population cafe chain like Starbucks, but we do not have the luxury of having this piece of information. Brand can exerts confidence and quality to the mind of a consumer. This is why a company can spend considerable amount of money on marketing campaign to convince consumers that their products are different than the competitors’ in terms of quality, experience, satisfaction and so on. By planting a particular brand image and perception inside the mind of the consumers, the company of such branded product can design a monopoly (a monopoly is a market situation where there is a single producer of a product and the producer can set a price- price setter) for its own niche market and set the price accordingly.

Normally, a branded product costs more than a generic product. But is it worth it to pay extra for a branded product? Well, if you ask me, I would give a classic reply “it depends”. (Economind, great mind thinks alike) Different people have different perception on a branded product. If you think highly of Starbucks and you derive high utility from consuming Starbucks and you consider the benefits are higher than the cost of Starbuck’s latte, you should go for it. If you are a person who rate Starbucks very low and your utility derived from drinking either Starbucks’ or the local coffee shop’s is the same, then perhaps you would go for the local coffee shop.

Now you know the framework for analysis inside the mind of economists. Just in case you are curious which cinema we are going to watch Dory, it’s Legend. Why? Because our utility derived from either Legend or Major isn't very different and we also gather enough information to make this decision.

Why can't a country print more money to be rich (Part 2): Worst Hyperinflation in History

We touched on the basic economic principle, that is, excessive money printing leads to dramatic rise in price level - inflation. Don’t get me wrong here. Inflation may also be caused by other factors, but we will only stick to money printing as one of the sole factors.  In addition to inflation, the idea of printing more money to be rich is a complete fallacy. We also envisioned a country with extreme money printing and what easy money can do on the price of our beloved sedan Mercedes, clothes, phones, food and other available goods on the market that you can name it. The envisioning is not real and there are a few times when an economic theory and model sounds perfect on the paper but it just does not work in real life due to unrealistic assumptions and other reasons. So as promised we are back again to find examples in real life whether printing more money does indeed bring turmoil to the economy. Before we get into some of the worst inflation, I have to make it clear that the economic notion of money growth and inflation is so complex that economists exchange argument back and forth and I am nowhere near the economists’ status. With that being said, it is possible to learn it the intuitive way by studying previous hyperinflations in the past.

Probably the most well-known hyperinflation in history, at least to me, Weimar Germany’s hyperinflation was a disaster to the economy pioneered by wild money printing. You must have heard of World War I and it is  one of the deadliest war of the modern era due to the modernization of weapon and the massive scale of the war. It is dubbed by historians “The War to End all Wars”, but this world war was followed by another world war began in 1941. Following the end of WWI, Germany was obliged to pay war reparation to other countries. Weimar Germany’s government resorted to money printing to exchange with foreign currency and as a result Germany’s Papiermark’s value fell significantly. A down-to-earth economic concept can be used to explain the devaluation of Papiermark. According to the Working Paper of Steve Hanke and Nicholas Krus, the daily inflation rate was approximately 21% and it took only 3 days and 17 hours for price to double. To put this data into context, price of goods on the market must be changed every hour or even every 10 or 15 minute. The German Mark depreciated to a point when people would use the notes for toilet paper, since it was cheaper to directly use the notes than to purchase the toilet paper.

German’s hyperinflation might be the most well-known but it didn’t earn the title of the worst hyperinflation in history. One of the worst hyperinflation in recent memory was Zimbabwe in 2008 when the inflation rate was 79.6 billion percent following the infamous land reform designed by non other than the chief architect President Robert Mugabe. The land redistribution from the rich white farmers to the local people, many economists believe, led to a dramatic fall in agricultural and manufactured outputs due to the lack of experience and training.  I remember quite vividly when my Corporate Finance Professor showed the class the trillion dollar Zimbabwe dollar note. There were so many zeros that I lost count. Price of goods doubled every 24 hours which must be a headache for those who hold the money. Moneyholders would buy needed items immediately in lunchtime before the price doubled during dinner. So what is the solution to combat this hyperinflation? Well, Zimbabwe ditched their “beloved” Zimbabwe Dollar for other foreign currency such as the US Dollar to restore people's confidence.

The title of the worst hyperinflation in history goes to Hungary after the WWII. Hungary was obliged to pay war reparation to the Soviet Union. At its peak, the monthly inflation rate in Hungary was 13.6 quadrillion percent which means price doubled every 15 hours.  

Central Limit Theorem: The Cristiano Ronaldo of Statistics

I believe whenever you watch a cooking contest, say U.S. Master Chef, you’ll see that Chef Gordon Ramsay, who is one of the three judges on the show, would taste the dish prepared by the contestants normally with only one small spoon. Then he will give his take on the dish whether he thinks the food is good or the food is trash. Chef Ramsay will never make a secret of his disdain for certain food because he will tell you in your face that your food sucks if he thinks it is. Have you ever wondered how he can be sure that he exactly knows how the whole dish taste like with just one single spoon? Well, the answer is simply most of the time one single spoon of the dish can tell you everything that you need to know about the whole dish. In the world of statistics, one spoon of the dish is a representative sample of the whole dish. The whole dish would be referred to as the population. You see, Chef Ramsay does not need to finish the whole dish to know whether the dish is delicious or not. Sure, if he wants to be extremely accurate, he can taste the whole dish, but his opinion on the dish would not be different from the taste of a single spoon. You may wonder “how does food taste test by Chef Ramsay have anything to do with statistics?” Well, it is a great and simple analogy with inferential statistics and especially today’s concept of Central Limit Theorem.

What fascinates me is that we can make a strong statement and inference about the whole population with just a small sample drawn from the population that we attempt to study. Such inference can be done thanks to an elegant concept called Central Limit Theorem (CLT). Economist Charles Wheelan called it the LeBron James of statistics. My inspiration for writing this article is because of Charles as well. For those who does not follow basketball but follow football, the CLT is like the Cristiano Ronaldo of statistics - powerful and elegant.

Before we unravel the gist of the Central Limited Theorem, probably it’s better to start with a simple example inspired by Charles. Let say that the famous school of engineering has a field trip to the beach. The engineering students were randomly assigned to 20 buses and the trip took 5 hours. After 5 hours, 19 buses arrived at the destination except for 1 bus that went missing. You and the rescuers searched the forest and found a bus with several foreign young people who don’t speak your language. Statistics to the rescue!!! You found that the average math score of these people are 65 (assume that everyone is carrying a math report card or you ask everyone to solve a difficult integral question. I know I know, it’s ridiculous but that’s for simplicity). You, as the smartest statistician of the rescuers, sighed and you told everyone that this is not the bus of engineering students. There is no way in hell engineering students who learn all of those complex derivatives and integral would score that low on math (on average). Later, with latest Google Translate technology, we learn that this is the bus of students who major in Khimal (a make-up language and you’ll find no result from Google). This shows why their average math score is not so high because they specialize in language not complex calculation. 

Well guys, that’s it. That’s the Ronaldo of Statistics. That’s Central Limit Theorem. Simply, CLT states that the sample drawn from the population will represent similar characteristics to the population as a whole. A bus of engineering student will be similar to the whole engineering student. A spoon of the dish is very similar to the whole dish. However, each sample drawn from the population will slightly differ from one another but there is a very low probability or low likelihood (unlikelihood???) that the sample is extremely different from the population. It’s just like the average math score of engineering students on each of the 20 buses will slightly differ from the true average math score, but the probability that engineering students on one of the bus have an average math score totally different from the true average math score of all engineering students is very, very low. Yes, there may be some engineering students who would score 65 on math, but it’s highly unlikely that most of the engineering students on the bus that we found would also score 65, as we know that engineering students are very competent in math or they wouldn’t be admitted to engineering school in the first place. Therefore, we can reject that the student bus with an average math score of 65 is not the engineering student group.

Yes, we made it. This is the intuition behind Central Limit Theorem and what’s left is just some calculation and formula related with sample mean and sample standard deviation and the normal distribution, but we won’t touch for today. I think the intuition will help you understand those formula very easily. I hope we can go over the formula in the next post. Until then, please appreciate the beauty of the Ronaldo of Statistics.

               

Hypothesis Testing and Type I and Type II Error: The Murder Trial

Source: http://i.stack.imgur.com/FPCq0.jpg

It has been a while since I last posted an article on this blog. Let's take a break from Economics and take a look at the beauty of Statistics. To be honest, I found Statistics to be very boring during my undergrad. That said, now I'm very intrigued of the power of Statistics. Statistics is more than just about calculating the tedious probability. I now find that probability is a useful foundation in Statistics, but there is more to explore in Statistics. To claim that Statistics is all about probability is like to claim that Economics is all about demand and supply. Anyway, let's get to our topic for today. In Statistics you may have heard about hypothesis testing and the Type 1 and Type 2 error. My Statistics Professor explained this concept in a simple way by using a murder trial as an analogy. In this article, I hope you will have tons of fun learning the concept of hypothesis testing, Type 1 and Type 2 Error. I will keep our discussion simple without getting into any mathematical formula. I hope I can further discuss a real statistics example in the next article.

Hypothesis Testing

Okay, let’s say there is a homicide case in our community and the police arrest a man called Suspect A. We, as a young economist, was hired for no reason to find out whether Suspect A is a murderer. Probably it is because economists love to come up with a statement and love to test whether the statement is correct or false. Therefore, we need to gather evidence and evaluate whether there is sufficient evidence to prove that Suspect A is guilty as charge. This process of evaluating a hypothesized statement based on the evidence is called Hypothesis Testing in Statistics.  

First, we should begin by stating our null hypothesis. A null hypothesis is usually (but not always) the hypothesis which one wants to reject or nullify. In the legal system, generally a person is innocent until proven guilty. Thus, in our murder case, our null hypothesis is that the suspect is innocent. In other words, the suspect did not commit the murder. On the other hand, the alternative hypothesis is the opposite of our null hypothesis and we are trying to find evidence to prove that the alternate hypothesis is correct and reject the null hypothesis. Simply put, the alternative hypothesis in our case is that the suspect killed his wife, which means the man is guilty. Here is the summary so far:

Null Hypothesis: H0: Suspect A is innocent

Alternative Hypothesis: Ha: Suspect A is guilty

Type I and Type II Error

In evaluating the validity and accuracy of our hypothesis, we may unintentionally make two types of mistakes or errors. First, based on our evidence, we may come to a conclusion that the suspect is guilty and sentence an “innocent” person to jail. For this decision, we make a serious mistake and send the poor man to jail for the crime that he did not commit. This is called “Type I Error” in Statistics. In a technical explanation, Type I Error (denoted by alpha) is the probability of rejecting a true hypothesis.

Another mistake that we may make in this murder case trial is that we may not find enough evidence to prove that he is a murderer and acquit (free) the man who in fact is the murder. In this situation, we set free a guilty person. This is known as “Type II Error”. In a formal way, Type II Error is the probability of accepting a false hypothesis.

In summary,

Ruling	In Reality
	The man is innocent	The man is guilty
Sentence the man to jail	Type I Error	Correct Decision
Set the man free	Correct Decision	Type II Error

In general,

Decision	In Reality
	Null hypothesis is true	Null hypothesis is false
Reject null hypothesis	Type I Error	Correct Decision
Accept null hypothesis	Correct Decision	Type II Error

In both of these circumstances, sending an innocent man to prison and setting free a guilty man are both wrong decisions that we want to avoid. I also sum up what we have discussed so far into a simple table. The ideal scenario is to minimize the two types of error. However, we will later learn that Type I and Type II Error are inversely correlated. Hope you are hooked. Ok this is it for today. I hope you now have some intuitive understanding of hypothesis testing, Type I and Type II Error. Next time, I will try to go a bit deeper into the formula to conduct hypothesis testing.  

The Chinese Stock Market Meltdown

Source: http://a.abcnews.com/images/Business/gty_china_stock_3_kb_150708_16x9_992.jpg

Hi folks. We’re back after one long summer break. I did a lot of traveling and enjoyed tons of unexpected experience along the way. After the trip ended, I was so bored out of mind that I had to find some stuffs to do to keep myself busy. My overwhelmed free time makes me greatly miss school and my busy schedule. A lot of things have happened to me in the past few months and so have the world. Today’s topic will be about the recent calamity of the Chinese stock market. We’ll start off by giving some background stories that led to the stock market meltdown. In the next article, we’ll further discuss what the Chinese government have done so far to calm the market and restore investors’ confidence.

In the previous decade China has relished double digit growth thanks to its rise in productivity and overwhelming exports to other countries. One imminent thing is that the fun party can never go on forever. If the Chinese economy are to grow at a 10 percent rate every year, its GDP will double in every 7 years. If the trend continues, China will take over the world, literally. It comes to one prophecy: China’s economic growth will slow down. In 2014 China economy grew by just well over 7 percent which is still relatively higher than the growth of western countries. Despite the disappointing data, China is still one of the faster growing economy in the world. The latest data also showed that Chinese import and export dropped and key indicators such as factory outputs and real estate market also faltered.

To spur growth, last year the People’s Bank of China (PBOC) eased credit by lowering the key interest rate, hoping that commercial banks will channel the attractively low-interest fund to companies to boost investments, outputs, thus creating more employment opportunities. Conversely, a huge part of the fund was channeled to brokerage firms which in turn lent the money to investors to increase their stock purchase which is known as “margin trading.” (Wall Street Journal) Simply put, margin trading enables investors with a margin account, who lack sufficient fund, to borrow money from a broker to buy more stocks.This is also known as leverage in financial terms. To quote the legendary investor Warren Buffett, “Leverage is the only way a smart guy can go broke.” Debt financing, if used effectively, can reap huge return, but it also increases the risk of bankruptcy in the time when cash flow is short. The Wall Street Journal (WSJ) reported that the debt of margin trading has risen to about 2 trillion yuan ($323 billion) in early June, an almost five-fold increase from the previous year. 

As a result of the loose credit and margin trading, the Shanghai Composite Index in June 2015 has risen by almost 150 percent since 2014 and peaked on June 12. The Shenzhen index has also increased about 180 percent in just a year. (Bloomberg data) Such dramatic increase in stock price is unheard of and unsustainable.The number is also amazingly hard to believe given the already immense size of the Chinese stock market capitalization (market value). More importantly, the bull market with dramatic stock price appreciation happened at a time when key economic indicators signal big problems -  the economy is slowing down, factory’s output decreases, import and export drops and the property bubble bursts. In Finance the term “price” and “value” are two different things. An increase in stock price does not translate into an increase in stock value. Stock value depends on many measures including current and projected earnings, future cash flow, market share, sale volume and so on. Stock price is what you pay in order to get its value. Sometimes the price represents the true value and some other time it does not which strongly depends on the demand and supply in the market. In the same way, Chinese stock value didn’t increase 150 percent in just a year which only means one thing: the stock is overvalued.

Source: WSJ

Sensing the danger of margin trading in the week of June 15, the PBOC began to tighten its credit to commercial banks with the hope of curbing the excessive funding to margin financing to purchase stock. The PBOC’s action sent fear to investors which followed by a huge stock selloff in the market, plunging the Shanghai index and Shenzhen index. I remember an analogy from one of my professor about the 2007 financial crisis. He talked about a classic dancing chair game of how the banks were dancing along with the upbeat music because everyone was dancing. When the music suddenly stopped, everyone with fear tried to find his own chair to sit, while some people who couldn’t find their own chairs are the losers. The comparison between the Chinese market and my professor’s story is that now the music has stopped, investors in China want their money out of the market because they come to term with the reality that their stocks are overpriced. In one trading day in July, the Shanghai index plunged almost 8 percent in just a single day. So far the Shanghai Composite Index has fallen almost 30 percent from its peak on June 12. Almost 4 trillion dollars of market capitalization has been lost. (CNBC)

An op-ed in WSJ gave a brilliant description of why the Chinese market is in a bubble. He pointed out to four signs: prices do not reflect the economic fundamentals, massive debt financing to buy stock, excessive volume of daily trading by retail investors, and exorbitant valuation. 

Next time we’ll continue our discussion and talk about what the Chinese government have done to calm the market and restore investors’ confidence. This market turmoil is the toughest test yet for the new Xi Jinping's administration and the credibility of this new administration lies on how it handles this tough situation. We’ll be surprised that some of its interventions with good intentions may actually backfire, shatter the confidence and drive people further away from the market.

What are the Implications of a Strong Dollar?

We will continue from the last article about the causes of the strong dollar. Today we will discuss the implications of a strong dollar and what it means for investor. I really like this quote about the health of the U.S. economy: When America sneezes, the world catches a cold. As the dominant currency in the international market, the surging of the dollar’s value has both positive and negative implications not just on the U.S. domestic economy but also on the global economy.

 

Source: http://thumbs.dreamstime.com/z/strong-dollar-weak-euro-conceptual-illustration-hitting-currency-figure-white-background-49218515.jpg

 

Implications on the economies and markets

           The first major implication of a surging dollar is its adverse effect on the earnings of U.S. multinational companies which has a large proportion of revenue generated from foreign market. Given a strong dollar in exchange rate, the sales of companies in foreign currency is discounted when it is converted into U.S. dollar term. This is known as “currency risk”. The Washington Post reported that Johnson & Johnson, whose sales from international operation account for more than half of its total sales, posted a drop in sales of 0.6 percent in the fourth quarter, although there was an increase in prescription sale. Figure 1 shows that 46.3 percent of the total sales of the S&P 500 companies are generated from outside the U.S.

           The fact that the earnings of U.S. companies are lowered due to a strong dollar is only one side of the argument. A strong dollar benefits those U.S. companies who import materials from foreign countries. Because of a surging dollar, the materials can be bought at a cheaper price, thus reducing the cost of production and increasing the profits margins, according to Keith Lerner. The Washington Post also reported that the aluminum supplier company Alcoa posted a solid profit in the fourth quarter of 2014. Thanks to the strengthening dollar, Alcoa imported its materials at a lower price from Australia, Brazil and Jamaica. Despite a rising dollar, Alcoa sales were not significantly discounted, since most of its sales are generated in the U.S.

 

Figure 1: S&P 500 companies’ foreign sales as a percentage of total sale

Source: Mackenzie Investments

           

One positive benefit of a strengthening dollar is that it drives down price of imported goods to the U.S. and keep inflation at a low rate. Cheaper goods can improve the purchasing power of American consumers and grow the demand in the economy. The U.S. low inflation rate, despite the Federal Reserve’s past aggressive bond-buying program and increase in money supply, is partly attributed to the low oil price. The low inflation below the Fed’s target of 2 percent has prevented the Fed from raising the interest rate which could bring about volatility in the market and increase the cost of borrowing.

Implication on international trade

A rising dollar could also jeopardize the competitiveness of U.S. export companies in the world market which could lead to increased trade deficit. Given that goods in a strong currency is more expensive in countries with depreciated currency, the U.S. export products become less attractive to foreign consumers which would reduce the sales of American products. Furthermore, a strong dollar also makes it more difficult for U.S. producers to compete domestically with cheaper imported goods from countries with weaker currencies when converted from a weak currency into a strong currency. Such disadvantage could force U.S. producers to lower its selling price and profit margin, affecting the earnings of the company. A strong dollar could be a major hindrance against full employment recovery, wage growth and the U.S. economic growth rate. While it can adversely affect the U.S. producers, foreign producers can reap the benefit by boosting their exports to the U.S. even further.

However, while the U.S. producers face barriers in competing against other countries with weak currencies, the U.S. consumers are the winners whose surplus and purchasing power are increased. According to the World Bank’s data, the U.S. export of goods and service relative to its total GDP was only 13.5 percent in 2013. As a consumption-based economy, the U.S. should gain from a strong dollar in an aggregate effect.

 

Implication on investment

Return of investors from foreign market is also diminished due to a strong dollar. Although the return is high, it will be reduced once converted into dollar, thus reducing the overall returns. For example, the MSCI EAFE index or Europe, Australasia and Far East of developed market stock has risen 4.5% by September in its local currency. The return once converted into U.S. dollar was negative 1 percent (Kelly, 2014). Thus, investors who aim to diversify their investment portfolio by investing in foreign stocks should take into account the currency risk as a result of currency depreciation against the dollar in Europe, Japan and other markets and the fact that their return in foreign currency is reduced significantly when converted to the U.S dollar term.

Mackenzie Investments advised its investors that in a strong dollar climate it is wise to invest in U.S. equities but selectively pick the U.S. companies that benefit most from a rising dollar. Those companies should not have much exposure to currency risk and have most of their business operation in the U.S. and generate most of the sales within the U.S. Moreover, those companies should benefit from the cheaper import material from abroad. The recommended sectors are utilities, consumer staples, healthcare and telecommunication. Moreover, Mackenzie Investments also encouraged investors to favor mid- and small cap companies, since most of these companies’ businesses are operated domestically and do not face with currency risk significantly.

Emerging markets may suffer the most from a strong dollar. Flanders and Dryden (2014) claimed despite relishing the boost in exports to the U.S., some nations of the emerging markets may face high inflation rate and foreign capitals diverted from within the countries to other stable markets which could results in “serious market volatility” as experienced during the Asian financial crisis in the 1990s. The two J.P. Morgan’s analysts also stated that equity prices in emerging market economies are negatively correlated with the trade-weighted dollars. This phenomenon may be explained by the fact that the dollar generally depreciates when the commodity price is low and foreign capitals flowing out of the emerging economies. They also found that countries of EMEA (Europe, Middle East and Africa) and the U.S. dollar have a -0.31 correlation, MSCI Emerging Markets Index and the U.S. dollar has a -0.82 correlation and Latin America economies and the dollar has a -0.86 correlation.

 

Will the dollar continue to rise?

The recent trend of the dollar appreciation caused currency experts and investor to bring their concerns on “Dollar-Euro Parity”. When two currencies is at parity, it simply means that both currencies have the same value and are traded 1:1. Robin Brooks, a strategist at Goldman Sach, predicted that Dollar-Euro parity will take place in the fourth quarter of 2015. The strategist even further forecasted that the Euro could be traded at a low 0.80 dollar by the end of 2017, which will be the lowest exchange rate since the inception of the Euro currency.

Predicting the movement of the currency exchange rate is a challenging analysis. Whether the dollar will continue to rise takes into account many factors. First, it depends upon the state of the U.S. economy, that is, whether the U.S. economy can still outperform the developed market. The outcome of the ECB’s version of quantitative easing and expansionary monetary policy still remain to be seen and it is too early to judge whether the QE could attain its goals. Forbes reported that if Europe’s economy showed sign of positive economic data, the dollar-euro parity will unlikely happen.  Second, the strength of the dollar also depends upon the decision of the Federal Reserve of when to raise the interest rate and by how much. Given the current positive data from the labor market and price stability, the Federal Reserve’s interest rate hike is imminent and is likely to happen by the end of 2015 which is predicted by many analysts.

Hedging against the U.S. dollar

In the climate of a rising dollar and foreign currencies depreciation, hedging against the dollar has been popular among investors who aim to mitigate the currency risk of investing in foreign markets. Hedging currency can take many different forms, including sophisticated derivatives, that is, forward contract, foreign exchange swap, currency options, purchase of a currency-hedged mutual fund or exchange traded fund (ETF).

The method of forward and option to hedge is sophisticated. Since the currency-hedged ETF is more convenient, investors start to pour fund into ETFs to protect their investment from a surging dollar. The Wall Street Journal (WSJ) reported that currency-hedged ETFs, mainly offered by WisdomTree Investment and Deutsche Bank, is currently worth 50.3 billion dollar thanks to the growing concerns of the recent trend of a rising dollar. The figure below from the WSJ also showed that the returns of currency-hedge funds consistently beat the returns of unhedged funds since 2014. However, it should be noted that the performance of a fund within just a short period of time does not represent a full and complete picture of the returns in the long run nor does it indicate that a currency-hedged fund will continue to exceed the return of an unhedged fund in the coming years. Since the currency-hedged ETF is new to the market and hedging can be expensive and reduce the return when the global economic condition and world market change.

The WSJ also presented an argument against currency hedging. Hedging against the dollar can yield benefits in the short run given that the dollar is rising at the moment. However, currency movement goes in both directions - a currency can appreciate and depreciate over a period of time. In the long run, the currency risk is minimal and returns should be generally the same for hedged and unhedged funds. However, there is a cost incurred when you decide to hedge which could diminish your overall return in the long run.

Figure 2: Currency-hedged ETFs asset, one year return of hedge and unhedged funds

Source: The Wall Street Journal

 

Whether or not to hedge against currency, investors are advised to gauge the magnitude of the currency risk and its degree of likelihood, understand your time horizon in holding the securities, weigh the potential benefits and costs of hedging.

 

Conclusion

As a dominant international currency, the value of the dollar against other foreign currencies results in several implications which bring concerns to investors and the world market. Several factors are attributed to the rise of the dollar value in relative to other foreign currencies, including the relatively more impressive U.S. economic growth compared to other developed nations, the potential of the Federal Reserve’s interest rate hike, the quantitative easing program of the ECB and BOJ, capital inflow to the U.S. market and the U.S. energy revolution.

Major implications include the decrease in earnings of U.S. companies whose sales are mainly generated in foreign countries, the decrease in the return of investments in foreign market once converted to the U.S. dollar, the negative impacts on the competitiveness of the U.S. producers, the more expensive U.S. export products and the cheaper import products to the U.S.

Against the backdrop of the current economic condition, a currency strategist at Goldman Sachs predicted that the dollar and the euro would be traded at parity by the 4th quarter of 2015 and the euro-dollar exchange rate could even further drop to the lowest rate at 0.80 dollar per euro by the end of 2017. However, the prediction would not remain valid if positive economic data in the eurozone start to emerge in the near future. In the time being, investors need to pay attention to whether or not the ECB’s quantitative easing program is a success.

In the current rising dollar climate, currency hedging can yield higher return and protect investments in the foreign markets in the short run. However, the returns of hedged and unhedged funds are generally the same in the long run because the value of a currency can either appreciate or depreciate. Investors need to take into account the cost associated with hedging which could affect their overall returns. Investors should also understand the magnitude of the currency risk, time horizon of the investment whether investors opt for a short term investment or a long term investment and weigh the costs and benefits of hedging before deciding whether to hedge against the dollar.