Brent Sheather: Shares survive sliding kiwi

Two weeks ago we looked at the major findings of the 2006 edition of the Global Investment Returns Yearbook produced by Professors Dimson, Marsh and Staunton from the London Business School.

Besides calculating and commenting on the long-term returns of global stock, bond, bill and currency markets, each year the authors have a particular focus.

This year it is the impact of currencies on the performance of sharemarkets. This topic is particularly relevant to New Zealand investors given the small size of our economy and sharemarket and the tendency of the kiwi over the long term to depreciate against every overseas currency in the world with the exception perhaps of the Iraqi dinar.

But your view of the kiwi depends on your perspective. Martians observing the world from above since the start of the 21st century would have a rather favourable view of the kiwi dollar - it has been a remarkably strong currency, rising 31 per cent against the US dollar since 2000. But looking much further back shows the kiwi in a quite different light.

Records from Global Financial Data back to December 1892 show the kiwi to have been a truly flightless bird, falling against the US dollar by a total of 72 per cent over the last 113 years.

Back in 1892 the New Zealand pound was apparently worth 4.9 US dollars. While oil and Chryslers were cheap, dairy farmers must have hated life. The kiwi currency, which changed from pounds to dollars in 1967, has thus apparently fallen against the US dollar by an average of 1.2 per cent a year over the last 113 years. The reason? Most probably higher inflation locally than overseas. Since 1931 local inflation has averaged around 4.4 per cent a year versus 3 per cent in the US.

The economic theory of purchasing power parity suggests that a currency will decline/appreciate by the extent to which inflation is higher/lower locally. So does this mean that economies with high inflation and thus weak currencies should be avoided by share investors? Putting the question another way, should we invest only in overseas markets where we think that the currency will remain strong? No, say the professors. As we well know, in matters financial, anything that obvious has to be incorrect. And so it is.

Using their database, the professors report that the opposite hypothesis is more accurate: "Some analysts expect superior long-run performance from foreign markets with a strong currency, but our 106 years of evidence does not support this opinion. It is the equities from weak-currency countries that have tended to outperform, though with considerable volatility. The obvious question is why?

"Possible answers are that a weak currency puts investors off and so stockmarket valuations get very cheap - in the middle of its real crisis the Brazilian stockmarket got sold down to a price-earnings ratio of about one-quarter that of the US. Alternatively an ultra-weak currency helps exporters to make extraordinary profits."

The other interesting finding of the study is that while almost every country's currency weakened against the mighty US dollar over the period, the extent of the weakness was invariably due to higher inflation in that country relative to the US.

In economist speak, real exchange rates changed, at most, by a fraction of 1 per cent a year. The professors conclude: "Currency risk does not add greatly to the long-run risks of international equity investment. Investors with no special insights about the prospects for different world markets should therefore hold as diversified a portfolio as possible. For longer-term investors, however, foreign exchange hedging mitigates downside risk by no more than a small margin. Stock market risk is reduced more effectively by international diversification than by currency hedging."

If an analysis of the long-term trend in the dollar has anything to tell investors it is that we should have some savings offshore. But don't think that just because the kiwi fell against the US dollar that the greenback has been a strong currency - far from it.

According to James Grant's Interest Rate Observer the US dollar has fallen by 97 per cent against gold since 1914. Any reflection on either the kiwi or US dollar's fortunes over the last 100 years would seem to argue for some gold or real assets like property and shares in one's portfolio to combat the insidious effect of inflation on paper money.

Brent Sheather is a Whakatane-based investment adviser.