I am often asked: What do you think of emerging market (EM) currencies? My usual answer is that many, especially those among the Asian currency block, are fundamentally undervalued against the U.S. dollar and represent an excellent long-term investment.
Many people however find it difficult to buy these EM or exotic market currencies. But there is an easy way for you to do it. And as you view the following charts, I think you'll quickly see what I mean.
Below are charts of five countries' stock markets (black line on the chart) compared with the value of their currencies (orange line on the chart) valued relative to the U.S. dollar. The correlation is very tight i.e. higher stocks and higher currency values, vice versa.
So, I think it can be said that if you are bullish on emerging market stocks, you must also be bullish on their currencies. And if you're bearish on the stocks, you're bearish on their currencies relative to the U.S. dollar.
Why is this correlation between EM stocks and their currencies so tight, when we don't see the same degree of correlation among the currencies of the industrialized world currencies relative to their stock markets?
It Is All About Liquidity!
The amount of currency issued and outstanding in emerging markets is relatively small compared to industrialized countries — makes sense. Plus, the demand for EM stocks results in a direct and corresponding relative demand for the currencies. That's because to buy those stocks in local markets you first have to convert whatever currency you are using to the local currencies in order to make that purchase.
Therefore, a stock decision becomes a currency decision. And the relatively small amount of currency outstanding relative to equity markets in EM countries, directly impacts the value of the currency.
Now as you look again at these charts above, consider this:
By investing in EM stock indices, which can easily be done with the whole host of ETFs, you are effectively making a currency decision.
Thus if you get excited about an EM currency story and don't want to go into the spot Forex market or the corresponding currency ETF isn't available, you can play your new favorite EM currency by owning the local stock index.
And for the average investor, it is much easier to find an appropriate EM or exotic market ETF than it is to find an equivalent direct currency play.
As EM liquidity increases in the years to come, this extremely tight correlation between local stocks and the local currency will begin to breakdown. But for now, EM stock index investing is a simple and powerful way to invest in an EM currency of your choice.
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