The cost of living varies greatly from state to state. Even though a dollar is a dollar everywhere, you can’t exchange it for the same amount of gas in California as you do in New Jersey. The costs of selling that gas varies with local tax structures and distance from the source. Local competition could affect the price too.
International transactions add another variable to the equation. Currency exchange rates are not fixed, and inflation (or the changing purchasing power of a currency) is not constant across countries either.
For an introduction to foreign exchange, check the Big Mac index
Investors who plan to add an international component to their portfolios need to understand something about exchange rates. An investment in foreign stocks or bonds offers an extra path for risk and for reward. In addition to the economic fundamentals that will drive the value of the investment, there is the possibility that changes in relative currency values will have an important effect on the bottom line.
Logically, exchange rates should not affect purchasing power around the world. When something costs $100 in Chicago or New York, a traveler ought to be able to exchange $100 for enough yen or euros to buy a similar item in Tokyo or Paris. Economists call this idea “purchasing power parity” (PPP).
In real life, logic doesn’t always prevail. Each year since 1986 The Economist magazine has constructed an index of purchasing power using a single commodity: the Big Mac. What started as a light-hearted guide for making exchange-rate theory more digestible has evolved over the years, and is now included in economics textbooks. The most recent update is on their website here.
McDonald’s hamburgers are sold around the world; their quality is consistent, but the prices are not, as shown in the table below. All prices have been converted to dollars for easy comparison. Where the local price is above the U.S. price, the local currency is overvalued according to the theory of purchasing power parity. When the price is below ours, the currency is undervalued.
The first column gives the local prices of the Big Mac converted to dollars. Comparing these provides a measure of how overvalued or undervalued a foreign currency is relative to the dollar, in the second column.
|Big Mac Price
|In Dollars Distortion
Source: The Economist, January 26, 2023
Although the Big Mac index is subject to some distortions by local sales taxes, trade barriers and other factors, The Economist reports that its PPP estimates are remarkably close to those derived by more sophisticated methods. The data show that the dollar has been strengthening against other world currencies in recent years.
Inflation has caused the median price of a Big Mac in the U.S. to rise by 6% in the last two years, according to the article. Other countries have experienced even more inflation than we have, but the effect has been offset by the changing currency relationships. For example, two years ago the Big Mac was 26% cheaper in Japan, and now it is 41% cheaper.
Another example to look at might be Starbucks
Starbucks is second to McDonalds in terms of its global scale, but it does have 32 thousand locations across 80 countries and a product that is ubiquitous across its businesses. This article by the visual capitalist shows both the cost of a Starbucks coffee in every country, and also compares it to the cost of living and the average earnings in those countries.
Although the nominal United States cost is nearly triple that of the cost in Turkey (where coffee is the cheapest), it is actually more affordable based on the median daily wage. On the other hand, Switzerland both had the most expensive coffee in term of price and is relatively high compared to the average earnings.
Caution for investors
The volatility in currency exchange rates is just another difficult fact of life for investors, one that adds both risk and reward to the international component of an investment portfolio. Although it may be important for investors to have a global perspective, it’s also important to stay well diversified, not concentrated in a single country or region.
If you are interested in considering ways to diversify your portfolio and are concerned about the risks that could be involved, please let us know. At Garden State Trust Company we help clients build portfolios that match their appetite for risk and goals with their time horizon in mind. We’d be pleased to provide a consultation.