A way to wipe away foreign currency concerns

For many investors, one of the biggest obstacles to investing in foreign stock markets is the added risk posed by currency fluctuations. It's a complication most retail investors could live without.

But currency valuations needn't be your enemy. On the contrary, says Goldman Sachs, they could be one of your best allies in uncovering the gems among foreign equity markets.

Forex and stock markets Strategists Dominic Wilson and Roman Maranets back-tested an equity investment strategy using the Goldman Sachs Dynamic Equilibrium Exchange Rate (GSDEER) - a measure of currencies' fair value based on each country's price conditions, terms of trade and productivity trends. The idea was to go long in equity markets of countries with significantly undervalued currencies, and go short in those with significantly overvalued ones. Currency hedging wasn't allowed; they wanted to capture the entire effect of forex markets on stock returns.

The results showed that over the past decade, the strategy would have been a highly successful one - generating returns of about 350 per cent in that time. Further, they found that this held true regardless of stock valuations for those markets. In fact, over time, the long-short strategy actually outperformed using a similar approach based on markets with the lowest and highest price-to-book valuations.

Cashing in on imbalances Why does it work? The strategists believe it's tied to the way exchange-rate imbalances affect other products and assets.

If a currency is undervalued, there are two ways for it to correct. The currency can rise, if it's free-floating. But if it's a partially or fully pegged or fixed currency - as many emerging-market currencies remain - the adjustment instead comes in the form of higher prices for goods and assets. The opposite, naturally, is true for overvalued currencies.

The strategists figure stocks act just like any other assets.

As a result, investors have two ways to win when buying, unhedged, into foreign stock markets with undervalued currencies. They can cash in on the rising asset prices for as long as the currency remains out of balance, and they can realize foreign-exchange gains on their stocks if and when the currency rises to its fair value.

Right now, the strategy points to several Asian markets with weak currencies; the strategists say Hong Kong, Singapore and Taiwan look like the best bets, since their stock markets are also carrying low valuations.

Canada, on the other hand, is among the countries with currencies trading above fair value. This implies that Canadian equities could be global under-performers over the next couple of years.