The Big Mac Index – Implications for US Investors
Every year, my family and I attempt to take about a week off in the summer and spend time in the 1,000 Islands region of Canada. It is our time to unplug and spend time as a family. This year was the first time we were able to do so since the COVID pandemic.
When we travel to different countries, I am always interested in how relatively expensive things are compared to the U.S. This past visit, I was felt like my U.S. dollars were especially strong, reminiscent of the early 2000’s. I was not surprised when I recently checked my loosely followed gauge, the “Big Mac Index,” from the Economist magazine.
For those who are unfamiliar with this “index,” it is a lighthearted measure of the cost of a McDonald’s Big Mac in different countries around the world. Because a Big Mac is virtually the same in each country you visit, it is used to gauge how “undervalued” or “overvalued” a currency is, when using a burger as an example. It helps to measure purchasing power parity which is the theory that currency exchange rates around the world should adjust so that a uniform basket of goods costs the same in different countries.
In the latest issuance of this index as of June 2022, an example given was how the USD relates to the British Pound. Their example identified a Big Mac as costing $5.15 here in the United States while it cost 3.69 pounds in Britain. The implied exchange rate is 0.72 pounds/USD, based on the burger. The exchange rate at that time was 0.83 pounds/USD. This implies that the USD is ~13% overvalued relative to the pound.
Another (more widely accepted) measure of how strong the US dollar is compared to other countries is published by the Federal Reserve Board, called “Nominal Broad U.S. Dollar Index.” This measures the strength of the U.S. Dollar against trade-weighted currencies.
As can be seen in the preceding graph, the U.S. dollar has been growing in strength since mid-2021 and appears to be at its strongest point since 2006.
The cause of the recent strength can be debated, but there are many factors at play. What we are concerned with is how it impacts our clients. The strength in the dollar should make imported goods less expensive and exports more expensive to our international counterparts.
From an investing standpoint, this growth has pressured international stock returns. To illustrate, let’s say you purchased 100 shares of foreign Company XYZ on January 1st when the currency exchange rate was 1 USD to 1 FX currency. This means that for each dollar exchanged, you could buy 1 unit of the foreign currency. In this hypothetical example, let’s fast forward 9 months to September 30th and pretend the exchange rate had moved to 1 USD to 1.25 FX and the stock stayed the same price in local currency.
In the example, even though the stock stayed the same price, because the exchange rate changed, a US investor would now have seen an unrealized loss in their holdings. You see, the 100 shares would have cost $100 on January 1st, but if they were to sell the shares and convert back to dollars, they would have realized a 20% loss (100 FX x USD/1.25 FX).
Of course, since the Nominal Broad U.S. Dollar Index began being measured in 2006, we have seen general strength in the dollar. However, this is not always the case. If the dollar were to depreciate relative to other currencies, the exchange can become a tailwind for U.S. investors.
We invest internationally because we believe it provides long-term diversification benefits for a portfolio and allows investors to participate in global growth. We wanted to illustrate how currency exchange rates can help or hurt investment returns.