The REAL Deal Regarding FX Exposure In International ETFs

Thanks to everyone who participated in the exercise as always!

Most of you wanted to buy strength above the breakout level, and supported this view with the improving momentum characteristics and constructive consolidation that's taking place just beneath the prior highs.

We'd agree with this take. So, what were we all buying?

It was a chart of the US Dollar/Brazilian Real (USD/BRL) cross, which jumped out at us for a number of reasons.

First and foremost, it's in a strong primary uptrend. After a 4-year base that resolved higher, the pair is now digesting those gains in a smaller continuation pattern just between our two risk levels.

If we're above 5.90, the path of least resistance is higher and our risk is very well-defined where the prior highs coincide with our objective at the 261.8% extension.

If we're above this level we like USD/BRL long with a target of 7.66 over the next 3-6 months.

But that's not the main reason we wanted to discuss this chart.

The real story we're focusing on today is the negative impact that weak currencies like the Brazilian Real and many others in Latin America have had on the international ETF vehicles that US investors use to gain exposure to these countries.

Let's break down this dynamic quickly. For more details, I encourage you to read our post on the same topic from a few years ago.

International country and global diversified ETFs own stocks all around the world in their local currencies. Thus, as most of these funds are unhedged, changes in the relevant exchange rates play an important role in their performance. Long story short, when investing in these vehicles, we don't just want to make sure that their underlying stocks are performing well in local currency, but also that the currency itself is strong... as both will impact the return profile of the ETF.

Let's use Brazil as an example to illustrate just how significant of an impact a country's currency can have on these investments.

As shown in the chart above, USD/BRL saw a swift rally higher in both early 2018 and again in early 2020. Take a look at how this US Dollar strength impacted the performance of the USD denominated iShares MSCI Brazil ETF $EWZ.

While the country's local index, the Brazilian Bovespa has stair-stepped to new all-time highs over the past several years, notice how EWZ has been chopping sideways in a messy range, and just recently made a lower high as the weak Real continues to weigh on the ETFs returns.

Here's a closer look at the MSCI Brazil ETF.

The recent failed breakout in January and subsequent weakness coincides with the USD/BRL catching a bid. So as the local currency, in this case the Brazilian Real, loses value relative to USD, so does EWZ because it is priced in US Dollars.

This International ETF bubble chart shows the performance of various country ETFs since September 1st on the x-axis along with the percent above/below their respective 2018 highs on the y-axis.

We've highlighted Brazil and Peru, which we'll talk about below. Note how each of these ETFs look pretty terrible compared to their peers as both remain trapped below their key 2018 highs in USD terms. Not to mention, Brazil has actually been the worst performer in our entire universe since September 1st.

Now contrast that with the same bubble chart, but this time with all of the International Indexes on a local currency basis.

And just like that, things don't look nearly as bad for these countries. The idea is to be in the upper right of this chart, and while Peru and Brazil still aren't exactly leaders since September, at least both are above their critical 2018 highs in local currency terms.

The takeaway is simply how different the performance can be between these indexes and ETFs due to a country's currency.

Let's look at one more example now with another Latin American ETF that's shied away from a potential breakout level in recent weeks. This is the iShares MSCI Peru ETF $EPU.

Similar to EWZ, the recent strength in USD has applied pressure on EPU. While we still have a good looking base here in USD terms, in local currency, Peruvian stocks are pressing on new highs.

Here is the Bolsa Val Lima Peru Index pressing on the upper boundaries of a beautiful 14-year base.

If you were to zoom out on the EPU chart, you'd see a much different picture as the ETF is still in a nearly 30% drawdown from its 2010 record highs.

Here is the US Dollar/Peruvian Nuevo (USD/PEN) cross, which shows consistent strength from the US Dollar off the 2018 lows.

And just like Brazil, above... Peru's currency weakness in recent years has caused a significant divergence between the performance of its local stock index and its international ETF.

Yet again, we're seeing lower highs and a choppy mess in EPU while Peruvian stocks in local currency keep chugging onward to new highs.

The bottom line is that the performance of these international ETFs can diverge significantly from the way a country's stock market is performing in its local currency.

As such, when we invest in these vehicles we want to be mindful of not just how the equity markets in these foreign countries are doing, but also how their currency is faring against the US Dollar.

Thanks for reading and please let us know if you have any questions!

Allstarcharts Team