Set Your Sights on Sweden

I'd bet that few Americans could point to Sweden on a map, let alone name a Swedish stock -- maybe LM Ericsson (ERICY Quote - Cramer on ERICY - Stock Picks) or Volvo (VOLVY Quote - Cramer on VOLVY - Stock Picks), though even fewer would know that Volvo has sold its car business to Ford and is now primarily a maker of trucks and buses.

Nonetheless, the country is home to a number of dynamic companies and I believe it will be an excellent investment destination over the next year or two. Its GDP growth has been very good for the last couple of years and it looks like the Swedish krona could rise substantially against the dollar.

Through the third quarter, Sweden's GDP was growing at a 3.4% annual rate, well above the 1.3% growth rate for the euro-zone economy. Sweden's unemployment rate, at about 5%, is also much lower than most of the continent's unemployment rate.

Sweden has a healthy supply of natural resources, including timber, iron ore and hydroelectric power. This part of the economy accounts for roughly 30% of GDP. If global demand continues to increase, growth in Sweden could continue to accelerate.

The Swedish version of the federal funds rate has been at 1.5% since April, when it was lowered from 2.0%.

Perhaps due to strong GDP growth, recent CPI data shows inflation has picked up in the back half of 2005. This creates visibility for the Riksbank to raise rates in 2006, and a series of rate hikes could be a positive for U.S. holders of Swedish stocks.

Typically, higher interest rates create demand for currencies. The overnight rate in Sweden is currently 1.5%; the U.S. rate is 4.25%. The 10-year bond in Sweden yields 3.29%; the U.S. 10-year yields 4.35%. This yield differential creates a headwind for the value of the Swedish krona against the dollar. The dollar has strengthened against the krona this year, as can be seen on the chart below.

Swedish Krona to $1

Source: Yahoo!

If Sweden begins to raise rates, capital could flow back into the krona, lifting its value. An American owner of Swedish stocks would benefit from the currency move.

The easiest way to gain exposure to Sweden while avoiding single-stock risk is the iShares MSCI Sweden Index Fund(EWD Quote - Cramer on EWD - Stock Picks).

It has a few flaws. It has a very heavy 22% weighting in Ericsson, which has been a volatile stock. And the consumer and banking sectors have weightings of 23% and 17%, respectively; an argument could be made that rising rates would hurt these sectors, but this tends not to be the case at the start of a tightening campaign.

One other risk is that Swedish stocks have risen sharply already. In 2005, the OMX Stockholm 30 Index rose 30%. Although that looks like a big move, it is only in the middle of the pack compared to other European markets.

Swedish Stocks The OMX Stockholm 30 Index rose 30% in 2005.

Source: OMX Stockholm

In dollar terms, as measured by iShares Sweden, Sweden is up less than 10%. While there are no absolutes, the future flow of capital into a small economy is often a more important driver than what happened last year.