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Protecting ETF Portfolios From the Currency Wars

NEW YORK ( ETF Expert) -- The last week has witnessed a renewed interest in foreign equities. In spite of a deepening recession in Europe, questions about China's growth, declining worldwide demand for commodities and little evidence of a self-sustaining global economy, some investors are filling their suitcases with overseas shares.

Valuation "wonks" might describe the phenomenon in simplistic terms; that is, investors obviously recognize the earnings yields are compelling.

The problem with this assertion is the fact that price-to-earnings bargains relative to U.S. stocks have existed for at least two years. More likely, investors love activist central banks and they expect foreign central banks to lower rates and/or devalue currencies.

Back in December, before many folks caught up with the trend, I discussed why a hedged investment in Japanese stocks had enormous potential. (See "A Foreign Stock ETF for a Rapidly Declining Currency."

Since that time, WisdomTree Japan Hedged Equity (DXJ) has packed on an astronomical 41.5%. Similarly, one should not be surprised when declining foreign currencies help pique desire for foreign equities.

Recently, the European Central Bank cut its target rate from 0.5% to 0.25%. The Bank of Australia also lowered its benchmark to 2.75%. New Zealand's central bank explained that it is actively intervening in its currency markets to reduce the value of the New Zealand dollar. While Thailand has yet to act to depreciate the "baht," its central bank is widely expected to cut rates or implement other measures to devalue its currency.

Rate cutting, quantitative easing and obvious efforts to devalue currencies are the primary reason for stock price appreciation in the United States and Japan since the bull's March 2009 inception.

In contrast, less-aggressive central bank activity in some countries and regions have hindered interest in the market-based securities of those areas. WisdomTree India Earnings (EPI) has been one of the biggest year-to-date losers due to the country's trade deficits, inflationary woes and currency appreciation.

There is a reason that many are suddenly smitten with funds like iShares MSCI Pacific (EPP) and iShares MSCI All-Country Asia excl Japan (AAXJ). In essence, it is the signals being sent out of by the central banks and governments of Asia-Pacific sovereign nations. They plan on fighting back.

Countries like South Korea, the Philippines and Thailand rely on exports to fuel their growth. While more mature countries such as Australia and New Zealand may be less-dependent on exports than emerging market counterparts, Australia and New Zealand depend a great deal on exporting natural resources/materials.

It follows that alongside the massive decline in the Japanese yen, investors should expect a substantial increase in Asia-Pacific central bank intervention to depreciate respective currencies.

Although stock investors may be looking out at the currency landscape and placing trades accordingly, currency ETFs representing countries in the Asia-Pacific region have yet to make dramatic moves. But they will. In fact, some analysts believe that a fallout from these currency wars may be less than 18 months away. Nevertheless, you might want to steer clear of excessive exposure to Asia-Pacific currencies where central bankers are determined to knock them down several pegs.

The problem for investors is determining how long to continue investing in the stock ETFs of depreciating currencies. One can go with WisdomTree Europe Hedged Equity (HEDJ) to protect against the possibility of a rapidly declining euro; one can go with DXJ to protect against a rapidly declining yen. Perhaps one can short CurrencyShares Australia Dollar (FXA) while simultaneously owning iShares MSCI Australia (EWA).

In the end, however, a race to the bottom in the currency wars could wreak havoc on the global financial system. An astute investor better know how and when to exit riskier assets if he/she expects to be successful over the longer term.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Disclosure Statement: ETF Expert is a website that makes the world of ETFs easier to understand. Gary Gordon, Pacific Park Financial and/or its clients may hold positions in ETFs, mutual funds and investment assets mentioned. The commentary does not constitute individualized investment advice. The opinions offered are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships. You may review additional ETF Expert at the site.

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