- Currency markets tend to be are very cyclical. We believe the factors are shifting towards strength in emerging markets (EM) currencies
- Currency markets offer value following a 5-6 year trend: the US dollar has increased its trade-weighted valuation by 30% over the last six years, whereas EM currencies have devalued nominally by more than 40%
- The relative growth differential also favors EM market currencies, while conditions for US dollar appreciation are abating
John Maynard Keynes made and lost a small fortune investing in European currencies in the inter-war years.
Several emerging markets, most recently Argentina, have committed the “original sin” of borrowing in foreign currencies when they were weak and then defaulting when they strengthened. Recently, investors became enamored with hedging strategies as both Europe and Japan proactively devalued and the US dollar soared.
So what’s next?
Several ingredients combine to form the cyclical nature of movements in the valuations of currencies. In our view, economic growth is first among these.
Historical data show that when a country’s growth rate increases relative to the rest of the world, this attracts long term capital in search of productive investment opportunities, which strengthens a country’s external position and, all else equal, contributes to its foreign currency reserves. In this scenario, a country’s interest rates are likely to rise, as growth stokes inflation or the central bank adopts a more hawkish stance. Higher interest rates reinforce the relative attractiveness of the country for foreigners and bond investors may enter the market in search of carry.
Secondary factors affecting currencies include technical considerations such as terms of trade; volatility; and investor positioning. Although these factors in our experience are contemporaneous rather than leading indicators, there can be autocorrelation or a tendency for momentum in the data, except when at extremes. We believe currency markets now stand at just such an extreme. The US dollar rally that began in 2011 has increased its trade-weighted valuation by as much as 30% according to some estimates (see Exhibit 1 below).
Exhibit 1: The US dollar index (DXY) has rallied strongly since 2011, in our view the conditions that drove this rally have now abated (the graph shows changes in the US dollar index over the period between 1980 and 01/12/16)
Source: BNP Paribas Asset Management, Bloomberg as of 05/04/17
Emerging market currencies, in turn, have devalued nominally by more than 40% from their 2011 peak and real effective exchange rates for a basket of EM now stand approximately 10% cheap to the long term average (see Exhibit 2 below).
Exhibit 2: After a parting of the ways that began in 2011 we see scope for emerging market currencies to rally versus the US dollar (the graph shows the real effective exchange rates for the US dollar and a basket of emerging currencies for the period between December 2000 and December 2016)
Source: BNP Paribas Asset Management, Bloomberg as of 28/02/17
The outlook for economic growth also favors EM. Green shoots appeared in EM data late last summer and have now sprouted into full grown expansion for many countries. Industrial output is now positive in all EM regions and “hard data” covering exports and consumption mark robust recovery across EM. The conditions that led to US dollar appreciation from 2011-2016 have now abated: the US is no longer accelerating relative to EM; volatility in currencies has subsided; and terms of trade, which for most EMs means commodities prices, have pulled out of their slump.
Having called the bottom on EM currencies, we have been decidedly long in our foreign exchange exposures for most of the last six months. We recently pared this back due to the strong moves in currency markets following the last Federal Open Market Committee (FOMC) meeting but plan to re-enter positions on the next correction in valuations.
We recommend investors similarly enter dedicated exposures as opportunities present themselves over coming months.
Currencies will always be a bumpy ride, but we can now say with conviction the cycle is on EM’s side.
Published on 6 April 2017
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.