Choice of funding currency set to determine EM FX performance in 2015

Solomon Teague
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Despite the strengthening dollar and lower oil prices, tactical opportunities in emerging market (EM) foreign exchange abound. The choice of funding currency will be crucial in driving returns in the asset class, say investors.

At first glance, it has been a forgettable start to the year for EM currencies, most of which kicked off 2015 in much the same way they ended 2014, by weakening against the dollar.

However, when traded against other leading currencies such as the euro, performance has been markedly better. And with the ink still drying on the European Central Bank’s quantitative-easing announcement, and US rate hikes looming ever closer, strategic bets are taking centre stage.  

If economic consensus proves correct, and 2015 sees the further strengthening of the dollar and the weakening of the other most-liquid currencies, notably euro and yen, this should encourage more EM FX traders to fund their purchases with those non-dollar alternatives.

The evidence of the last two years is compelling. A basket of 19 EM currencies traded against USD lost 11.5% on a compounded basis in that period, while against EUR it has only weakened by 3%, and against JPY it has delivered a positive return of 22.1%.


Marcus Svedberg, chief economist at East Capital, an emerging and frontier markets fund, says: "For EM FX generally, excluding the oil producers, I expect to see continued weakening against the dollar, but strengthening against the euro.

"Most of this move has already happened – we are more than halfway through. But for now this means EM equities will look more attractive to Europe-based investors than US investors."

The strengthening greenback might also encourage dollar-based investors in EM local currency debt indexes to look for alternative ways to gain the same exposure, given the trend of currency moves have increasingly undermined returns in this asset class.

Perhaps surprisingly, James Wood-Collins, CEO at Record Currency Management, says EM FX offers an alternative to such EM local currency debt indexes, which predominantly include sovereign debt and are popular among many investors.

Such indexes, he says, derive their returns from yield pickup, spot moves and a duration premium.

"FX derives its returns from the same things except the duration premium, so we see EM FX as at the short end of local currency sovereign debt," he says.

Crucially, the FX market offers greater flexibility with the funding currency, allowing dollar investors to buy local debt and pay with euros instead, enhancing returns.

The case for FX gets stronger as US rates rise, he says, adding: "Investors will probably prefer shorter duration as it protects them from the repricing risk. There is less exposure to capital controls with FX forwards."

Providing traders fund their EM FX investments with one of the many available weakening currencies, such as euro or yen, there are plenty of opportunities for tactical allocations to the asset class.

Louis Gargour, managing partner and CIO at LNG Capital, says: "The winners in the current environment are the countries with low-cost labour that import oil. Broadly speaking that means Asian EMs benefit and LatAm EMs don’t.

"Eastern Europe is caught in the middle – it should be benefiting from cheaper oil, but most are instead suffering because they rely on exports and imports to and from Russia."

Potential stars

Two currencies consistently singled out as potential stars for 2015 are the Indian rupee and Turkish lira.

East Capital’s Svedberg says: "Everyone loves India, they love its reforms, the impact of lower oil, of growth and demographics. It has a strong central bank. But this level of consensus should eventually make people cautious because there is room for disappointment.

"If growth does not accelerate as much as is hoped, if the price of oil continues to rise or if its reforms do not go according to plan, the rupee could take a hit."

He adds: "It is the same in Turkey, which is seeing strong growth and falling inflation. Turkey could meet its 555 plan [5% growth, 5% inflation, 5% current-account deficit] for the first time. But its central bank has shown itself to be trigger-happy, no doubt under pressure from the government.

"If it cuts rates too aggressively, it could reverse some of the gains it has made."

Svedberg expects both to appreciate against EUR, though with INR having been stronger in recent months, it has more scope to depreciate. On the other hand, he warns Turkey’s higher level of integration into the European economy leaves it more exposed to the fortunes of the eurozone, be they positive or negative.

This risk does not apply to Turkey alone, and EMs as a whole will feel pressure to cut rates, says Svedberg.

"Around 80% of EMs are energy importers, so many of them are importing a lot of disinflation at the moment," he says. "So there is room to cut and we may see it sooner than expected to prevent their currencies getting too strong and ensure they remain competitive.

"But as long as the dollar keeps strengthening as expected, this should not be too big a problem."