FX best way to play emerging markets, says Nomura

In an interview yesterday, the Nomura FX strategist argues that since 2002, emerging market currencies have outperformed equity returns both in US dollar terms and in local currency. Tracking data back to 1999, Nomura calculates that a pure emerging market-denominated currency investment had a 69% correlation with local currency equity markets, as well as providing attractive volatility-adjusted excess returns. In 1999 both asset classes (FX and equity) offered a similar excess return of about 100 basis points. Today a currency investment offers an excess return of 250bps, compared with 150bps from local currency-denominated equities.

“The basic point is: How often do you hear people talking about Bric growth?” says Morris. “The usual conclusion they reach is that you must buy emerging market equities to participate. But the data doesn’t back that up. FX does a much better job at delivering Bric growth to investors.”

The outperformance can be explained in two parts, says Morris. First, inflation tends to be higher in fast growing developing economies, eroding some of the returns from rising equity markets. Second, growth-driven inflation leads to monetary policy tightening that pushes up short-term interest rates, reinforcing the economics of the carry trade, of which emerging currencies are generally the most sought after.

Just getting exposure to emerging market equities in the first place can be difficult because the markets are by definition less developed. Morris says that by some estimates emerging markets GDP accounts for 40% of global GDP, yet their total share of the MSCI World Equity Index is only 12%. “You simply can’t get exposure to emerging market growth by investing just in equities; by using FX, you can solve that problem.”

If what Morris says is true, why aren’t more investors taking advantage of the superior returns of FX investing?

Some of it may be down to how people view the asset classes, says Morris. “People are wary of FX, because they believe returns are more random or inexplicable than equity returns.” But he thinks they are wrong: “Emerging market FX is different: returns are highly correlated with equity returns, as the data shows. They have the same country beta.” Furthermore, they also offer higher cumulative excess returns on a GDP-weighted portfolio basis.

Critics point out that emerging currencies aren’t as liquid as the G10 currency group, and that many currency pairs aren’t freely convertible. But that is not universally true: currencies such as the Brazilian Real and the Mexican peso are as liquid as the Canadian and Australian dollar in the Americas time zone.

“Many emerging currencies are traded in a non-deliverable format for technical reasons, but this isn’t a problem,” says Morris. “It doesn’t diminish liquidity and scalability, which remain much higher than that of equities.”