Reversal of fortune and flows to weigh on emerging market currencies this year
The bear case for EM FX markets has gathered momentum, with more and more analysts questioning the medium-term to long-term investment case.
Powered by superior economic growth, solid balance-of-payments surpluses, relatively low macroeconomic imbalances, improving political and economic systems, and boosted by the effective devaluation of key developed market (DM) currencies by quantitative easing (QE), emerging market (EM) currencies as an asset class has been one of the best games in town for the past decade at least, a boon for local fixed-income and equity inflows.
Indeed, as the relative risk perception between DM countries and EM ones began to narrow from around the 1980s, investment flows into emerging markets increased from $25 billion in 1980 to $1.2 trillion in 2013 and, over the past 10 years alone, these flows have averaged 5% to 6% of GDP of the recipient countries, up from around 2% in the 1980s, and 4% in the 1990s.
Now, though, with the US having begun to taper its QE programme, and China’s growth looking set for a sustained downturn, the relative risk and reward profile, and corollary investment flows, appear to be reversing once again away from the EM sector in general.
“We could easily see greater pressure than forecast on a range of EM economies and markets from the ongoing rise in US yields and the rebalancing of their own economies, and EM equities and currencies have generally struggled again on the back of these dynamics,” says Dominic Wilson, chief markets economist of Global Investment Research, in New York, who adds that with elections upcoming in a number of countries (Turkey, Brazil, and India) increased political risk mght also weigh on the EM sector.
Against this general view, it has been fashionably expedient since the US Federal Reserve began to taper its QE programme, and the US dollar began its recent inexorable rise, to posit that such problems are concentrated in the Fragile Five EM currencies, the Brazilian real, Indonesian rupiah, Indian rupee, Turkish lira, and South African rand.
However, says Ray Farris, head of APAC macro product for Credit Suisse in Singapore, this optimism might well turn out to be ill founded. “While we agree that some of the surplus currencies will outperform most of the deficit currencies, we expect broad US dollar strength to produce a mix of policy action and capital outflow that weakens even the surplus currencies versus the dollar.”
At the individual country level, CS estimates that only the economies of Malaysia and the Philippines are currently above potential and that only Chile, Hungary, and Turkey will swing into positive output gaps in 2014.
“In most cases, weak growth reflects credit cycles and domestic demand growth that have rolled over, increasing their dependence on exports for recovery, and yet the developed economic recovery is not transmitting to EM through exports,” says Farris, adding that even those EM countries with current-account surpluses are still vulnerable to capital outflows prompted by spikes in US yields.
Indeed, factoring in the market consensus view of declining growth in China adds further shades of uncertainty to even those EM economies that might otherwise look solid enough to avoid further currency losses on the basis of sound fundamentals alone.
For example, although on the surface exports to China from most countries are actually quite small, the global supply-chain linkages into the country via third countries, especially from intermediate goods and commodity exports from EEMEA countries, necessitate a more holistic notion of trade linkage.
In this context, using the Organization for Economic Cooperation and Development’s Trade in Value-Added (TiVA) data, says Peter Attard Montalto, emerging markets economist for Nomura International, in London, South Africa stands out on all measures (given a mixture of processed and unprocessed commodity exports, with Russia second, while, surprisingly perhaps, Hungary actually scores higher looking at China and the Asia-5 (the five countries Nomura thinks are most exposed in Asia to China’s slowdown, given supply-chain linkages: Australia, South Korea, Hong Kong, Malaysia, and Singapore).
What’s more, although over the past few years all currencies appear to have peaked against the dollar from a purely mechanical perspective, if the definition of currencies that have peaked is tightened to count only those that have not traded within 5% of their post-2002 highs over the past few months there is still scope for further weakness in many EM currencies, says Bilal Hafeez, FX strategist for Deutsche Bank in London, adding that many smart investors believe that the US dollar is entering one of its six- to 10-year long-term upwards re-rating cycles.
Even from a longer-term perspective, despite the oft-repeated view that many emerging markets remain essentially a convergence play to the asset values of developed markets, there is little in the way of historical precedent to substantiate this view.
For example, the role of EM currencies as an internationally traded asset class is still remarkably limited compared with the increasing weight of their base economies in the global economic mix; of the $5trillion or so daily FX volume reported in the Bank for International Settlements’ 2013 triennial survey the top-three EM currencies totalled less than 7%, with the Mexican peso at 2.5% (compared with 1.3% in 2010), the Chinese renminbi at 2.2% (0.9% in 2010), and the Russian rouble at 1.6% (0.9% in 2010).
Looking at stock markets is also instructive in determining trends for increased take-up of EM FX, given that EM currencies need not only to have increasingly evident economic clout, but also to be used as international reserve assets, as tools in invoicing and settlement of international transactions, and as objects of speculative desire if FX trading volume is to increase.
In this context, says Frances Hudson, global thematic strategist for Standard Life Investments, in Edinburgh, just five of the 38 countries with stock markets in 1900 have moved from emerging to developed market status as of now. Of the rest, 17 were and are developed, 14 were and are classified as middle-income emerging.
In sum, in fact, those with developed markets in 1900 still dominate the equity landscape, comprising 84% of the MSCI All World Index.