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.”
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.”
The other challenge for EM FX will come in the second half of the year if the oil price starts to recover, as some analysts are predicting. This would send the current balance of power within the EM space into reverse, chiselling away the advantage enjoyed by the majority of oil importers, for that 20% minority of producers.
The most obvious of these remains Russia – for now sovereign non grata. Expectations for the rouble price anywhere between around 60 against the dollar – for those that anticipate a gradual recovery of the oil price for a 2015 average of around $60 – to above 80 at the more pessimistic end of the spectrum.
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Similarly, the low oil price is creating a lot of pressure on some African currencies, particularly the Nigerian naira, and on South Africa due to the deterioration in commodities, oil and gold, says LNG’s Gargour.
However, while the naira did see declines towards the end of last year, others suggest the moves have been relatively moderate, considering oil’s importance to the economy.
Svedberg says: “The market expects more. But it has elections coming up, so we may not see any further moves until after that. It is the same with Kazakhstan, which usually trades in line with the rouble. It is hard to understand why it has not seen greater falls.”
Inevitably, market confidence has taken a knock. The chastening experiences that rouble – and Swiss franc – investors have endured in recent months is defining the mood of EM currency markets, says Gargour.
“In some EMs we are seeing P&L driven more by the potential for capitulation and the abandonment of managed FX bands, and a rethink of monetary policy than by a rational response to fundamentals,” he says.
Record’s Wood-Collins remains bullish. “We see a diminishing risk in EM contagion,” he says. “Investors are getting much better at distinguishing between currencies, as we can see from the lack of contagion in EM FX from the rouble.”
If that observation stands the test of time, and EM currencies as a whole are able to withstand further shocks from the Russian financial system or the eventual US rate hike, the case for the EM FX asset class could strengthen in the medium-term.
It could embolden more cautious and longer-term buy-and-hold investors to the currency markets, which have traditionally been the preserve of more tactical and specialist traders.
“That is common in other asset classes, but it isn’t something you generally see in FX,” says Wood-Collins. “The major currencies move against each other in cycles, but generally they go up and down.
“But in EM FX you should see a steady appreciation over time for currencies as long as there is GDP convergence, a credible monetary policy that responds to inflation expectations and sufficient liquidity.”
Record, echoing the strategic allocation pitch of real-money EM investors, identifies a group of convergence markets, where GDP per capita is growing faster than those of developed markets, which should mean over a longer time horizon they steadily appreciate against developed market currencies.
The strategy is designed for longer-term buy-and-hold investors, offering a diversified exposure to EMs that should pay out over time through nominal rate appreciation and the higher interest rates paid by EM currencies.
These are funded by a diversified basket of shorts on G10 currencies, hedging out some of the volatility associated with EM FX.