Issue date: 2021-09-30
This belief is underpinned by three main factors: 1) long-term valuations; 2) emerging markets’ economic fundamentals; and 3) a less favourable outlook for the US dollar, owing in part to waning ‘US exceptionalism’.
Long-term valuation picture
Firstly, emerging market currencies appear cheap from a long-term historical perspective. One way to look at this is by considering real effective exchange rates (REERs). These give the real (i.e. inflation-adjusted) value of a currency against other country currencies, weighted by the amount of bilateral trade. The chart below shows the average REERs of the currencies of all emerging market countries in the JP Morgan GBI-EM Global Diversified Index. This shows that the composite REER of emerging market currencies is currently below the 25-year average (red line), suggesting cheapness compared to the past.
Favourable economic fundamentals
On the economic front, the outlook for emerging market currencies is supported by significantly improved external account balances. In 2020, this was largely driven by severe import compression, owing to domestic recessions linked to the pandemic. However, thanks to the strong synchronised global recovery in 2021, emerging market external accounts are now benefiting from surging exports. At the same time, regional economies are now growing strongly, which is reflected in rising per capita incomes. Furthermore, the outlook for some key emerging market currencies is supported by robust commodity prices. More specifically, for such countries, their ‘terms of trade’ are improving, meaning their export prices are rising faster than their import prices.
“…while mounting inflationary concerns are changing monetary policy expectations globally, the trend towards hawkishness is most apparent in emerging markets.”
Another key economic/financial determinant of currency trends is the direction of monetary policy and interest rates. This is important because other things being equal, rising emerging markets’ interest rate differentials over developed countries is typically supportive for their currencies. In this respect, while mounting inflationary concerns are changing monetary policy expectations globally, the trend towards hawkishness is most apparent in emerging markets. For example, Brazil has already raised interest rates three times this year. Furthermore, according to JP Morgan, the proportion of emerging market central banks which are expected to raise interest rates by March 2022 has doubled from 19% in January to 38% recently. However, the equivalent number in developed markets is only 11% and unchanged over the period2.
The case for a weaker dollar and declining US exceptionalism
For all emerging market currencies, the primary benchmark of comparison is always the US dollar, so its outlook also matters greatly. In this regard, US relative economic outperformance among developed market peers has been supportive in past years. A key driver of this ‘US (growth) exceptionalism’ has been the highly dynamic US tech sector. This has been a magnet for global capital inflows, supporting both US equities and the US dollar.
However, with the technology sector’s share of the S&P 500 Index near a record high at 28%, further impetus for ‘US exceptionalism’ may be lower. In turn, this could result in reduced global capital inflows into the US and a weaker US dollar. Indeed, while net foreign private purchases of US equities amounted to a record high USD356 billion in 2020, inflows this year have been much slower, with April actually seeing net foreign selling of US equities3. At the same time, US current and fiscal deficits are unusually elevated at present, amounting to a combined 18% of GDP4.
Key risk factors
While we feel the outlook for emerging market currencies is generally good, there are some important risk factors. On the trade front, while emerging market exports are now rising strongly, so are imports. As such, the bullish case would diminish if import growth began to exceed export growth in a sustained way, as this would weaken external fundamentals. Regarding relative interest rates, a key exogenous risk factor for emerging market currencies is a sustained rise in US Treasury yields – all else equal, this would make emerging markets less attractive for international capital. In terms of the dollar outlook, it is not difficult to imagine scenarios where US economic growth might continue surprising. This would sustain ‘US exceptionalism’ and support capital inflows to the US and the dollar.
A final caveat is the high importance of country-specific risks in emerging markets. There are two relevant aspect to this broader point. First, the more general positive arguments outlined above will necessarily apply in varying degrees to individual countries. Second, in emerging markets, there can be developments, quite often in the political domain, that can easily trump everything else. In our view, this is something that greatly underscores the importance of individual country analysis and effective selection.
We think the outlook for emerging market currencies is supported by historical valuations, economic fundamentals and a likely declining impetus for dollar strength from ‘US exceptionalism’. However, economic fundamentals are subject to change and it is notable that a risk factor for emerging markets is actually exogenous – namely, sustained rises in US Treasury yields. Furthermore, both valuations and economic fundamentals vary significantly between individual emerging markets. Given the potentially dominant impact of country-specific risks, effective selection will therefore be essential for profiting from emerging market currencies.
1 End-March 2020 to end- June 2021
3 Haver, as of June 2021; net foreign private purchases of US equities in 2021 YTD = +USD39.2bn, April 2021 = -USD12.3bn
4 Based on consensus forecasts for the US current account deficit in 2020 and the US fiscal deficit in 2020-21 (Source: Consensus Economics, June 2021)
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