John Maynard Keyes made and lost a small fortune investing in European currencies in the inter-war years. Several emerging markets, most recently Argentina, have committed the “original sin” of borrowing in foreign currencies when they were weak and then defaulting when they strengthened. Recently, investors became enamoured with hedging strategies as both Europe and Japan proactively devalued and the US dollar soared. So what’s next?
Several ingredients combine to form the cyclical nature of currencies. In our view, growth is first among these. Historical data show that when a country’s growth rate increases relative to the rest of the world, this attracts long term capital in search of productive investment opportunities, which strengthens a country’s external position and, all else equal, contributes to its foreign currency reserves. In this scenario, a country’s interest rates are likely to rise, as growth stokes inflation or the central bank adopts a more hawkish stance. Higher interest rates reinforce the relative attractiveness of the country for foreigners and bond investors may enter the market in search of carry.
Secondary factors affecting currencies include technical considerations such as terms of trade; volatility; and investor positioning. Although these factors in our experience are contemporaneous rather than leading indicators, there can be autocorrelation or a tendency for momentum in the data, except when at extremes.
We believe currency markets now stand at just such an extreme. The US dollar rally that began in 2011 has increased its trade-weighted valuation by as much as 30% according to some estimates. Emerging market currencies, in turn, have devalued nominally by more than 40% from their 2011 peak and real effective exchange rates for a basket of EM now stand approximately 10% cheap to the long term average.
Growth also favours EM. Green shoots appeared in EM data late last summer and have now sprouted into full grown expansion for many countries. Industrial output is now positive in all EM regions and “hard data” covering exports and consumption mark robust recovery across EM. The conditions that led to US dollar appreciation from 2011-2016 have now abated: the US is no longer accelerating relative to EM; volatility in currencies has subsided; and terms of trade, which for most EMs means commodities prices, have pulled out of their slump.
Having called the bottom on EM currencies, we have been decidedly long in our FX exposures for most of the last six months. We recently pared this back due to the strong moves in currency markets following the last Federal Open Market Committee (FOMC) meeting but plan to re-enter positions on the next correction in valuations. We recommend investors similarly enter dedicated exposures as opportunities present themselves over coming months.
Currencies will always be a bumpy ride, but we can now say with conviction the cycle is on EM’s side.Download to read more