EMERGING MARKETS

Currency worries may be misplaced

The sudden depreciation of the rouble at the end of 2014 was a startling reminder for emerging market investors of the late 1990s crisis. A 9% one-day fall in Russia’s currency in late November represented its biggest slide since 1998. The rouble decline comes after two straight years of falling emerging market currencies. Falls of 8% in both 2013 and 2014 were mainly attributable to the Federal Reserve first signalling its intention to taper its asset purchases and then hinting at a rise in its primary funding rate. Worries have also been raised among investors of slowing emerging market growth and structural problems within key emerging market economies. The result has been a wave of negative sentiment.

Reassessing the risks

So does the current negative sentiment and decline in emerging currencies presage a secular reversal of the long-term appreciation trend?

Certainly there are volatility and risks for emerging currencies ahead in 2015. But some of these risks may have been misconstrued or miscalculated.

The most watched and analysed risk for 2015 is the Fed and its future course of action. A hike in rates is widely expected in 2015 and markets believe it will have a negative impact on emerging market currencies. However, a lot of this is already priced into EM currency prices.

As can be seen on chart below, while most emerging market currencies were overvalued in May 2013 (compared with historical averages), by the end of October 2014 more than half were undervalued. This is at least partly due to anticipation of the ending of the Fed’s asset purchases and expectations of rate hikes.

However, it is worth bearing in mind that in the last Fed rate-rising cycle in 2004-06, emerging currencies in fact rose versus the dollar. So there is not a clear negative correlation between Fed hikes and emerging currencies. If the Fed increases rates because the US economy has sufficient growth momentum to withstand a rate hike, emerging markets could in fact benefit from this positive growth momentum.

While the Fed is capable of raising too early (see article on Monetary Policy Divergence), it is more likely that it will not raise rates until it believes a virtuous cycle of growth exists. At the same time, the ECB and the BoJ will maintain a very accommodative stance throughout 2015, which keeps emerging carry attractive⁽¹⁾.

More misconceptions

Another keenly-watched risk is the price of commodities. Again, the headline news is currently negative. The slide in the price of crude oil to less than $70/barrel at end November 2014 from more than $100/barrel in July 2014, is widely seen as harmful to emerging economies.

This is only partially true. While nine emerging markets, including Russia, Colombia and Venezuela, are net commodity exporters, some 17, including China, Indonesia, India and South Korea, are net importers. And for the commodity importers, input prices have dropped, making their manufacturing more competitive.

The third source of risk stems from generalised concerns about slowing economic growth across the emerging market spectrum. Yes, growth is no longer in the high single digits, but IMF predictions of 4%-4.5% growth to end 2016 are still healthy given stagnation in most developed economies.

Sources : Bloomberg, Bank of International Settlements (left), JP Morgan Research (right)

Reform momentum

Less prominent in the media and in analyst reports is commentary about the positive reforms in many emerging markets. The so-called Fragile Five is now a misnomer given the different trajectories of each market. Indonesia and India have undergone considerable positive change in the last year, raising central bank rates to push real rates higher, reducing their current account deficits and taking measures to keep inflation under control. Meanwhile, South Africa has stabilised. Only Brazil and Turkey have continued to decline in terms of their fundamentals. But low oil prices in 2015 could help them to fight inflation and reduce their current account deficits.

Furthermore, across emerging markets as a whole, debt is less than 40% of GDP, roughly the same level as in 2007, just before the financial crisis.

By contrast, developed market countries have a GDPdebt ratio of nearly 110%. This compares to a little over 70% before the financial crisis. Following the Asian crises of the late 1990s and the crisis in the European periphery in the early part of this decade, a clear capacity to repay sovereign debt provides comfort to investors.

Investment opportunities

Overall, there is now considerable dispersion across the emerging market risk spectrum. General emerging currency exposure is probably inadequate: emerging market exposure is still desirable but should be selective, as the map indicates.

EM CURRENCY WINNERS AND LOSERS

Among the BRIC countries, India is our preferred currency, with high carry, rising real rates, positive reforms momentum, a shrinking current account deficit and positive effects from low oil prices. The Chinese yuan does not have high appreciation potential, given expected further monetary easing by the PBoC and growth of around 7%. However, the Chinese reminbi could be seen as a good stabiliser in an emerging portfolio, as currency volatility is less than for other emerging currencies. The Brazilian and Russian currencies have weak growth prospects and deteriorating fundamentals, i.e., deteriorating fiscal results and low reform momentum in Brazil, political risks, a bad business climate, corruption and bureaucracy in Russia. Mexico is still a productive currency to have in an emerging portfolio; it could suffer from a global negative sentiment (as it is used by some investors as a liquid EM FX proxy), but Mexican fundamentals remain good with a low current account deficit, positive growth prospects (US-linked) and productivity-enhancing reforms in telecoms, energy and education.