Emerging Market currencies: Hopes and Realities
Media coverage of Emerging Market currencies tends to oscillate between the very bearish and very bullish, with little differentiation between low and high-yielding currencies or between regional blocks let alone between the dozens of currencies still referred to, rightly or wrongly, as “emerging”. Price action in 2019 only partially vindicates this approach.
News articles about the November EM currency rally and the long list of factors supporting further outperformance next year have been rife.
EM currencies, particularly high-yielders, materially outperformed in the fortnight following the US elections thanks in part to a pick-up in portfolio inflows. The prevailing view was/is that a less conflictual Biden presidency will be a net positive for global trade and commodity prices. EM currencies appreciated further following news on 23rd November that the more affordable Astra Zeneca vaccine was up to 90% effective and Trump’s announcement that he would allow the transition of power to President-elect Biden.
However, in the past two weeks a GDP-weighted basket of EM currencies (excluding the Chinese Renminbi) has appreciated only 0.9% versus the Dollar and underperformed a basket of developed market currencies (+1.3%). Moreover, high yielding EM currencies (+1.1%) have only marginally outperformed low-yielding EM currencies (+0.7%).
Domestic and regional factors over-and-above “global risk appetite” have arguably contributed to the outperformance of Central European and Latam currencies and the more mixed (read subdued) performance of high-yielding EM and Asian currencies. One explanation is that some of these EM currencies are already pricing in a lot of “good” news.
The consensus forecast is seemingly that EM currencies will outperform both the Dollar and developed market currencies going forward. The long list of supporting factors includes i) cheap EM valuations, ii) EM currencies’ yield advantage, iii) the benefits to EM of further Dollar depreciation and iv) a rebound in global economic growth.
We sympathise with this view, albeit with some important caveats. One is that more interventionist Asian central banks may stop their currencies from fully joining any EM currency party in 2021. Moreover, we would split the next 13 months into three timelines.
Media’s often polarised coverage of Emerging Market currencies
Media coverage of Emerging Market (EM) currencies, and equities for that matter, tends to oscillate between the very bearish and very bullish. Larger multi-months swings and roundabouts in EM currencies than in developed market currencies have historically contributed to this polarised approach. This was certainly the case in 2019 with five of the six best and worst performing major currencies belonging to the EM universe, the exception being the Swedish Krone which weakened about 5.8% (see Figure 1).
Moreover, the media tends to view EM currencies as one homogenous block, with little differentiation between low and high-yielding currencies or between regional blocks let alone between the dozens of currencies which are still commonly referred to, rightly or wrongly, as “emerging”. There is a case to be made, as we did in “Emerging Markets falling between the cracks (and BRICS)” (5th March 2015) that the distinction between developed, emerging, in transition and frontier economies has in the past 10-15 years become somewhat more blurred and arguably misleading (for example it is not obvious to us why the economies of the Czech Republic, South Korea, Singapore and Taiwan are still regarded as emerging).
Nevertheless, EM currencies’ performance last year was not always as extreme as reported. For example a Bloomberg article published on 30th August 2019 pointed out that EM currencies had suffered their worst month of August in 22 years, However, it failed to mention that low-yielding EM currencies had only marginally underperformed developed market currencies and that a number of Emerging Asian currencies had either appreciated slightly versus the Dollar (THB) or weakened by only 1% or less (TWD, SGD, IDR).
This at times sensationalist journalistic tendency to view EM currencies in simplistic black-and-white terms has again been in evidence this year. Back in March-April, arguably the peak in global risk aversion, the media was squarely focussed on EM currencies’ underperformance while in recent weeks articles about the EM currency rally and the long list of factors supporting further outperformance have proliferated.
EM currency bullishness glossing over recent performance and regional divergences
EM currencies, particularly high-yielders (TRY, BRL, COP, ZAR, RUB and MXN) materially outperformed in the fortnight following the US presidential and Congressional elections on 3rd November (see Figures 2-4), thanks in part to a pick-up in portfolio (or “real money”) inflows. Data published last week by the International Institute of Finance point to Q4 2020 likely being the strongest quarter for non-resident equity and bond inflows into EM economies since Q1 2013, i.e. since just before the “taper tantrum”.
The prevailing view was (and arguably still is) that a Biden presidency will oversee a less conflictual relationship between the US and its key trading partners (including China, Mexico and Canada), a net positive for global trade and commodity prices. Moreover, even a gradual thawing of relations between the US and China (and a cooling of the trade-war) would be a positive for economies with close trading links with China. EM currencies appreciated further following news on 23rd November that the more affordable Astra Zeneca/Oxford University vaccine was up to 90% effective and President Trump’s announcement that he would allow the transition of power to President-elect Biden to start.
EM equity funds, which recorded almost uninterrupted outflows from March to September, have attracted almost $14bn in the past two weeks, according to data provider EPFR. A Financial Times article dated 25th November concluded that “Emerging market currencies and stocks have been big winners, rallying hard for the past two weeks“.
However, Figures 2 and 3 show that in the past two weeks a GDP-weighted basket of EM currencies (excluding the Chinese Renminbi) has appreciated only 0.9% versus the US Dollar and underperformed a basket of developed market currencies (+1.3%). Two developed market currencies – NOK and NZD – occupy the top five spots (see Figure 4). Moreover, a GDP-weighted basket of high yielding EM currencies (+1.1%) has only marginally outperformed a GDP-weighted basket of low-yielding EM currencies (+0.7%), according to our calculations.
Domestic and regional factors over-and-above “global risk appetite” have arguably been an important determinant of relative performance. Central European currencies (CZK, HUF, and PLN) and Latin American currencies (COP and BRL) have made decent gains versus the Dollar in the past fortnight, and particularly in the past 72 hours (see Figures 2-4). However, other high-yielding EM currencies have either appreciated only incrementally (RUB, ZAR) or depreciated (TRY, IDR) while emerging Asian currencies have on the whole treaded water.
One plausible explanation is that some of these EM currencies are already pricing in a lot of “good” news and have lost of some of their elasticity to further “good” news in recent weeks. This includes the extremely high (and still rising) odds that Joe Biden has secured the US presidency, with most key swing states having already certified their vote counts in favour of the Democratic candidate.
Taking a step back and looking at currencies’ performance so far in 2020 (with just under a month till year-end), EM currencies still occupy the bottom ten places while four developed European market currencies – SEK, EUR, DKK (which is pegged to the Euro) and CHF occupy the top four spots (see Figure 5). The question now of course is whether the stars will align for EM currencies and whether they i) extend their November-gains versus the Dollar AND ii) outperform developed market currencies.
Long list of factors supporting further EM appreciation…and long list of caveats
The consensus forecast, at least based on recent Financial Times and Bloomberg articles, is that they likely will. The list of factors put forward in favour of EM currencies outperforming both the US Dollar and other developed market currencies is long and varied but so are the caveats in our view, as detailed below.
1. Cheap EM valuations
EM currencies are still down versus the Dollar year-to-date, including all high-yielders (only the Indonesian Rupiah and Indian Rupee are down by less than 3%), or have recorded only marginal gains (see Figure 5).
Caveat: The Brazilian Real, Colombian Peso and Turkish Lira have appreciated 9.6%, 7.1% and 6.9%, respectively, versus the US Dollar since 3rd November (see Figure 4), with the USD/COP and USD/BRL crosses currently at their lowest levels since respectively early March and late July.
2. EM currencies’ yield advantage
The argument is that in a “risk-on” world the relative returns offered by high-yielding EM currencies will outweigh the risks. Indeed most developed market central banks have cut their policy rates to record-lows near or below zero (see Figure 6).
Caveat: The yield spread between EM and developed-market currencies has narrowed this year partly as a result of EM central banks cutting their policy rates even more aggressively. Figure 6 shows that year-to-date the gap between a GDP-weighted basket of EM central bank policy rates and a GDP-weighted basket of developed market central bank policy rates has narrowed by a further 13bp to just 369 basis points – only 13bp away from the 12-year low recorded in August (the recent up-tick in the EM central bank policy rate has been solely due to the Central Bank of Turkey’s 625bp of policy rate hikes since August).
3. Further US Dollar weakness
The consensus forecast is seemingly that the Dollar will continue to weaken medium-term. The twin premise is that US fiscal policy under a Biden Presidency will be i) loose enough to push US and global equities higher, which historically have correlated with a weaker US Dollar (see Figure 7), but ii) not loose enough for the Federal Reserve to even contemplate tightening monetary policy any time soon so that low US interest rates (and government bond yields) will continue to weigh on the Dollar. There is indeed a risk that if the Democratic Party loses the run-offs for the two vacant Georgia seats in the Senate on 5th January and thus fails to regain a majority in the upper house of Congress, the scope for President-elect Biden to implement a large second fiscal stimulus package will be curtailed by a Republican majority in the Senate.
Caveat: Should the electoral college formally vote through Biden as President on 14th December (increasingly the consensus forecast) and the Democratic Party secure 50 seats in the Senate (and thus a majority as Vice-President elect Kamala Harris would have the casting vote) the odds of a large fiscal package being green-lighted in early 2021 would rise materially, in our view. We think this would in turn likely give the US economy (and equities) a leg-up but may also result in the Federal Reserve at least talking up the odds of a policy rate hike in the second half of 2021. This policy mix would arguably be less damaging to the US Dollar.
4. Virtuous cycle of weaker US Dollar positive for EM
The argument is that a weaker US Dollar lowers the local-currency cost of large USD-denominated debt repayments for EM households, corporates and governments, which in turn drives greater consumption, spending and investment – a positive for open economies reliant on fast economic growth and thus for EM assets, including currencies.
Caveat: A weaker US Dollar presents an extra challenge for EM economies for which the US is a major trading partner (e.g. Mexico, Colombia) and EM external trade balances to the extent that a weaker US Dollar could weigh on US imports of goods and services which are still well below their pre-pandemic levels (see Figure 8). Put differently an improvement in EM income balances (as a result of lower external debt repayments) could be partly or fully negated by a deterioration in EM trade balances (due to a loss of competitiveness/demand), with EM current account balances providing little or no extra drive to EM currencies. Moreover, while some economies, in particular China, have increased their share of global trade in recent months, not all EM economies have been or will be as successful in our view.
5. Rebound in global economic growth.
Progress on multiple vaccines in the past three weeks, including from Pfizer/BioNTech and Moderna, has driven expectations that mass inoculation against Covid-19 – at least of the elderly, most vulnerable and front-line health workers – could become a reality in coming months. The cheaper Astra Zeneca/Oxford University vaccine has also raised hopes for poorer EM countries. Mass immunization would in time enable governments to lift or at least materially loosen national lockdown and social distancing measures which would in turn facilitate a sustained pick-up in pent-up domestic and global economic growth. The argument that strong global GDP growth (and trade) tends to favour EM economies and currencies is well documented and generally backed by empirical data.
Caveat: Doubts have been raised in recent days about the sample size of the trial data for the more affordable Astra Zeneca/Oxford University vaccine. At the same time poorer EM economies are less well positioned than richer developed economies in terms of their advance-orders of vaccines. Finally, as we argued in Time is priceless but has a steep cost (25th November 2020) there is still a number of critical health questions to be answered and logistical challenges to overcome including:
i) These vaccines’ efficacy in eradicating transmission of Covid-19;
ii) The length of immunity conveyed;
iii) Potential (cumulative) long-term side effects,
iv) The ability of pharmaceutical companies to mass-produce these vaccines in a short-space of time;
v) The ability of governments to distribute these vaccines (some, such as the Pfizer/BioNTech vaccine, have difficult handling properties) to health-care providers (including hospitals, doctors’ surgeries, pharmacies, health centres or care homes); and
vi) The ability and willingness of populations to get themselves inoculated.
Governments have seemingly taken the view that most if (if not all) related health questions will be answered and logistical challenges overcome…but that this will require more time. As a result governments in most major economies, including in Asia-Pacific and Europe, have stated that they will likely keep their economies in some form of lockdown throughout most of December. There is little doubt, in our view, that the financial, economic and social cost of current lockdowns will be very high in absolute terms and weigh further on global growth which has slowed sharply since this summer.
Asian central banks’ interventionist policies likely to cap currency gains (and losses)
We would add a further caveat for Emerging Asian currencies, namely the ability and willingness of Asian central banks to use interest rate policy and intervention in the FX market to manage their currencies, whether to curb daily volatility and/or guide them over the medium-term. The rather tepid performance of Asian currencies versus the US Dollar year-to-date (see Figure 5), including in the past month (see Figures 2-4), as well as still muted realized volatility (see Figure 9) points to Asian central bank intervention in FX markets, in our view.
We see little reason to expect Asian central banks to deviate from this modus operandi in the next twelve months. Whether they allow or engineer their currencies to appreciate in trade-weighted terms (in order for example to deal with inflationary and/or external-debt repayment pressures) or to weaken (in a bid to improve export competitiveness) will of course boil down to individual central banks (and governments). However, based on precedent, we would expect Asian central banks on the whole to continue fading any large and/or sustained currency moves and at the margin to prioritise high economic growth over low consumer price inflation. As a result, few Asian currencies may fully join any EM currency party in 2021.
Our summary outlook for December and beyond – a game of three halves
Thirteen months is a long timeframe to forecast and we may well have to revise our outlook for EM currencies throughout 2021. Moreover, currencies (or equities) rarely move in nice straight lines for extended periods of time, with trend appreciation (or depreciation) likely to be punctuated by pull-backs (or relief rallies).
Nevertheless, our core scenario at this stage – which we will elaborate on in forthcoming Fixed Income Research and Macro Strategy (FIRMS) reports – can be crudely broken into three timelines: 1) the next couple of months, 2) February till mid-year and 3) the second half of 2021.
We expect global risk appetite to remain reasonably buoyant in coming months thanks to the not-so-distant prospect of one or multiple vaccines coming on line and the very high likelihood of Joe Biden fully assuming the US presidency on 20th January. However, national lockdowns will likely continue to weigh on already very weak global GDP growth while the odds of the US approving a second fiscal stimulus package in the next 4-6 weeks remain low in our view. Moreover, we think that delays to mass Covid-19 vaccination will puncture governments’ ambitious expectations (and promises) and that poorer, populous EM economies will lag richer nations in terms of distributing the vaccine to a significant share of their populations.
If this proves correct we would expect the Dollar to continue depreciating versus both developed and EM currency blocks but at a still very slow pace, with EM currencies prone to sharp sell-offs (even if short-lived). Asia-Pacific economies are likely to benefit from rapid Chinese economic growth and its robust imports but Asian central banks are unlikely to allow rapid currency appreciation given the still very uncertain global outlook.
Beyond February we think there is greater scope for more rapid Dollar depreciation and EM currency outperformance although this scenario is likely to be coloured by the timing and modalities of a second US fiscal package and the magnitude of a recovery in global growth.
We expect the US Dollar’s decline to slow or even reverse somewhat in the second half of 2021 on the premise that the Federal Reserve may want to get ahead of the inflationary curve and start at least signalling the possibility of moderately tighter US monetary policy. Moreover, by then a number of EM currencies are likely to have lost the lustre of cheap valuations.
 While a GDP-weighted basket of high-yielding emerging EM currencies (BRL, COP, IDR, INR, MXN, RUB, TRY and ZAR) weakened 4.7% versus the Dollar in August 2019, according to our calculations, a GDP-weighted basket of low-yielding EM currencies (CLP, CZK, HUF, ILS, KRW, MYR, PHP, PLN, RON, SGD, THB and TWD) weakened only 1.4%. This performance was comparable to that of a GDP-weighted basket of developed market currencies (AUD, CAD, CHF, DKK, EUR, GBP, JPY, NOK, NZD and SEK) which weakened 0.1% versus the Dollar.
 Asian currencies outperformed despite a backdrop of central bank rate cuts and an ongoing US-China trade war, suggesting that central banks may have been intervening in the FX market to stabilise their currencies or at least fade their downside.