Dream and reality emerging

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Contrary to received wisdom, emerging market currencies do not always outperform. EM FX recently needed a carry to keep up with developed market currencies. The same can be said of EM local currency debt, where carry – and not FX spot returns – was the key contributor to total returns of this asset class.

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Demystifying DM and EM FX returns

Although conventional wisdom suggests that emerging market (EM) currencies tend to outperform developed market (DM) currencies, in recent years, the opposite has been the case. As Figure 1 shows, a basket of DM currencies have outperformed a basket of EM currencies since 2007 (measured against USD). The same holds true if measured from March 2009, when risky assets troughed following the credit crunch.

However, we also find that when we account for carry (implied from the interest rates priced into 1-month FX forwards), the returns converge and are broadly the same (Figure 2). This suggests that, in general, EM FX returns have largely been derived from higher interest rates and the subsequent carry, which materially offset spot returns (Figure 3). In the case of DM FX, the opposite holds true: spot has been the main source of returns, while carry has been in the background (Figure 4).

Different EM region, different (sources of) returns

Not all EM currencies performed in this way. The three main regions (LatAm, EMEA and Asia) diverged in both spot and carry returns. As Figure 5 shows, EM Asia has been the best performer in terms of spot returns but, when we account for carry (Figure 6), returns for LatAm currencies increase materially and exceed those of EM Asia. In fact, EM Asia currencies’ carry returns have been so much lower than other EM regions that even EMEA currencies (the worst performer in terms of spot) caught up, in terms of absolute return. Figures 7 and 8 show a decomposition of LatAm and Asian returns.

Figure 1: EM FX lagged DM FX in terms of spot returns

Figure 1: EM FX lagged DM FX in terms of spot returns

Figure 2: Accounting for carry, DM and EM returns converge

Figure 3: EM FX returns decomposition

Figure 4: DM FX returns decomposition

The fact that EM Asia currencies outperformed in terms of spot returns supports our long-held view that EM Asia is the most attractive region structurally (i.e. the currencies appreciate in line with economic fundamentals). Indeed, EM Asia mostly experienced higher growth than the other two regions, while inflation was lower. Our economists expect the same trend to continue going forward. Indeed, a selected EM Asia currency basket has been one of our high-conviction investment ideas for some time.

Theory into practice

The divergences between spot performance of EM and DM currencies (and even intraregional EM FX divergences) suggest that an element of purchasing power parity (PPP) may be at work: high-inflation currencies (EM) underperformed low-inflation currencies (DM) in terms of spot returns. Within EM, Asian currencies (low inflation) outperformed EMEA currencies (high inflation).

The fact that DM and EM currencies total returns have been similar (Figure 2) suggests that, in this area at least, the FX market might be efficient. Although EM currencies offered a high carry, when compared to DM FX, the benefit of this carry was reduced by

Figure 5: Asian currencies delivered highest spot returns

Figure 6: …but lag LatAm FX once we account for carry

Source for both charts: Barclays, Ecowin. DM FX basket: EUR, GBP, JPY, CHF, SEK, NOK, AUD, NZD, CAD EM FX basket: Currencies from LatAm, EMEA & Asia baskets LatAm FX basket: BRL, PEN, CLP, MXN, COP, ARS EMEA FX basket: RON, RUB, ZAR, ILS, TRY, PLN, HUF, CZK Asia FX basket: CNY, THB, MYR, INR, TWD, PHP, KRW, IDR, HKD, SGD

Figure 7: LatAm FX returns heavily skewed to carry…

Figure 8: … while EM Asia FX returns were more balanced

EM Asia currencies outperformed in terms of spot returns supports our long-held view that EM Asia is the most attractive region structurally

the underperformance of EM spot vs. DM spot – and total returns of both were broadly the same. In other words, “interest rate parity” appears to hold here.

However, this does not appear to be the case when assessed from the perspective of the US dollar (the most liquid and the main investment currency). Particularly for EM currencies, this can be seen in Figure 3. Against USD, the attractive carry the EM currencies offer was not wiped out by the respective currencies’ depreciation (as EM currencies remained broadly flat against USD). In other words, from the prospective of the main investment currency (the US dollar), interest rate parity does not appear to hold – providing scope to extract positive returns from carry trades.

EM local currency bonds: more of carry, less of FX spot

The same trend can be seen in the EM local currency government bond space. Here, apart from carry interest and FX spot components, we are also considering the principal component (i.e. whether the underlying bond rises or falls in value). As Figure 9 shows, carry interest (denoted by the black-shaded area) has been the key source of returns for EM bonds, with gains from spot playing a minor role. Indeed, this is in line with our above finding that carry is the key source of returns from EM currencies.

While FX has not had a material impact on total EM bond returns over time, it does materially affect volatility. This is apparent in Figure 10, where we compare hedged and unhedged local EM bond indices. Clearly, the index with a currency exposure shows a higher degree of volatility from the pre-crisis period (2007) to date: 11.7% vs. 2.8%.

Moreover, as the same graph shows, hedging a high-yielding currency exposure is costly and materially affects returns (as indeed our earlier analysis would suggest). The impact of the cost of hedging, over time, is depicted by the difference between the blue and grey lines. While the blue line shows the return on EM bonds in local currencies, the grey line takes into account the cost of hedging. The impact on returns is clearly notable. Hedging costs are high, precisely because of those local interest rates (borrowing the currency to sell it forwards, thereby covering your exchange rate exposure, is expensive).

Although FX is a key source of volatility and may meaningfully weigh on returns, we note that, even during the years when it did restrain returns, the interest component provided a buffer and softened the impact of unfavourable FX movements. Local currency denomination allows us to get exposure to higher domestic interest rates (as, if hedged, the interest rate return decreases materially) but also acts as a potential source of volatility. EM local currency bonds are currently one of our favourite ways to implement our views on the high yield fixed income asset class.

Figure 9: FX is not the key source of returns for EM bonds

Figure 10: …but it adds to volatility

Source for both charts: JP Morgan bond indices, Barclays. For this analysis we use the JPM GBI-EM diversified index, rather than our SAA benchmark (Barclays EM local currency government index) as the index has a longer history and is commonly used by various active EM bond managers.

EM currencies: constructive, but selective approach

Overall, the assumption that EM currencies outperform DM currencies is thus an oversimplification. However, this could change. Among other things, some DM currencies appear to have appreciated beyond levels justified by their long-term fundamentals (such as AUD or CHF, while JPY correction is now fully under way). This should limit the scope for them to appreciate further. In fact, they are likely to weaken against USD and EM currencies over the long term.

In terms of EM currencies, we retain a broadly constructive long-term outlook. Compared to their DM peers, they offer more attractive economic growth prospects, better fundamentals and attractive local investment opportunities. That said, we recognise that some currencies are likely to offer better prospects than others.

From a regional perspective, we continue to prefer EM Asia to Central and Eastern European currencies. This is due to our constructive outlook on the Chinese economy, the ongoing, but gradual, appreciation of the renminbi, and stronger fundamentals of regional economies (for example, current account surpluses, rather than deficits). On the other hand, and although prospects for central and eastern European currencies have improved – as euro area existential concerns have eased and the German economy (their largest export market) has shown signs of re-accelerating – their respective weakness in domestic demand, dovish central banks and our expectation of EUR/USD deprecation makes us less upbeat about these currencies, when measured against USD.

While we remain generally constructive on the long-term prospects of EM currencies (although more for some than for others), investors should not expect big spot returns. As many DM governments have introduced policies that either directly or indirectly weakened their respective currencies, EM governments are unlikely to allow their currencies to appreciate materially either.

That said, there may be some exceptions, such as RUB or MXN, where local authorities have a less activist approach to FX. This, coupled with their reasonable carry and attractive idiosyncratic factors (such as structural reforms in Mexico or bond-market liberalisation for RUB) makes us constructive on these currencies.