EM currency rally: hold on tight
The monetary policy/risk on-off dynamic holds the key as to whether EM currencies can continue their storming start to 2012
FX predictions for 2012: volatility could go up or down, EM currencies might appreciate or depreciate and EM FX markets will be affected by whats happening globally.
If that sounds comically unhelpful join the club. In short, after the intellectual and psychological torment of failing to predict the twists and turns of EM local markets last year, few investors and analysts are confident they can predict the markets fortunes this year.
First, though: the good news.Following sharp losses during the second half of 2011, EM currencies have had a storming start to 2012.
The MSCI Emerging Market Currency Index is up 3.6% since the beginning of the year, recouping almost half of the losses seen during the second half of 2011, when the index fell 7.4%.
This FX rally has been driven by a sharp rebound in capital flows to EM flows into Emerging Markets Equity Funds hit a 42-week high during the week ending January 25, according to EPFR data, while flows into EM bond funds hit a 24-week high.
As Nick Chamie of RBC Capital Markets highlighted in a research report yesterday afternoon, there has been a very strong correlation between capital flows and EM currencies over the past year the chart below shows EM bond fund flows mapped against the performance of five fully convertible EM currencies (BRL, MXN, TRY,ZAR, KRW).
In other words, foreign investor flows will greatly influence FX performance unless domestic marginal buyers be they pension funds or central banks take up the slack.
The catalyst? More positive than expected US and Chinese data and the belief that an immediate eurozone implosion can be avoided, coupled with liquidity-driven trades, triggered by the ECBs generous liquidity tap for banks in December and again in February. Whats more, with the Federal Reserve signalling last week that it will keep policy rates on hold until late 2014, and with expectations rising that DM policymakers will sanction further quantitative easing and/or liquidity measures in the coming months, the potential for further support for EM capital inflows and currency appreciation appears clear.
At the same time, of course, EM currency performance will be beholden to top-down macro calls the eurozone crisis and the outlook for the greenback. Tomes have been penned on both prospects, which we are reluctant to dive into now. Lets work on the following baseline scenario as priced in by markets via the January rally as Nomura analysts put it in a January 26th report:
|The impact on FX trends should partly depend on FX policies (determined by the relative focus on inflation vs growth) by EM policymakers. As such, EM FX trends may be driven more by idiosyncratic forces at the country level than by global liquidity trends.
The year is still young, and it is too early to say for sure how these trends will play out. The situation in Europe still has potential to derail the current more constructive patterns. But at this point, the above trends are the ones we are observing, and our portfolio is positioned to take advantage of them extending further.
Whats more, those betting on a muddle-through scenario have fundamentals on their side. As HSBC Asset Management explains in a report released today:
|Many emerging markets currency valuations look cheap on such real purchasing power measures and also have attractive interest rate differentials relative to the developed world, where yields are likely to remain very low. The currencies that potentially stand out to us include those of China, Indonesia, Korea, Malaysia, Singapore, Mexico and Chile.|
Here's the accompanying table:
In this scenario, then, the EM FX outlook is primarily subject to policy risks, rather than valuation/exogenous facts. On the former, context is instructive: 2010 and early 2011 saw a raft of currency interventions by policymakers across EM in a bid to prevent further sharp appreciation and to maintain export competitiveness in the face of sustained capital inflows fuelled by ultra-loose policy in Europe and the US. Should inflows and appreciation continue, especially against the backdrop of slowing growth, could we see another round of currency interventions and competitive devaluations across EMs?
How this policy/risk appetite dynamic plays out will be key to reading EM FX performance this year.
On the policy front, some analysts detect a greater tolerance for moderate currency appreciation among EM policymakers.
According to BarCap analysts Olivier Desbarres and Nick Verdi, many EM policymakers this time may in fact welcome currency appreciation given mounting concerns over growth on the one hand, coupled with still sticky inflation. FX appreciation would create additional space for monetary easing.
As they wrote in a recent research note:
|We expect few central banks to aggressively fade let alone reverse their currencies recent outperformance. We think policy-makers will re-focus this year on still sticky inflation and allow some disinflationary FX appreciation.|
|We think Central European and Turkish policy-makers welcome currency appreciation as it reduces households and corporates sizeable external debt-servicing costs and gives central banks greater room to cut policy rates.
[However], should risk appetite sour, we still see Central European currencies as the weakest link given their close ties with the eurozone.
|We do not think non-Japan Asia (NJA) central banks will try to reverse the 2% NEER appreciation in their currencies year to date. Instead, our core scenario is that they will allow modest balance of payment surpluses to translate into modest currency appreciation and let FX play a mild disinflationary role this year.|
They note that intervention risks are particularly elevated in Brazil and Chile, given that the USD/BRL is only 3.5% below the 1.70 level that prompted the BCB to begin its intervention programme last time around, while the USD/CLP is only 0.7% away from the 465 level that prompted the Chilean central bank to launch its intervention programme last year.
Meanwhile, while policy intervention risks are perhaps highest in LatAm, the region is likely to bear the most direct impact of further policy easing in the US in particular. Consequently, most analysts expect the Brazilian real and Mexican peso to appreciate this year, while also anticipating strong gains for the South African rand, an open currency that is considered by many to be significantly undervalued.
GROWTH TO THE FORE
But other analysts disagree that EM central banks will tolerate currency strength at the perceived cost of growth, since the crisis has shown that higher inflation might be a price worth paying. As David Lubin, chief emerging markets economist at Citigroup, told Emerging Markets:
|The post-Lehman world made central bankers very sensitive to things that affect growth rather than things that affect inflation. Conversely, during the risk-on period and subsequent currency appreciation pressures, a number of EM central banks were worried that excessive EM FX would do unacceptable damage to real economic activity, and policy measures to redress this were enacted. In short, the purity of inflation targeting was replaced with a less pure concern with the level of exchange rates, rather than the level of the inflation target. Whats more, emerging markets central bank obsession with exchange rates has been sustained since September, when many EM central banks threw dollars [into their financial systems].
And now, as central banks see their currencies starting to strengthen again, you can see easing is now [in vogue] with the Israeli rate cut clearly orientated to weakening shekel while Hungary decided that a rate hike would cause the forint to strengthen to unacceptable levels.
While analysts are sharply divided on central banks tolerance for currency appreciation, its also not clear how rate cuts will affect currency performance.
In G10 economies, there is, roughly speaking, a mechanistic relationship between interest-rate differentials and spot FX if rates are lowered, currencies weaken. However, in EM, its a bit more complicated. Rate cuts if conducted in a risk-on environment often tend to boost exchange rates, since foreign capital subsequently chases equities, with equity inflows more than compensating for any declines in bond flows. Since, generally-speaking, equity markets are larger in EM than debt markets, this dynamic probably makes sense.
IN THE FIRING LINE
Even if investors make the right monetary policy and currency call, lets get back to the monster in the closet for EM FX: risk appetite. Here, CEE will no doubt be in the firing line.
Heres Desbarres and Verdis take on the outlook for EM FX in a risk-off scenario:
|Should risk appetite sour, we still see Central European currencies as the weakest link given their close ties with the eurozone.
[Non-Japan Asia] central banks would likely allow modest currency weakening should renewed concerns about global growth weigh on FX inflows into Asia, but they have the tools and the willingness to support their currencies. The INR remains the most vulnerable, in our view, given Indias high twin deficits and still-high inflation and interest rates.
For those investors with the luxury of a long-term investment horizon: the message appears to be play on fundamentals, not positioning based off projected swings in risk appetite, given the immense policy and growth uncertainty.
Desbarres and Verdis colleagues, Koon Chow, Guillermo Felices, have mapped actual FX performance against the results of a Reuters poll in early December, prior to the recent market rally. The results show that the currencies flagged by market participants in the early December survey as likely to be the best/worst performers in 2012 have generally fared the best/worst since then.
Here's their chart mapping the results:
Chow and Felices take this to indicate that while almost all EM currencies have benefitted from the sharp upturn in risk appetite so far this year, those with the strongest fundamental drivers, rather than typical high-beta currencies or those with the highest carries, have outperformed:
|The improvement in risk appetite appears to have been used as a cue to put on longs and shorts with some discrimination. We are not denying that a high enough tide can lift all boats we have been, and are still, worried about a number of European currencies, which have also done well against the dollar. But it is gratifying to see that other currencies have outperformed and that short covering has not been the only driver of FX swings in the year-to-date. In our FX forecasts, the Asian currencies have the greatest room to rally, while the reverse is true for Central European currencies.
Thus, despite the recent rise in risky assets, some discrimination has been exercised, which suggests to us that modest pullbacks in risk appetite can be shrugged off as investors lare long the currencies where they forecast the strongest spot appreciation. The discrimination also probably means that relative value trades (based on fundamentals rather than positioning per se) can still work.
BETTING THE FARM
For fixed-income investors, rather than just pure-play currency managers, the stakes are high, as well. Debt investors are betting the farm on local currency performance, which recently has been the largest single driver of the asset classs performance, more so than sovereign default risk, balance of payment flows, or risk appetite. Last year, for example, emerging market debt's allure as a diversification trade against Western debt burdens took a knock, given the abrupt strengthening of the greenback. By September, local currency sovereign bonds delivered negative annualized returns as currency weakness, in trade-weighted terms, offset returns from coupon payments and capital appreciation of the asset class.
Much to mull over.