EM equities and FX risk

When we looked yesterday at the way emerging markets and developed markets have moved in lockstep over the last few years, the correlations were based on the main MSCI regional indices.

The standard versions of these are USD-denominated, which raises another question: Does it make any difference if we look at the situation in local currency terms? Or put another way, if investors in EM equities hedge their FX exposure, do they end up with an asset class that has a rather different relationship to DM equities?

The table below shows the correlations between the USD version and the local currency version for the MSCI Emerging Markets benchmark and the same three regional indices we looked at last time: MSCI Asia ex Japan, MSCI EM Europe and Middle East and MSCI Latin America. Again, these are monthly returns over the last 10 years, based on Bloomberg data.

The conclusion is pretty clear-cut – moves in the local and USD versions of the EM indices are even more closely correlated to each other than the EM indices are to the MSCI USA. If EM currencies are rising, stocks are rising too for the vast majority of the time, while falling currencies usually means falling markets.

Given the way that foreign flows impact short-term movements in both equities and currencies, that’s not terribly surprising. What’s perhaps a bit more interesting is that these correlations have generally not risen much over the past decade (in contrast, we saw before that the correlation between EM equity performance and the MSCI USA has risen).

As the charts below show, the only region for which there has been any really noticeable move in the correlation between the USD and LC version of the equity benchmark is Latin America. Even here, the change is merely from 0.887 to 0.944 - ie from very strong to even stronger.

MSCI Asia ex Japan – USD vs LC

MSCI Emerging Markets – USD vs LC

MSCI EM Europe and Middle East – USD vs LC

MSCI Latin America – USD vs LC

So even FX-hedged EM equities haven’t offered significant diversification from developed market equities recently. What’s more, the strength of this relationship raises the question of whether FX hedging when investing in EM equities is likely to be a useful strategy.

On a long-term view, an investor allocates to emerging markets because they believe they will outperform developed markets despite the greater risks. And history suggests that positive EM equity returns will normally be accompanied by currency appreciation. The charts below show the relative performance of the USD and local currency version of each benchmark over the last 10 years (USD is white, LC is orange).

MSCI Asia ex Japan

MSCI Emerging Markets

MSCI EM Europe and Middle East

MSCI Latin America

In each case, the index has performed better in USD terms than local terms over this period. So even before allowing for the costs of a hedging strategy, hedging away currency effects would have led to lower performance.

That’s the longer term. What about the shorter term – hedging the FX when markets are likely to fall? Notice on the charts above how the USD version performs substantially worse than the local currency version for all benchmarks as both market performance and currency effects go into reverse.

Hedging would have cut losses here and would have dampened volatility. But even if the hedging was timed and implemented perfectly, there was a more effective solution from the perspective of achieving better absolute returns: simply moving out of EM equities altogether. After all, as we’ve already established, when the currency trend is the wrong direction, the equity trend is likely to be down as well.

Going forward, it’s possible this relationship could change, in which case the question of FX hedging EM equities would become much more important. But based on recent history, taking EM equity risk should go hand-in-hand with taking EM FX risk – splitting the two up does not appear to be a logical strategy for most investors.