With the current market environment appearing to have all the key ingredients for a widespread currency crisis, it may seem as though the long-range forecast for EM is heavy thunderstorms – but Gary Greenberg, Head of Emerging Markets at Hermes Investment Management, thinks the rough weather may pass sooner than many expect.
Since 2011, emerging markets (EM) have been in the midst of a “great unwind” – domestic deleveraging, decelerating demand in China, and the fear of imminent monetary policy tightening by the US Federal Reserve. Add to this lower commodity prices, a strengthening US dollar and the recent renminbi scare, and it is no surprise that we have seen EM currencies yield to rising pressures.
The worst performing currency, the Brazilian real, has lost half of its value during this period with the Russian rouble, South African rand and Turkish lira no better off. Deteriorating sovereign and corporate balance sheets have led to the credit ratings of Russia and, more recently, Brazil, to be downgraded to junk status. More downgrades are expected, precipitating further sell-offs in credit and sovereign debt markets. Unfortunately, fundamentals are weaker today than they were during the taper tantrum of 2013, so in illiquid domestic bond and corporate debt markets where there is high foreign ownership, a stronger dollar or higher US interest rates could put further pressure on currencies as investors scramble to protect their capital.
Given all the bad news, it may seem as though the long-range forecast for EM is heavy thunderstorms, but we think the rough weather may pass sooner than many expect.
Can China live the dream?
We have been disappointed by the pace of economic reform in China recently, and also by the government’s ineffective attempts to manage the liberalisation of both the renminbi and the stock market. The conflict between the incompatible goals of Party control and a market economy has come to a head sooner than most observers imagined.
We believe that Xi Jinping’s “Chinese dream” of creating the world’s leading economic, military, political and cultural power by 2050 will not be achievable under a socialist economic model. Therefore, after the recent false starts and missteps, China will resume the process of reforming state-owned enterprises and slowly continue to progress towards a market-based consumer economy. It will not be easy, and further weakening of the renminbi cannot be entirely ruled out – but China’s current account remains positive at the current exchange rate, so it is unclear what a lower currency would accomplish. In fact, on a trade weighted basis, the renminbi is not meaningfully overvalued.
US normalisation is priced in
In our view, the strength of consensus expectations of a Fed rate hike has exacerbated the great unwind for EM. The continuing debate about the timing, not the certainty, of an increase in US interest rates has ensured that the market has largely priced in the event. Inflows into EM have moderated significantly since the taper tantrum, diminishing the risk of a sudden capital flight in the face of higher interest rates. In fact, for developing countries other than China, the currency sell-off in August was not matched by an acceleration of outflows nor a significant drop in foreign exchange reserves, and their equity markets held up well in local currency terms. EM foreign exchange reserves have retreated to mid-2013 levels, but are still up $3.1tn on a valuation-adjusted basis since 2010, according to UBS. The largest outflows were from China, which controls capital flows, and as expected the September data showed a significant reduction in month-on-month net outflows. We expect these to moderate even further.
As long as higher rates – expected or actual – do not adversely affect sovereign or corporate balance sheets, we believe that EM currencies in countries that adopt market-friendly economic models could cease to be headwinds. At times, these currencies could even become tailwinds for certain nations, sectors, and stocks. For example, broad currency depreciation has helped to offset weaker commodity prices for exporters of natural resources and agricultural produce in Russia and Brazil.
Mitigating currency risk
Passively allocating across emerging markets can increase the risk of currency volatility for investors. It is possible, however, to build a portfolio that mitigates currency risk through skilful active management. EM is not a homogeneous asset class: markets will react differently to changing dynamics, resulting in varying currency risk between countries, and this reasoning should inform investment decisions.
For instance, healthy current accounts and foreign exchange reserves are being maintained by China, Korea, India and Taiwan, which comprise about half of the benchmark. Their currencies are more stable in comparison with those of fragile economies like Turkey and Brazil. Such top-down considerations can help investors construct portfolios that mitigate currency volatility. It is also possible to manage currency risk through bottom-up decisions, such as avoiding index-proxy stocks like Petrobras, PetroChina and Gazprom, which tend to get buffeted by currency and commodity price movements.
The vulnerability of EM to tighter US monetary policy still concerns many investors. However, more than two years on from the taper tantrum, we believe that the market has largely priced in the impact of rising US interest rates. It has not yet shown confidence in the ability of Chinese authorities to liberalise the national economy and stock market in the long term, though may be acclimatising to the idea. In time, the great unwind in EM – domestic deleveraging, decelerating demand in China and the expectation of higher US rates – should dissipate, benefiting selected markets and stocks.