The writer is head of global foreign exchange, interest rates and emerging markets strategy research at Goldman Sachs
It might seem counter-intuitive that there has been a bull market in emerging market currencies against the backdrop of one of the most aggressive rate increase cycles by major central banks. But that is what we have seen and this bull market is likely to extend.
Views of EM performance reflect two common misperceptions. First, they are often coloured by the stories that make it to the top of your news feed — the meltdown in the Turkish lira or the triple-digit-plus inflation in Argentina. These are undoubtedly important developments in what are large emerging economies, but for the past several years, they have barely been representative of the trends across the EM mainstream. More importantly, they make up an insignificant share of most active investor portfolios.
Second, currency performance and broad EM index benchmarks are typically measured against the dollar. As the dollar has unquestionably had a strong run for the past couple of years, EM currency performance, as with that of almost every other currency, tends to look less flattering by comparison. But that is more a statement about the dollar.
Correcting for these two misperceptions is straightforward. Take a basket of the 15 or so most liquid EM currencies that make up the overwhelming majority of active EM investor portfolios — China, India, Indonesia, South Korea, Taiwan, Singapore, Malaysia, Philippines, Poland, Hungary, Czech Republic, South Africa, Israel, Brazil, Mexico and Chile — and an altogether different picture emerges.
An equally weighted basket of this group saw losses against the dollar in 2021 and 2022 but was up in both years when measured against the euro or the yen. In other words, the benchmark or comparator matters — while it is hard to beat the dollar when it is in a bull market, EM currencies outshone most other developed market peers.
But that picture is even better when one takes into account the higher “carry”, or yield, earned from investing in short-term debt instruments in EM currencies relative to similar instruments in developed market currencies. On this “total return” basis, EM currencies were up 10 per cent versus DM currencies (ex the dollar) over 2021-22, and up another 5 per cent year to date in 2023.
What accounts for this bullish performance, all the more remarkable against a backdrop of heightened interest rate and equity market volatility? The key reason is that policymakers across this group of EMs were early and aggressive in raising policy rates in 2021 once inflation raised its ugly head.
Brazil kicked off the EM interest rate rise cycle with a 0.75 percentage point bump in March 2021, with several central banks following suit in the months thereafter. That was about nine months ahead of the Bank of England’s first increase at the end of that year, a year ahead of the US Federal Reserve and nearly 15 months ahead of the European Central Bank.
Given their own history of high inflation and less well-anchored inflation expectations, there was little hand-wringing among these EM central bankers about whether inflation could be transitory or more persistent. And in fact, with broad-based declines in EM inflation across the last couple of months, investors are now wondering if countries such as Brazil — where the headline inflation rate has dropped below 4 per cent — could even start to cut policy rates.
Would such rate cuts start to erode the “bull market” in EM currencies? Not necessarily. EM currencies can continue to deliver positive total returns. With DM economies on a slow but non-recessionary growth path alongside gradual disinflation, major central banks are in the late innings of their monetary policy tightening, so any normalisation in rates in EM is likely to be prudent in the face of rising rates in big developed economies, maintaining a still generous interest rate differential.
Plus, within EM, the steep cuts already priced into market expectations in the near term means that even as rates begin to normalise, it should be possible for central banks to surprise markets on the hawkish side. Finally, with inflation declining across most EM jurisdictions, increasing real rates should continue to support the currencies even as nominal rates normalise.
The real challenge for EM currencies in the months ahead is that they become a victim of their own success. As more investors recognise the potential returns, valuations may become a headwind and warrant a nimbler investment approach. But we are not there yet.
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