It’s been a rough and volatile year for emerging market currencies, some of which like the Brazilian real have slumped to record lows. Going into the third and final quarter of the year, investors are expecting the weakness to continue and things to get worse before they get any better. Here’s why:
The Fed: Will They/Won’t They?
“We’ve been waiting a long time, perhaps as much as six years, wondering when the Fed is going to do something about interest rates, and it’s always just around the corner,” said Bryce Fegley, portfolio manager of the Saturna Global High Income fund.
The market is still expecting a rate hike, albeit a tiny one, but the continued uncertainty over when that is going to happen continues to create volatility and put downward pressure on emerging market currencies.
Strong Dollar a Key Factor
The eventuality of a hike has parlayed into a strengthening of the U.S. dollar and that, of course, impacts the value of emerging market currencies.
“The closer a rate hike gets, the more effective the dollar looks from an interest rate perspective because we can have marginally higher rates on savings here,” Fegley said. “If at the same time you have weakness in the Eurozone, in Latin America and in Asia, then it appears there’s a differential on what you earn on savings in real rates, so this has driven the dollar strength.”
Looking beneath the surface, though, the dollar had actually weakened consistently compared to other currencies, peaking in 2011 and 2012, Fegley said, while emerging market currencies were at the time driven higher by trade flows from China and demand for resources, “so much of their current weakness stems from dollar overvaluation and resource demand.”
Continued Capital Outflows
Emerging markets have been heavily reliant on foreign capital for growth and as capital has been flowing out of these economies their currencies have weakened, said David Spika, global investment strategist at GuideStone Capital.
“I think that to see currencies stabilize, we are going to have to see better growth in emerging markets, but I don’t see that happening anytime soon,” he said.
China Slowdown Has an Impact
Growth from China is key to pull emerging market currencies up in the other direction, Spika said. China, in his view, is not going to have a hard landing because Chinese policymakers have the right set of tools to offset that but there is still concern about China’s growth and that has an impact for all the emerging market economies.
Commodities Need to Rise
While some believe that much of the commodity price pressure that has contributed to currency weakness has been factored in, investors like Spika still choose to go with those countries that consume, rather than produce commodities, he said, until there’s some stability in commodity prices, and the currencies of commodity exporters such as Brazil and South Africa continue to be among the hardest hit.
Economics an Issue
The credit default swaps of economies like Brazil and South Africa are “off the roof,” said Peter Kohli, CEO of DMS Funds, “reflecting a default because the currencies of these countries have been crushed.” He expects the currencies of countries whose economies are poorly managed to continue to weaken. The Turkish lira is one example and Turkey’s current account deficit is high. The same goes for Russia (Kohli expects further ruble weakness), but “the Indian rupee is holding steady and the Reserve Bank of India has lowered interest rates,” he said. “The Indian economy is doing fairly well compared to many other emerging markets, and India’s current account deficit is under 2% of GDP.”
Politics and Policies
“The Brazilian economy has been very badly managed since Lula,” Fegley said, “and there are a number of things going on there that undermine investor confidence and causes people to be risk averse. Improved governance and political change could help this.”
Brazilian Real: A Good Long-Term Investment Bet?
Fegley has a model that compares the value of currencies on a purchasing power parity basis.
“If you look at Brazil with all its problems, and measure the purchasing power parity of the real and the differential in interest rates, the Brazilian currency actually looks like a bargain,” he said. “If the government can bring the economy back to stability and you’re willing to take that risk and wait it out five years, then the real could be a good investment.”
Currencies are driven by a multitude of factors, including short-term concerns, trade deficits, trade flows, risk aversion and so on. Those factors, combined with capital outflows, can “overwhelm” the purchasing power parity of currencies in the short term.
“But for investors who can wait it out and measure the short-term risks against the long-term value, you can find good value in many of these currencies,” Fegley said.