By Hayden Briscoe
Emerging markets have fallen from favor, but does that mean investors should avoid them entirely? We don't think so.
We still see opportunities in some emerging-market (EM) currencies, with Asian currencies among the most attractive. A look at recent history sheds some light. Display 1, below, plots baskets of Asian and Latin American currencies against an index of commodity prices. It tells a lot about what's been happening in emerging markets the last decade and a half.
It's essentially a commodities story - this is clear from the strong run-up in prices from the beginning of the commodities boom in the early 2000s to the intensification of the global financial crisis in late 2008. Until the crisis, economic conditions were benign. As commodity prices rose, so did the currencies of major EM commodity exporters, including Latin American countries such as Argentina, Brazil and Chile.
Asian countries - notably China - accounted for much of the demand for commodities as their economies expanded and exports boomed, which drove up their currencies, too. This virtuous cycle fell flat in 2008 as commodity prices plummeted. Emerging markets responded to the crisis by investing in infrastructure, and this led to a three-year recovery in demand for commodities, which, in turn, caused commodity prices to rebound. As they did, however, the behavior of Asian and Latin American currency baskets diverged.
Asian currencies resumed their secular rise and exceeded their previous peaks, but Latin American currencies recovered only partially. Since 2011, Asian currencies have traded within fairly consistent parameters, while Latin American currencies have fallen back to their 2009 lows.
Latin American Exporters Still Tied to Commodities Cycle
What caused the divergence? Quite simply, Latin American exporters' currencies have remained tied to the fortunes of commodities markets, which have waned since 2011 as slowing global growth has reduced demand and new production has put further downward pressure on prices.
A key reason for the tight link between Latin American currencies and commodity prices is that Latin American countries didn't take advantage of the highly favorable terms of trade they enjoyed during the commodities boom. If they'd invested in fixed assets and infrastructure, for example, their economies might have become more efficient and productive - and less tied to the commodities cycle. (It would be unfair to single out only Latin American countries here, though, as similar comments could be made about developed-world commodities exporters, such as Australia and Canada.)
Asian currencies, meanwhile, have remained resilient partly by default. As the global financial and European sovereign-debt crises forced many developed countries to cut interest rates to near zero, Asian yields seemed more attractive, resulting in capital inflows that lifted currencies. This condition has prevailed despite the EM sell-off that began early last year, when the US Federal Reserve indicated that it would begin tapering quantitative easing - a signal that the rate differential between emerging markets and developed markets was about to narrow.
Even as global investors begin to see more short- to medium-term growth potential in the US and Europe than in emerging markets, we don't think the relative strength of Asian currencies will fade anytime soon.
Asian Countries to Reap Commodities Dividend
Our research suggests that this structural advantage is about to be enhanced by a "commodities dividend" for Asian countries and currencies, as declining commodity prices should allow margins in Asian businesses to expand, leading eventually to further investment and economic recovery.
This scenario assumes that growth in commodity-dependent countries won't soon return to levels that will cause commodity demand and prices to rise. There seems little risk of this with China, a key commodities consumer, needing to keep growth moderate as it tries to deleverage its economy.
The impact of the commodities dividend will be seen in the external accounts (and currencies) of many countries. It has already been visible in the recovery in China's trade surplus since President Xi Jinping came to power in late 2012 and began slowing fixed-asset investment (Display 2).
Of course, not all Asian countries will benefit to the same extent. India and Indonesia, for example, have poor external positions. In many other countries, though, current account surpluses are rising - we expect that some, including Malaysia's, could double this year.
All this speaks to the need for active investment management and the need for most global investors to stop thinking of emerging markets as a homogenous bloc. Instead, they should look for distinctions between individual economies and regions. Through that lens, many Asian currencies seem attractive.
Hayden Briscoe is Director of Asia-Pacific Fixed Income at AllianceBernstein.