Bull market may extend in emerging market currencies

The writer is head of global foreign exchange, interest rates and emerging markets strategy research at Goldman Sachs

It may seem counter-intuitive that emerging market currencies have rallied against the backdrop of one of the most aggressive rate hike cycles ever by major central banks. But this is what we have seen and this bullish market is likely to be extended.

Considerations of EM performance reflect two common misconceptions. First, they’re often colored by the stories that make it to the top of your news feed—a recession in the Turkish lira or triple-digit-plus inflation in Argentina. These are undoubtedly important developments in large emerging economies, but for the past several years, they have been barely representative of mainstream EM trends. More importantly, they make up a negligible portion of most active investor portfolios.

Second, currency performance and the broader EM index benchmark are typically measured against the dollar. As the dollar has undeniably strengthened over the past few years, EM currency performance, as with almost every other currency, looks less attractive by comparison. But this is more a statement about the dollar.

Correcting these two misconceptions is straightforward. Take a basket of 15 or more 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 a completely different picture emerges.

An equally weighted basket of this group saw losses against the dollar in 2021 and 2022, but was up against the euro or yen in both years. In other words, the benchmark or comparator matters – while the dollar is hard to beat when in a bull market, EM currencies tend to outperform most other developed market peers.

But the 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. Based on this “total return”, EM currencies were up 10 percent over DM currencies (outside the dollar) over 2021-22, and another 5 percent in 2023 year-to-date.

What is responsible for this bullish performance, all the more remarkable against the backdrop of increased interest rates and equity market volatility? The key reason is that policymakers from this group of EMs were early and aggressive in raising policy rates in 2021, when inflation raised its ugly head.

Brazil started the EM interest rate hike cycle in March 2021 with a jump of 0.75 percentage points, followed by several central banks in the following months. This was almost nine months ahead of the Bank of England’s first hike later that year, a year ahead of the US Federal Reserve and almost 15 months ahead of the European Central Bank.

Given their own history of high inflation and less well-established inflation expectations, there was little dispute among these EM central bankers about whether inflation might be temporary or more stable. And indeed, with a broad-based decline in EM inflation over the past few months, investors are now wondering whether countries like Brazil – where headline inflation has dropped below 4 percent – ​​might start cutting policy rates as well. Are.

Will a rate cut like this start the “bull market” in EM currencies to subside? not necessarily. EM currencies can continue to deliver positive total returns. With DM economies gradually on a slow but non-recessionary growth path, major central banks are in a late inning of monetary policy tightening, so any normalization of rates in EM is prudent in the face of massive rate hikes. is likely to happen. Developed economies still maintain wide interest rate differentials.

Also, within the EM, market expectations for a steep cut in the near term already mean that even if rates start to normalize, it should be possible for central banks to spook markets. Finally, with inflation declining in most EM jurisdictions, increases in real rates should continue to support currencies even as nominal rates normalize.

The real challenge for EM currencies in the coming months is that they will become victims of their own success. As more investors recognize the potential returns, valuations could become a headwind and warrant a nimbler investment approach. But we’re not there yet.

The writer is head of global foreign exchange, interest rates and emerging markets strategy research at Goldman Sachs

It may seem counter-intuitive that emerging market currencies have rallied against the backdrop of one of the most aggressive rate hike cycles ever by major central banks. But this is what we have seen and this bullish market is likely to be extended.

Considerations of EM performance reflect two common misconceptions. First, they’re often colored by the stories that make it to the top of your news feed—a recession in the Turkish lira or triple-digit-plus inflation in Argentina. These are undoubtedly important developments in large emerging economies, but for the past several years, they have been barely representative of mainstream EM trends. More importantly, they make up a negligible portion of most active investor portfolios.

Second, currency performance and the broader EM index benchmark are typically measured against the dollar. As the dollar has undeniably strengthened over the past few years, EM currency performance, as with almost every other currency, looks less attractive by comparison. But this is more a statement about the dollar.

Correcting these two misconceptions is straightforward. Take a basket of 15 or more 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 a completely different picture emerges.

An equally weighted basket of this group saw losses against the dollar in 2021 and 2022, but was up against the euro or yen in both years. In other words, the benchmark or comparator matters – while the dollar is hard to beat when in a bull market, EM currencies tend to outperform most other developed market peers.

But the 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. Based on this “total return”, EM currencies were up 10 percent over DM currencies (outside the dollar) over 2021-22, and another 5 percent in 2023 year-to-date.

What is responsible for this bullish performance, all the more remarkable against the backdrop of increased interest rates and equity market volatility? The key reason is that policymakers from this group of EMs were early and aggressive in raising policy rates in 2021, when inflation raised its ugly head.

Brazil started the EM interest rate hike cycle in March 2021 with a jump of 0.75 percentage points, followed by several central banks in the following months. This was almost nine months ahead of the Bank of England’s first hike later that year, a year ahead of the US Federal Reserve and almost 15 months ahead of the European Central Bank.

Given their own history of high inflation and less well-established inflation expectations, there was little dispute among these EM central bankers about whether inflation might be temporary or more stable. And indeed, with a broad-based decline in EM inflation over the past few months, investors are now wondering whether countries like Brazil – where headline inflation has dropped below 4 percent – ​​might start cutting policy rates as well. Are.

Will a rate cut like this start the “bull market” in EM currencies to subside? not necessarily. EM currencies can continue to deliver positive total returns. With DM economies gradually on a slow but non-recessionary growth path, major central banks are in a late inning of monetary policy tightening, so any normalization of rates in EM is prudent in the face of massive rate hikes. is likely to happen. Developed economies still maintain wide interest rate differentials.

Also, within the EM, market expectations for a steep cut in the near term already mean that even if rates start to normalize, it should be possible for central banks to spook markets. Finally, with inflation declining in most EM jurisdictions, increases in real rates should continue to support currencies even as nominal rates normalize.

The real challenge for EM currencies in the coming months is that they will become victims of their own success. As more investors recognize the potential returns, valuations could become a headwind and warrant a nimbler investment approach. But we’re not there yet.