EMs during the past year have wrestled with manifold macroeconomic challenges – weak exports, falling productivity gains, diminishing savings rates and rising corporate leverage.
However, for unhedged investors, the most pernicious drag on returns has been the strengthening of the US dollar, which has risen by around 12% against a basket of 15 EMs in spot terms year-to-date.
In recent days, EM FX fell to a decade low, according to a Bloomberg basket of 20 developing-country currencies, driven by lower oil prices, a slowing China and a fears over Japan’s reflation bid.
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While monetary stimulus from the US and Japan should have boosted risk assets such as equities, triggering a 15% rise in the S&P, EM currencies, as in the past, have been shaken by the greenback’s, albeit anticipated, rise.
The Mexican peso has fallen by around 9% and the Brazilian real by around 8% against the dollar, yet these are among the EM success stories for the year, particularly for LatAm.
The rouble and the rupee represent EMs' contrasting fortunes of the past year. Of the widely traded currencies, the rouble, which declined around 40% this year, has been an outlier among a bunch of generally poor performers.
Adam Myers, European head of FX strategy at Crédit Agricole CIB, says: “Without doubt, Russia and the rouble have been the big negative surprise story of 2014. The ongoing impact of economic sanctions upon growth and employment should not be underestimated in 2015.
“If persisting, their prolonged implementation risk Russia being re-classed as a frontier market in time.”
Luis Costa, head of CEEMEA strategy at Citi, adds: “The price right now looks about right for the rouble.”
The rouble is adjusting to the removal of what was probably the strongest framework for currency intervention any EM has ever seen – a dollar peg, backed by a war-chest of reserves – which held it steady for years.
Rouble volatility
The shift to an inflation-targeting free-floating monetary regime is likely to mean persistent rouble volatility for some time, with the benefits seen as materializing in the medium-term.
With the Central Bank of Russia committed to its new policy of reduced currency interventions, 2015 does not look much better.
“Unless China comes to Russia's rescue, for example with a deal to buy its gas, it is hard to see Russia doing well in 2015,” says Crédit Agricole's Myers.
At the other end of the spectrum is India, which delighted investors as much as the rouble dismayed them. In the build up to India's general election in May, there was concern about the direction the economy was heading in, its ability to rebuild its manufacturing sector and whether the winner would have the appetite and mandate to push through the necessary reforms.
The result of the election has given India a new lease of life. The BJP government is “the first single party in over 30 years, and probably the first centre-right government ever,” says Vijay Krishna-Kumar, director at Mumbai-based Gulmohar Alpha Capital Advisors. “Both these changes are a tremendous positive for Indian equities longer term.”
Manik Narain, EM strategist at UBS, says: “At the current price of oil, India will practically eliminate its current-account deficit, for the first time in a decade, which should mitigate pressure on the rupee.
“We expect to see growth pick up in 2015-16 and FDI inflows should accelerate. Reforms such as liberalizing labour laws, implementing a national goods and services tax, and reducing regulatory hurdles for businesses are making progress.”
This does not mean the rupee is set to appreciate against the dollar, but it does mean, with a 6% yield, rupee investors can earn a total return from carry. UBS also advocates a relative value trade of long rupee against the rand.
“Famed Chicago monetarist Raghuram Rajan took over governorship of the Reserve Bank of India (RBI) at the depth of the rupee crisis – following the taper tantrum – last year and has brought about an unseen Volcker-like credibility to the RBI's inflation fighting credentials,” says Gulmohar's Krishna-Kumar.
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Narain at UBS says: “In the seven months since the election, the Reserve Bank of India has already made significant progress in containing inflation expectations and moving towards an inflation-targeting regime. For me, this is the biggest positive of the year across EMs.”
In general, Asia has been an outperformer with the Indian rupee, the Philippine peso, the Indonesian rupiah and the Thai baht holding up well against the dollar, demonstrating the superiority of Asian growth compared to LatAm and Europe.
“China might be slowing down, but it is still growing faster than Europe or the US and that has benefited Asia – as has Japan's fiscal stimulus,” says Myers.
Analyzing how Asia will react to various possible dollar scenarios for 2015 is difficult. The hope is that the dollar’s rise, driven by US expansion, will boost Asian EM exports. However, Myers believes 2015 could see the fortunes of LatAm and Asia reverse.
He says: “In 2014, we saw LatAm struggle and Asia do well. This could reverse in 2015. If China continues to slow, that could drag Asia down, while a brightening outlook in the US could mean a better year for LatAm. But European EMs look set to struggle. The eurozone is still in a mess and it is hard to see Poland, Bulgaria, Romania, Czech or Hungary doing well in that environment.”
Another factor to consider going into 2015 is exposure to imported energy. Large oil importers stand to profit from lower energy prices, especially if they have only a modest economic exposure to exports.
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A good example is Turkey, a large oil-importer that does not rely on a large export sector to carry its economy. This combination should help it reduce its 6.5% current-account deficit in 2015.
Some sovereigns will fall into only one of these categories. South Africa will benefit from falling energy prices, but will suffer in equal measure from falling demand for its resource exports.
Myers says: “A falling oil price is good news for EMs and most have benefited from this in 2014. But if their currencies fall by even more in 2015 than the price of oil declines, they'll be paying more for their oil and that will hurt them.”
Narain adds: “UBS expects the dollar to continue to outperform EM FX in 2015 and we recommend going long the dollar against low-yielding, export-centric economies like Singapore, Thailand and Hungary in particular. This gives you exposure to a number of different themes, including the declining advantage of EM growth over the US, rising US rates and sluggish growth in Europe and Japan.”
This rising cost of dollar funding is another big challenge for EM sentiment in 2015.
Myers says: “The cost of dollar funding is rising fast, as the Fed contemplates its first rate hike and is a massive issue for EM currencies. It won’t matter much in Europe or Australia, but in countries like Chile, Taiwan or Turkey it matters a lot.
“A 1% to 2% increase in the cost of dollar funding will cause investors to reduce their exposures to EMs as the carry payment declines. And as investors reduce their EM positions, the cost of dollar funding will be pushed even higher. It becomes a self-fulfilling prophecy.”
Narain adds: “The rising dollar is more pernicious for EMs than developed markets because on average between 60% to 80% of EM external liabilities are denominated in dollars, and as commodity prices are denominated in dollars.”
Source of malaise
Much of the malaise dates back to the ending of the Fed's quantitative easing (QE), the mere threat of which triggered the taper tantrum last year.
“The ending of Fed QE has really hurt LatAm EMs, particularly Argentina, Colombia and Chile – Argentina because of its massive debt, and Colombia and Chile because they have large dollar-denominated funding requirements,” says Myers.
“As US rates rise, these currencies are going to get hammered. The only thing that will mitigate the problem will be if the US increases demand for their exports.”
QE from Europe or Japan is unlikely to make up for the end of US QE, states UBS. It says 30% of US overseas investment goes to EMs, compared with only 7% to 15% for German and Japanese investors.
“The only way the European Central Bank (ECB) is really going to influence EM FX is if it can get Europe growing again, which will boost EM exports to Europe, and that means fixing the banking system,” says Narain.
Europe's significance to EMs is as a market for its exports, so a growing Europe would make a difference to EMs more than a cheap euro. The best way for the ECB to influence EMs is therefore to get Europe growing, boosting EM exports to Europe.
Ultimately, taking a one-year view, the fortunes of most EMs are to a large extent out of their own hands and will be determined by the cost of dollar funding, the price of oil and risk appetite, among other factors. Amid such uncertainty, EM central banks must be alert.
Citi's Costa says: “EMs are likely to look to be more like Turkey, which is highly dynamic in its reactions to market moves. It is constantly calibrating its policy, hiking or easing on a daily basis to smooth the path of currency moves. It is still intervention, but it is a different kind of intervention to central banks buying and selling FX.”