InvestmentsJul 4 2016

Fed rate decision lifts prospects

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Fed rate decision lifts prospects

Despite a slowing Chinese economy and recessions in Brazil and Russia, prospects for emerging market (EM) currencies may be better than investors think.

Given fears of a global slowdown, an impeachment vote in Brazil and a bounce in commodity prices, it has been an eventful year for EMs.

Prospects for the asset class are frequently dictated by the outlook for US monetary policy and the dollar – a stronger US currency making it more expensive for companies with dollar-denominated borrowings to repay the debt.

Therefore it is no surprise that many EM currencies bounced strongly this year after the US Federal Reserve pared back rate hiking plans in 2016.

The currencies of two commodity-reliant economies – Brazil and Russia – have been the top-two EM currencies over the past three months with double-digit returns, though they remain 5.7 per cent and 21.4 per cent weaker respectively since May 2015.

Despite the potential for more sharp swings in developing countries’ exchange rates, the area’s long-term story remains intact. The growth rate in emerging economies shows tentative signs of picking up and widening the gap with the rate in developed economies.

Developing states are likely to remain more productive than developed ones for many years, supported by a greater proportion of workers to pensioners. For instance, the number of pensioners as a percentage of the working-age population in China and India was 12.5 and 8.4 per cent respectively in 2014, compared with 21.6 per cent in the US.

EM currencies: Expert views

William Palmer, co-investment manager on Barings’ Global Emerging Markets fund, comments:

“As bottom-up quality growth investors, we tend to avoid companies that are materially impacted by currency movements. Our philosophy is grounded in investing in companies where there is a high probability of earnings delivery, while future currency trends are highly unpredictable.

“As a result we have not changed our investment positions due to the recent moves in EM currencies.

“In general, US dollar weakness normally translates into EM currency appreciation, which historically has been accompanied by rising EM equity markets. EM currency appreciation is typically positive for importing companies and those that have US dollar debt on their balance sheets, while selective exporting firms have fared less well.”

Claudia Calich, manager of the M&G Emerging Markets Bond fund, adds:

“Against the prospect of slower global economic growth, the US Federal Reserve has clearly turned more dovish as this year’s first quarter progressed, emphasising global downside risks.

“In turn, the repricing of expectations for Fed hikes prompted a large US dollar correction, including against EM currencies. This was among the key drivers of a strong rally among local currency-denominated EM bonds in March.”

Bonds issued in, say, the Chinese renminbi, Indian rupees or Brazilian reals offer one potential way to profit from appreciating emerging countries’ currencies. Swings in exchange rates can be expected to account for around two-thirds of EM local currency bond returns.

The added potential yield available in EMs over developed markets can help offset any currency losses and has been expanding. For instance, EM bonds yield 4.75 per cent more than US debt. Furthermore, EM currencies are still significantly undervalued against developed alternatives.

EM currencies can still offer much value. There are optimistic prospects for currencies in Mexico, Russia and Indonesia.

Mexico was caught up in last year’s EM sell-off, despite its decent economic prospects. The Russian currency should bounce further if oil prices are sustained, while Indonesia enjoys lower unit labour costs relative to many other EMs, along with government-backed, business-friendly reforms.

By contrast, there is some pessimism on the export-driven Thai and Taiwanese currencies. Exports comprise around 70 per cent of output in both economies and they have struggled of late, weighed down by the contraction seen in manufacturing across Asia (excluding Japan) since early 2015.

Clearly risks persist for EM currencies, such as another shock devaluation of the Chinese currency – as seen last summer – a growth surprise or a sell-off in commodities.

However, with Chinese policymakers’ apparent change of heart, indicated at March’s National People’s Congress, to focus primarily on growth and exchange-rate stability, it appears they will attempt to weaken the renminbi over a longer period than expected. This, in turn, provides a more favourable backdrop for EM currencies.

Stuart Ritson is a fund manager in the EM debt team at Aviva Investors