By Paul DeNoon (pictured) and Kenneth Colangelo
Emerging-market (EM) currencies have long been a popular investment theme. It’s commonly assumed that attractive returns can be earned from the appreciation of EM currencies versus the dollar. The truth is a bit more complicated. Historically, passive, long-only exposure to a basket of EM currencies (such as the exposure offered by exchange-traded funds) has not been especially lucrative.
EM currencies appreciated by an average of 1.5% and 2.0% a year from the end of 2002 to the end of April 2013 (depending on the basket and weighting methodology). Not a horrible outcome, but curiously tepid given that this happened during the heyday of EM investing.
Let’s take a closer look at the history of currency appreciation using the JP Morgan Emerging Local Markets Index Plus (ELMI+), which tracks total returns from investing in the short-term money markets of EM countries. Using the ELMI+ we constructed an index for the spot valuation of EM currencies versus the dollar. The results, shown below, are less than spectacular. Over the period in focus, EM currencies appreciated by about 17%, or roughly 1.5% annualized. But a large portion of the gain occurred during the first 24 months of the period. Also of interest is that the US Federal Reserve’s policy of quantitative easing didn’t boost EM currencies as much as other risky assets after the global financial crisis.
Is Economic Theory Wrong?
Economic theory didn’t go wrong, but it may have been misinterpreted. Theory states that faster real economic growth, if it’s the result of better productivity growth, should cause real appreciation in EM currencies. The operative word is “real” and this is what gets lost in the discussion. Real exchange rates reflect the value of one country’s products in terms of another’s, taking inflation into account. Real exchange rates are highly relevant to importers, exporters and multinationals, but for developed-market stock and bond investors the relevant measure is the nominal exchange rate—simply the value of one currency in terms of another
Looking at inflation differentials and estimates of real exchanges rates helps to confirm that the theory does work. Since 2003, the cumulative increase in EM consumer inflation has exceeded US inflation by over 37%. When added to the 17% nominal appreciation above, that implies a significant real appreciation (over 50%) in emerging country currencies. (The theory would use a different inflation measure, but you get the point.)
In an attempt to support the broad conclusion, we created real and nominal effective EM exchange rate indexes (REER and NEER) using Bank for International Settlements data. We used the countries in the ELMI+, but used a simple equally weighted approach. We compared this index to a US dollar REER index in the chart below. According to this methodology, the NEER of EM currencies has appreciated by about 19% relative to the US dollar, similar to the nominal appreciation calculated using the returns from the ELMI+. EM REER has appreciated by 39% versus the US dollar’s REER, not nearly as drastic as the real appreciation seen by simply looking at inflation differentials, but still more than twice as much as the nominal relative appreciation.
Implications for Investors
If appreciation has not played much of a role in passive EM currency returns to date, we don’t see this changing in the foreseeable future. We think there’s some scope for nominal appreciation in EM currencies, but it’s unlikely to be broad-based. There will be winners and losers. In fact, there are signs that past appreciation has hurt some EM countries’ export competitiveness, EM economic growth has decelerated and few if any EM policymakers are eager for a stronger currency. In fact some are acting to stem further appreciation. The case for nominal appreciation in other currencies could be much stronger.
Thus, active EM currency selection is vital for success in EM investing. To make the most of the opportunity, dedicated EM currency strategies and overlay strategies should allow longs and shorts of both EM and developed currencies. Finally, investors should have a coherent currency view that is distinct from the bond and equity-selection decisions they are making. In fact, we’d hope that, going forward, bond and equity investors will think about each of the strands of EM investing on its own merits. By identifying the best country, currency, industry, yield curve and security allocations investors are more likely to arrive at efficient, well-diversified portfolios.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Paul DeNoon is Director of Emerging-Market Debt and Kenneth Colangelo is Economist, Frontier Global Economics, both at AllianceBernstein.