The head of global foreign exchange, interest rates, and emerging markets strategy research at Goldman Sachs offers an intriguing analysis on the bull market in emerging market currencies. Despite the aggressive rate increase cycles by major central banks, emerging market currencies have seen significant gains, and this upward trend is expected to continue.
Many people’s views on emerging market performance are influenced by sensational news stories such as the Turkish lira meltdown or triple-digit inflation in Argentina. However, these events are not representative of the overall trends across the emerging market mainstream and have minimal impact on most active investor portfolios.
The measurement of currency performance and broad emerging market benchmark indices against the dollar often leads to misinterpretations. Due to the strong performance of the dollar in recent years, EM currency performance may appear less impressive in comparison. However, this is more of a reflection on the dollar’s strength rather than the performance of EM currencies themselves.
To gain a more accurate understanding, it is essential to consider a basket of the most liquid emerging market currencies that make up the majority of active EM investor portfolios. When compared to the euro or the yen, this basket reveals positive performance in recent years, despite losses against the dollar. EM currencies have outperformed most developed market peers.
Furthermore, when taking into account the higher yield from short-term debt instruments in EM currencies compared to developed market currencies, the total return on EM currencies has been impressive. Over the past two years, EM currencies have shown a 10% increase compared to DM currencies (excluding the dollar), and there has been an additional 5% increase so far in 2023.
What factors explain this bullish performance, especially in the face of increased interest rate and equity market volatility? The key reason lies in the proactive approach taken by policymakers in emerging markets. These EMs were early to raise policy rates in response to inflation, unlike their developed market counterparts.
Brazil was the first to kick off the EM interest rate rise cycle, followed by other central banks. Their actions came well ahead of rate increases by major central banks like the Bank of England, the US Federal Reserve, and the European Central Bank. This early and aggressive response has contributed to the bullish performance of EM currencies.
Concerns arise about whether rate cuts in EM could reverse this bull market. However, EM currencies can continue to deliver positive total returns. With developed market economies experiencing slow growth and gradual disinflation, major central banks are reaching the later stages of their monetary policy tightening. In this context, any normalization of rates in EM would be prudent, considering the rising rates in developed economies. This ensures a significant interest rate differential that supports EM currencies.
Furthermore, with market expectations already factoring in anticipated rate cuts, central banks have the potential to surprise markets with a more hawkish approach. Additionally, as inflation declines across most EM jurisdictions, increasing real rates should provide further support for currencies, even as nominal rates normalize.
The main challenge for EM currencies in the future may be their own success. As more investors recognize the potential returns, valuations may become a hindrance, necessitating a more agile investment approach. However, we are not at that point yet.
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