Making the case for investing in Emerging Market Currencies

Monica Fan - is Managing Director, Head of Business Development at Millennium Global Investments Ltd

Sovereign debt crises, unorthodox monetary policies and political instability were once the hallmarks of emerging economies. Today, these are more appropriate descriptions of the world's three largest developed economies. Over the past year, the volatility of the supposedly riskier emerging market currencies was comparable to that of developed market currencies (see Figure 1). A permanent solution to the sovereign debt crisis in the eurozone remains distant. The Federal Open Market Committee has embarked on "Operation Twist" to resuscitate the U.S. economy after its failure to respond to two rounds of quantitative monetary easing. Japan's economic woes are being exacerbated by its revolving door of prime ministers: parliament recently installed its 6th prime minister in less than five years. Developed economies' growth rates and investment returns are likely to remain lacklustre and well below trend in coming years. Investors, especially underfunded pension plans with a daunting chasm in their assets and liabilities, are turning to emerging market assets for higher returns.

Global Pension Plans are Underweight Emerging Markets

Presently, pension plans are grossly underweight emerging markets. Their average allocation, of about 5 per cent¹, is only a fraction of emerging markets' market capitalisation in global equity indices of 13 per cent² and emerging markets' share of global GDP of 40 per cent³. Two major factors that have contributed to pension plans' underinvestment in emerging markets are: the relatively limited choices of liquid, diversified and risk controlled emerging market investment vehicles; and investors' nervousness about large drawdowns on emerging market assets when there is a "flight to liquidity" during financial crises. These concerns have been magnified by current fears that the U.S. economy is on the brink of a recession and the catastrophic drawdowns in emerging market asset returns during the 2008 global financial crisis are still fresh in the minds of investors.

Figure 1: Emerging market currencies were not more volatile than developed market currencies over the past year
Sources: Bloomberg & Millennium Global, 1 September 2010 - 22 September 2011

Emerging Markets Have Reduced their Vulnerability to Financial Shocks

Over the past decade, many emerging countries have made significant structural improvements to their economies that have reduced their vulnerability to global financial shocks. Many emerging countries have bolstered their foreign currency reserves, reduced their level of external debt, public debt-to-GDP ratio and their reliance on foreign currency denominated debt.

By contrast, growth in many developed economies has been stimulated by unsustainably high levels of monetary and fiscal stimulus. The 2008 credit crisis triggered the current deleveraging in developed economies and the resulting impairment of the credit intermediation process in developed economies will depress their trend rates of growth in years to come.

Productivity growth and real GDP per capita in emerging economies is likely to continue further towards those of developed economies in the next decade. Consumer, corporate and government balance sheets in emerging markets are less leveraged, banks are better capitalised and the credit intermediation in most emerging economies is functioning normally.

The International Monetary Fund forecasts the growth differential between emerging and developed economies will widen from an average of 3.7 per cent per annum over the past decade to 4.7 per cent per annum over the next five years.

Figure 2: Emerging Market Currencies Are Undervalued
Sources: International Monetary Fund, World Economic Outlook Database, April 2011 & Bloomberg as at 31 December 2010

Emerging Market Currencies Are Poised for Real and Nominal Appreciation

We believe emerging market currencies are poised to appreciate against developed market currencies as real GDP per capita in emerging economies catches up with that in developed economies. If emerging economies are able to contain their inflation at low levels, the real appreciation of emerging market currencies will also result in nominal appreciation. Figure 2 compares the under/overvaluation of the purchasing power parity⁴ exchange rates versus their spot USD-exchange rates⁵ of 15 developed and 22 emerging markets (on the vertical axis) with real GDP per capita⁶ (on the horizontal axis). Based solely on this criterion, all the emerging market currencies, excluding the Brazilian real, are deeply undervalued especially the Indian rupee, Argentine peso and Taiwan dollar.

Investing in Emerging Market Currencies

Many pension plans' first foray into the emerging markets was through equities, then fixed income. There is now growing interest among pension plans in currency strategies as liquid, transparent and cost effective way to access the growth opportunities in the emerging markets.

A large proportion of the return from emerging market debt is attributable to the return on emerging market currencies. Over the past decade, almost half of the US dollar denominated return on the JP Morgan Global Bond Index Emerging Markets Composite Index is attributable to the returns from emerging market currencies (see Figure 2). In contrast, emerging market currencies have contributed closer to 14 per cent of the US dollar denominated return on the MSCI Emerging Markets Free Index over the same period. It is worthwhile remembering that the currency impact cuts both ways and needs to be risk managed. During 2008, the 19% loss on emerging market currencies (against the US dollar) was almost double the 11% gain on the emerging debt.

Emerging market currencies are significantly more liquid than emerging market equities and emerging market debt. Average daily turnover in emerging market currencies of US$529 billion⁷ dwarfs average daily turnover of US$68 billion in emerging market debt⁸ and US$65 billion⁹ in emerging market equities.

Emerging market currencies enable investors to benefit from the currency appreciation of emerging market economies without the unintended exposures to the duration risk and credit risk associated with emerg¬ing market debt.

Further, a currency portfolio that is fundamentally weighted i.e. by emerging economies' share of global GDP or global trade, can provide investors with a better proxy of the growth opportunities in emerging markets than the market capitalisation of emerging market debt and equity indices. For example, the market capitalisation of China in the MSCI Emerging Markets Free Index of about 17 per cent¹⁰ significantly under represents China's share of emerging market GDP which exceeds 25%¹¹. A fundamentally weighted currency portfolio would better reflect the universe of growth opportunities in the emerging markets.

Figure 3: Currency account for half of the total returns on the JPMorgan Emerging Bond Index
Source: Bloomberg & Millennium Global, 1 January 2001 - 31 August 2011.

Risk Aversion Filters Seek to Mitigate Drawdowns in Emerging Market Currencies

Investors justifiably fear large drawdowns in the event of a financial crisis. However, even in "normal" market conditions we believe it is prudent to continually monitor warning signs of distress in the financial markets because extreme drawdowns can be mitigated with risk aversion filters. For example, Millennium Global's global emerging market currency strategy plus a risk filter (GEM Plus) is a fundamentally weighted emerging market currency strategy with a built-in risk aversion filter that seeks to mitigate the drawdowns that typically occur in periods of severe market stress through switching to domestic cash. Our risk aversion filter synthesises high frequency forward looking indicators of turbulence across various asset classes. Hypothetically, between January 2001 to June 2011, the risk aversion filter could have reduced the maximum drawdown on a diversified portfolio of currencies from 18.5 per cent to 5.5 per cent, and improved the return-to-risk ratio of the portfolio from 1.4 to 2.2.

Benefits of a Strategic Allocation to Emerging Market Currencies

Given the unstable correlation between emerging market currencies and developed market equities and bonds, investors can significantly improve the performance of their traditional assets by allocating 15 per cent¹² of their portfolio to a risk managed basket of emerging market currencies. Figure 4 shows the volatility, return, information ratio and maximum drawdown on the hypothetical GEM Plus Strategy, S&P 500 Index, JP Morgan Global Aggregate Bond Index and two hybrid portfolios that comprise 85 per cent of the S&P 500 or the JP Morgan Global Aggregate Index and 15 per cent of the hypothetical GEM Plus strategy, for the period 1 January 2001 to 31 August 2011. Hypothetically, the addition of a portfolio of risk controlled emerging market currencies improved the return and reduced the volatility of the S&P 500 and the JP Morgan Global Aggregate Bond Index.

Figure 4: Diversification Benefits of Adding Emerging Market Currencies
Source: Bloomberg & Millennium Global, 1 January 2001 - 31 August 2011.

Conclusion

Emerging economies are poised to become the powerhouse of global growth in the coming decade. The World Bank anticipates that by 2025, the Chinese renminbi will be one of three global reserve currencies alongside the U.S. dollar and the euro¹³. Undervalued emerging market currencies are on a rising trajectory as real GDP per capita in emerging economies converges towards developed economies. Investors can participate in the long term capital appreciation of emerging market currencies by investing directly in emerging market currency strategies. We caution that the bullish long term outlook for emerging markets is likely to be punctuated by episodes of severe financial distress, such as the current anxiety about an impending U.S. recession. During these periods, we believe that effective risk aversion filters play a crucial role in preserving investors' capital.