Emerging market currencies at ‘multi-decade lows’

Steve Johnson

EM FX may be at its cheapest since the 1980s in inflation-adjusted terms

This year has been a sobering one for emerging market currencies, with the JPMorgan sector index sliding 11.4 per cent against the backdrop of an ascendant dollar, the Argentine peso losing half its value against the greenback and the Turkish lira surrendering a third of its spending power.

If there is a silver lining for bruised and battered EM forex, though, it is that many market-watchers believe these currencies have fallen so far that they are now temptingly cheap.

A net 51 per cent of fund managers said emerging market currencies were undervalued (75.5 per cent said they were, 24.5 per cent said they were not) in the most recent Bank of America Merrill Lynch survey, the highest reading in the monthly survey’s 14-year history, as the first chart shows. (This is arguably about the first time fund managers have been logical. In the past they have tended to view currencies as cheap when the JPMorgan index has been close to its highs, and expensive when the benchmark has been weak).

This view is shared by several analysts who maintain their own EM currency valuation models, which arguably have more long-term validity than the JPMorgan index, given the latter’s focus on nominal, ie non-inflation adjusted, exchange rates.

“Currencies have sold off and our EM (ex-China) currency index is now the most undervalued it has been since 2009,” said Charles Robertson, chief economist at Renaissance Capital, an emerging markets-focused investment bank.

Patrick Zweifel, chief economist at Pictet Asset Management, went further, saying: “We are at extremes [of valuation] versus the dollar. We haven’t been there since the mid-1980s.”peak

Pictet’s model is based on determining the long-run, trade-weighted equilibrium exchange rates of 32 emerging market currencies that would prevail in the absence of speculative capital flows, changes in international reserves and discrepancies in national cycles. 

It adjusts nominal exchange rates to take into account relative inflation differentials (a country with high inflation should tend to see its currency weaken in nominal terms), relative differences in productivity (high productivity should equal a strong currency) and net foreign assets (net creditors should tend to see their currencies appreciate).

EM FX is 24 per cent undervalued by this measure, as shown in the second chart, more than two standard deviations from the mean and the largest underpricing on record, barring a short spell in 1985.

To be fair, there are a couple of caveats to this statement. First, the extreme weakness of EM currencies vis-à-vis the dollar is partly due to the greenback’s unusual strength at present, even against other developed market currencies.

Yet even against the euro, emerging market currencies trade at more than one standard deviation below their long-run average, Mr Zweifel said. “There is no doubt that EM currencies relative to DMs are very cheap,” he added.

Second, as mentioned above, Pictet’s model is based on long-term fundamentals and does not take into account cyclical factors such as temporary swings in relative economic growth rates.

“If a country is actively slowing down versus another one there are good reasons for its currency to depreciate [so] part of this extreme undervaluation is due to the cyclical underperformance of EMs relative to DMs, which started in 2010,” Mr Zweifel added. 

Nevertheless, this factor cannot explain much of the undervaluation, particularly since EM FX has continued to weaken since the third quarter of 2015, when the EM-DM economic growth differential troughed at 1.4 percentage points, since when it has rebounded somewhat to 2.6 points, according to Pictet’s data. As such, Mr Zweifel believed cyclical factors could only explain 5 points of EM FX’s 24 per cent mispricing.

Renaissance Capital’s model is based on a GDP-weighted basket of the real effective exchange rates (REERs) of 25 emerging market currencies.

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Stripping out the heavily managed Chinese renminbi (which can swamp the rest of the data given the country’s vast economy), it finds EM FX is trading at its weakest level since a brief spell in 2009, and before that 2005, as depicted in the third chart. (Even factoring in China, it is cheaper than at any point since 2012.)

“In aggregate, [EM currencies] are 4.5 per cent below their long-term average, the lowest since early 2009,” said Vikram Lopez, analyst at RenCap.

Among the most undervalued currencies by RenCap’s calculations are the Turkish lira, which has a long-term average REER of 3.75 to the dollar, compared with 5.58 at present, the Mexican peso, which “should” trade at 16.1 to the dollar rather than 20, and the Argentine peso, with a REER of 29.8 to the greenback rather than the current 36.7. The analysis does suggest the renminbi, at 6.97 to the dollar, is markedly overvalued, however, and by rights should be nearer 8.10.

“No EM is more than 20 per cent overvalued on a REER basis and more than half of the countries are below ‘fair’ value, which makes a significant change from a year ago, when both India and China were more than 20 per cent overvalued and more than half the countries in the index were at least 5 per cent overvalued,” Mr Lopez added.

Not everyone is convinced by such analysis, however. Oliver Jones, markets economist at Capital Economics, said: “Even though emerging market currencies have fallen a long way against the dollar in recent months, in most cases their valuations do not yet appear particularly low. This pours cold water on the idea that low valuations will provide significant support to many EM currencies.”

His analysis suggests that, barring a few outliers such as the Argentine and Philippine pesos and Turkish lira, most EM currencies currently trade close to their average REER and have been far weaker in real terms at some point since the global financial crisis.

“Most EMs’ REERs are still only slightly weaker, or even a bit stronger, than their averages of the past five years, despite the fact that their nominal exchange rates against the dollar have weakened across the board since mid-April by about 10 per cent on average,” Mr Jones added.

One caveat here is that Capital Economics calculates REERs based on differentials in producer price inflation, which Mr Jones said can give smaller valuation gaps than REERs based on consumer price inflation levels.

Nevertheless, he predicted that EM currencies, in aggregate, were likely to continue falling against developed world currencies for the rest of this year and next.

His prognosis is based on a view that the US Federal Reserve will continue raising interest rates for now, maintaining the pressure on EM currencies. Then, by the middle of 2019, Mr Jones expsects the US economy to slow “fairly sharply” and stock markets to “fall significantly” — a potentially painful backdrop for the emerging world. 

“Whenever the US stock market falls sharply EM currencies also do badly, irrespective of what is happening at the Fed, because of a general retreat from risky assets that hurts EM in particular,” Mr Jones said.

Nevertheless, he did note that this relationship appears to have broken down in recent weeks, with EM currencies staging a tentative recovery even as the US stock market has taken a beating. 

Even if EM FX can continue to shake off Wall Street weakness next year, Mr Jones expected the renminbi to weaken as China loosened monetary policy to combat a softening economy, dragging down other Asian currencies that “are correlated with the renminbi”. 

Moreover, with inflation projected to average 45 per cent in Argentina next year and 18 per cent in Turkey, their currencies are almost certain to fall further in nominal terms, even if they do stabilise in real, inflation-adjusted terms.

In contrast, Mr Zweifel did expect EM currencies to normalise over the next three to five years, although this would require a strong, but not too strong, US economy; a robust Chinese construction sector to support commodity prices; and solid global trade growth.

One other requirement, an appropriate policy response from emerging market central banks, does seem to be coming through, with rate rises in countries such as Argentina, Turkey, the Philippines, Indonesia and India. 

Mr Lopez also pointed to tighter monetary policy as something that could potentially make EM currencies “too good to resist,” alongside other possible catalysts such as measures to weaken the dollar, a pause in the Fed cycle or an end to the nascent trade wars.

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