Commentary: On Emerging Market FX --- Invest Selectively
Against other majors, the dollar is set for a bull run. Europe is
not going to blow up, but it is going to muddle along for years before
it can achieve meaningful growth. CAD and AUD offer both yield a AAA
sovereign rating. However, as rates rise stateside, and sentiment
improves, both of these relative advantages will diminish. And I don’t
think we need even mention the JPY. At the same time, in PPP terms, emerging market currencies continue
to trade at a discount. Certainly, demand for assets denominated in emerging
market currencies is also a huge driver of FX rates, and ultimately is a
reflection of investor risk appetite. Therefore, it will be interesting to see
how emerging market currencies behave in the next five years. The Fed
will almost certaintly keep rates low until in hits its 6.5 percent
unemployment threshold. From here until then, risk appetite is bound to
increase as the economy continues to chug along. At the same huge
interest rate differtials will continue to persist. So in the short to
medium term, emerging market currencies look well positioned for further
gains. When the Fed finally starts unwinding its balance sheet,
probably around 2017, some capital will come home, but investors will
still look to emerging markets for growth, barring some meltdown, for decades to come. However, taking into account the two major factors which drive emerging market FX, namely yield differentials and demand for assets denominated in EM currencies, it would be wise to invest selectively. INR and ZAR are trading at huge discounts in PPP terms against the dollar. This fact however probably does not make either of these currencies attractive longs, as both India and South Africa continue to face big challenges that threaten future medium term growth. India has disastrous government finances, high inflation, and a growing current account deficit. South Africa faces internal labor and political strife, growing twin deficits, falling precious metal prices, and weak demand in its main export market, Europe. So in short, despite what the Economist'sBig Mac index says about these currencies, they are trading at a discount for a reason. The fact that significant downside risks have been priced into these currencies does not make them 'undervalued.' If anything, I seen the Rand falling even further, perhaps even to 10 to the USD.
In sum, the secret to playing emerging markets are research, due diligence, and patience. EM currencies are riskier than majors, since the underlying economies are more vulnerable to both internal and external shocks. The key is take advantage of this risk premium while minimizing potential downside. This can only be done by copious amounts of investigation and homework into the EM currency which catches your fancy. Do not fear risk, embrace it, and channel your passion into the enhanced due diligence required to take greater risks. And reap the rewards.
At the same time, in PPP terms, emerging market currencies continue to trade at a discount. Certainly, demand for assets denominated in emerging market currencies is also a huge driver of FX rates, and ultimately is a reflection of investor risk appetite. Therefore, it will be interesting to see how emerging market currencies behave in the next five years. The Fed will almost certaintly keep rates low until in hits its 6.5 percent unemployment threshold. From here until then, risk appetite is bound to increase as the economy continues to chug along. At the same huge interest rate differtials will continue to persist. So in the short to medium term, emerging market currencies look well positioned for further gains. When the Fed finally starts unwinding its balance sheet, probably around 2017, some capital will come home, but investors will still look to emerging markets for growth, barring some meltdown, for decades to come.
However, taking into account the two major factors which drive emerging market FX, namely yield differentials and demand for assets denominated in EM currencies, it would be wise to invest selectively. INR and ZAR are trading at huge discounts in PPP terms against the dollar. This fact however probably does not make either of these currencies attractive longs, as both India and South Africa continue to face big challenges that threaten future medium term growth. India has disastrous government finances, high inflation, and a growing current account deficit. South Africa faces internal labor and political strife, growing twin deficits, falling precious metal prices, and weak demand in its main export market, Europe. So in short, despite what the Economist's Big Mac index says about these currencies, they are trading at a discount for a reason. The fact that significant downside risks have been priced into these currencies does not make them 'undervalued.' If anything, I seen the Rand falling even further, perhaps even to 10 to the USD.
In sum, the secret to playing emerging markets are research, due diligence, and patience. EM currencies are riskier than majors, since the underlying economies are more vulnerable to both internal and external shocks. The key is take advantage of this risk premium while minimizing potential downside. This can only be done by copious amounts of investigation and homework into the EM currency which catches your fancy. Do not fear risk, embrace it, and channel your passion into the enhanced due diligence required to take greater risks. And reap the rewards.