In this piece we compare two ways to take advantage of the USD's richness versus emerging market currencies: EM equities and EM local currency debt. We believe that for relative value, diversification, and potential alpha reasons, EM local currency debt deserves a prominent place in portfolios today.
The USD takes roughly decade-long swings relative to global currencies, wielding a significant impact on returns to USD-based assets relative to non-USD assets. When the dollar is cheap, as it was around 2011, its rise drained returns to foreign stocks and bonds. But, when it's rich, as it is now, its decline portends a boost.
Exhibit 1 looks at non-USD asset class returns in the left chart and isolates FX spot returns of those same asset classes on the right chart during two periods in history: the 2003-2011 period, when the USD's decline from expensive levels boosted returns to foreign equities and bonds; and the more recent 2011-present period, when a cheap USD's rise did the opposite. Comparing the two periods, the USD's recent rise cut the Sharpe ratio of local debt from 1.0 to -0.1 and emerging equities from 0.8 to 0.
The second chart highlights how different the baskets of EMFX are among EM equities and EM local currency debt. EM equities (MSCI EM) are made up predominantly of Asian currencies that over history have been either pegged or managed relative to the USD. This has resulted in lower USD-relative volatility of the MSCI-EM basket. The local currency debt basket (GBI-EMGD) has been the most volatile, comprising over its history Latin American currencies as well as CEEMEA, of which many of the latter are more tethered to the euro. Until China joined GBI-EMGD in 2020, Asia was only about 30% of GBI-EMGD. In both cases, the return/volatility ratios fell sharply during the USD rise period relative to the USD decline period: from 0.5 to -0.7 for local debt and from 0.8 to -0.1 for EM equities.
Going forward, we see many factors currently in place that are bullish for EM local debt—arguably the best set of conditions we have seen in twenty years, based on valuations, diversification considerations, and alpha potential.
Exhibit 2 shows the USD's expensiveness in general on a Behavioral Equilibrium Exchange Rate, both against EM equities (MSCI EM) and EM local currency debt (GBI-EMGD). This valuation metric adjusts the real exchange rate for structural changes in the underlying fundamentals over time (rising per-capita GDP, terms of trade, productivity, and inequality, among others). After all, these countries are emerging, so the expectation of mean reversion on an unadjusted PPP (real exchange rate) model can sometimes be unrealistic; the Behavioral Equilibrium Exchange Rate is more useful in that respect.
After valuation, we identify two other factors that are generally supportive of returns to EM currencies: interest rates and growth differentials.
On interest rates, Exhibit 3 shows average nominal and real interest rates by the local debt and EM equities baskets. In both cases, current interest rates are essentially back to the 2004-2011 average, offering high total return potential above spot FX appreciation. It's extremely rare to get this combination of cheap currencies with high rates – and it doesn't generally last long.
As an aside, we observe that local debt rates are always higher than EM equity rates, again due to compositional differences given that Asian currencies are typically lower yielding than those in Latin America or CEEMEA. This latter fact relates to the relative stage of development of local capital markets. An increasing number of GBI-EMGD countries have become more and more comfortable with conventional inflation-targeting policy regimes. It goes hand-in-hand with the development of their local capital markets, which provided reliable funding sources in the Covid-shock era and beyond. Seeing the benefits, we believe countries will continue on the path of market communication, transparency, and orthodox monetary policy, which is likely a very positive relative structural backdrop for the local debt countries relative to the EM equity countries.
Continue reading with original charts here.
