Executive Summary
Emerging equities are more volatile than developed market equities. This owes little to the volatility of emerging stock markets in local terms and much more to the strong positive correlation between their local stock markets and movements in their currencies. The spring of 2018 was a classic example of this, with US dollar strength driving significant emerging weakness. Emerging markets do exhibit momentum, so it would not be odd for the weakness to persist for another quarter, although after transaction costs the momentum effect is probably not capturable. Our analysis of the underlying fundamentals for emerging markets, on the other hand, gives us confidence that the assumptions behind our forecasts are sound and emerging value stocks represent the most attractive asset we can find by a large margin, and in the longer term we believe valuation is much more predictive of returns for emerging than momentum is. Our models do not take into account the potential effects of a trade war, but while a trade war is presumably a negative for emerging assets, it should arguably be at least as negative for US assets and seems unlikely to change much about the relative attractiveness of emerging markets in global portfolios.
Emerging markets had a really lousy second quarter. This was true for pretty much any index with “emerging” in the name, regardless of whatever other words were there along with it. MSCI Emerging Equities (EM) was down 8%. The JP Morgan EMBI Global Diversified Bond Index (EMBI) hard currency bond index was down 3.5%. The JP Morgan GBI-EM Global Diversified+ local debt index (GBI-EM) was down 10.4%, and the JP Morgan ELMI Plus emerging currency index (ELMI) was down 5.8%. With the S&P 500 up 3.4% for the quarter and MSCI EAFE down a tame 1.2%, it was therefore a pretty tough quarter for our asset allocation portfolios given our large bias toward emerging securities and against US equities.1 Whenever we have a quarter like this we react by looking at what happened, why it happened, and whether it poses a challenge to the assumptions that caused us to have the biases in our portfolios in the first place. In this case our analysis suggests that what has happened is not particularly out of line with other historical events in emerging markets. The event shows starkly the distinction between emerging and developed markets and is a demonstration of why we consider emerging markets to be riskier than other assets that we invest in. Momentum has historically mattered in emerging markets, so there is some reason to expect that there may be more pain to come in the short term. However, nothing that has happened in the markets or to the underlying fundamentals causes us to doubt our longer-term thesis that emerging markets are the best investment opportunity available today by a substantial margin.
So what happened last quarter, and why were emerging markets hit so hard? Simply put, it was a very strong quarter for the US dollar (USD), with the DXY dollar index up 5%.2 That is a 1.1 standard deviation event, which makes it a little out of the ordinary, but not a true outlier. It probably comes as no surprise that when the USD rises, the US stock market outperforms non-US markets. But what makes emerging markets unique is the fact that this doesn’t simply occur due to the currency
translation effect. This quarter, for example, the currency basket of MSCI Emerging fell by 4.8%, precisely the same as the fall for the currency basket of MSCI EAFE. In other words, while some specific emerging currencies fell a lot in the quarter – the Turkish lira fell 13.4% and the Brazilian real fell 10%, for example – you’d be hard-pressed to call this a general case of emerging currency weakness so much as USD strength. But while MSCI EAFE rose 3.5% in local currency terms, slightly outpacing the rise in the S&P 500, MSCI Emerging fell 3.5% in local currency terms. This is par for the course. It is only a mild overstatement to say that the basic difference between the developed world and the emerging world is that when a developed world country has a declining currency, all else equal that is good for that country’s stock market, whereas when an emerging country has a declining currency, all else equal that is bad for that country’s stock market.
This is true over and above the fact that emerging market currencies tend to have a positive beta – that is they tend to rise when global stock markets are rising, and fall when stock markets are falling. Some developed market currencies, like the Australian dollar, also show a positive beta, although other “safe haven” currencies like the Japanese yen and Swiss franc tend to do well when global stock markets are falling. Exhibit 1 shows the correlation between currency and local stock market movements for 35 developed and emerging markets after we remove the effect of co-movement with the S&P 500.3
Two-thirds of developed currencies have a negative correlation with their local stock markets, and the figure for EAFE as a whole is -0.2, whereas every single emerging market of those listed above has a positive correlation, and the figure for MSCI Emerging is 0.6. This correlation is arguably the reason why emerging markets are more volatile than developed markets in the first place, as we can see in Exhibit 2.
In local terms, MSCI emerging has been almost exactly as volatile as the US or EAFE markets since the end of 2009, but due to the strong positive correlation between the local returns and the return to emerging market currencies, the volatility in US dollars is significantly higher than for the S&P 500 or EAFE.
But while this explains the riskiness of emerging at a surface level, it doesn’t do much to tell us why the correlation is so positive or whether that volatility is a symptom of truly greater fundamental risk or not. Carl Ross, a senior member of GMO’s emerging debt team who leads our sovereign market analysis, notes four channels in which a falling currency could plausibly have an impact on the local economy or stock market, and these are summarized below.
Debt service channel
Insofar as a country has debt denominated in US dollars or other hard currencies, a falling currency can make debt service costs more onerous, hurting the economy or corporate cash flow directly. This is not a material issue in the developed world, as the vast majority of debt in developed economies is denominated in the local currency. But emerging countries do borrow in foreign currencies. The trouble with this explanation is that the interest on that debt is just not that high as a percent of GDP, as we can see in Exhibit 3.
At a current interest cost of 1.2% of GDP, a large 20% devaluation would have an impact of about 24 basis points of GDP – not completely immaterial to be sure, but a small fraction of the volatility of emerging GDP growth. When you take into account the impact of foreign currency revenues from exports, which will have increased in local terms given the devaluation and helped cash flow, as well as the generally large foreign exchange reserves of many emerging countries, it is hard to see this as a particularly material impact.
Trade channel
A lower exchange rate will make exports more globally competitive and imports more expensive. While you would expect some winners and losers across companies from this shift, in aggregate the corporate sector should be a net beneficiary, while the household sector would be more of a casualty. The corporate sector produces the bulk of exports whereas households consume a large fraction of imports, so the corporate sector benefits and households are worse off. This is the effect that appears to predominate in the developed world, driving negative correlations between stock markets and currency movements. In principle it should also exist in the emerging world, although it goes in the opposite direction of the effect we see. One possible issue that impacts emerging countries with this channel is that if the country acts simply as an “assembler” – putting together devices such as smart phones or computers – the import content of exports is very high and the local value-added is small as a percentage of exports. But even in such a case, a lower currency should certainly improve the competitive position of whatever value-added is produced locally.
Monetary policy channel
A falling currency will, all else equal, cause inflation to rise in that country due to rising import prices and likely price rises from domestic companies that compete with imports. In a country with well-anchored inflation expectations this inflationary kick would probably seem like a one-off event that a central bank can safely ignore.4 But inflation expectations are less well-anchored in the emerging world, and a central bank may well feel forced to tighten monetary policy to protect against rising inflation or simply to bolster the currency itself, despite the fact that the falling currency was probably a sign of a weakening economy in the first place. This pro-cyclical monetary shift would tend to make downturns worse than they otherwise would be, because central bank orthodoxy holds that monetary stimulus is the appropriate response to economic weakness. Given stock markets generally do poorly in times of economic weakness, this effect works in the direction we see empirically.
Portfolio channel
A falling currency can cause both local investors and foreign investors to flee a market. In the case of foreign investors, this is a fairly simple case of investors acting like momentum traders. The falling currency means foreign investors are experiencing losses measured in their home currency, and many investors react to losses by increasing their estimate of the riskiness of the investment that just lost money and decreasing their expected returns to the investment. Higher risk and lower return are obviously a bad combination, and as a consequence we see selling after currency losses. Local investors, who Carl points out in many cases measure their wealth in USD terms in the first place, can react negatively to the perceived loss of wealth and try to get money out of the country into “safer” investments.
In aggregate, this leads to a somewhat mixed picture where it’s easy to imagine that emerging currencies and stock markets should be less negatively correlated than developed markets, but frankly it doesn’t seem to justify the strong positive correlation we actually see.
But what does this mean for the future?
Clearly, if the USD continued to strengthen, it would be a negative for emerging markets. Will it happen? It is hard to dismiss the possibility. A strong US economy and rising interest rates are more likely to be associated with an expensive USD than a cheap one. But on that front, it’s worth recognizing that the USD is already pretty expensive, as we can see in Exhibit 4.
After last quarter’s rally, the USD is 0.8 standard deviations overvalued on a trade-weighted purchasing power parity basis.5 Over the last 20 or so years, it has gotten more overvalued than that on two occasions, peaking out at about 1.5 standard deviations expensive, or about 9% higher than its current level. If that were to happen, we believe you might expect it to cost emerging equities another 15% in total performance as a bear case scenario.6 On the other hand, even with relatively high interest rates to buoy it, 0.8 standard deviations is reasonably far above fair value, and we would expect weakness from here to be more likely than strength.
What else can we say about the potential future for emerging based on last quarter’s events? Exhibit 5 shows the correlation between currency movements and stock market returns in the previous quarter and following period returns for emerging markets.
Currency returns themselves seem not to matter at all, with a correlation of effectively zero out to two years. So, there is no reason to believe that the currency moves from last quarter tell us much. Total returns for emerging do have some power, however. There is evidence of short-term momentum in emerging markets with a correlation of 0.12 between last quarter’s return and next quarter’s. For an 8% move such as we saw last quarter, the momentum effect suggests next quarter’s return could be about 1% worse than average. Given that the round-trip trading cost for an emerging market portfolio is somewhere in the realm of 50 to 200 basis points, that’s an interesting effect, but not obviously an exploitable one. When we look at the correlations for a simple valuation metric, however, you can see why we tend to be more enthusiastic about value as an asset allocation tool. This is shown in Exhibit 6.
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