During the past few months, there seems to have been a sea change in emerging-markets investing that has caused a broad retreat in those countries’ currencies. Volatility has shot up, and strategists are scrambling to reduce their exchange rate targets for the rest of the year. “Overall, the appeal of emerging markets as a growth trade appears to have come to an end,” says Bartosz Pawlowski, head of strategy for Central and Eastern Europe, the Middle East and Africa at BNP Paribas in London. “There has been a significant slowdown in many emerging economies, and that makes asset allocation decisions skewed toward the U.S. or developed markets.”
Many strategists say the rout really got going after U.S. Federal Reserve chairman Ben Bernanke’s May 22 remarks that following years of quantitative easing, the Fed “could take a step down in the next two meetings” if the data merited it. Bernanke then pulled the rug out from under emerging-markets currencies on June 19 by predicting an end to the Fed’s bond-buying program by next year. “Talk of tapering off QE basically completely screwed the carry trade in emerging-markets currencies,” says Ilan Solot, currency strategist at Brown Brothers Harriman & Co. in London, referring to the practice of borrowing a low-yielding currency to buy a higher-yielding one. “You can’t have a carry trade in volatile markets, and the markets are now very volatile, with big moves in just a couple of days.”
Pawlowski says that although many institutional investors remain committed to emerging-markets debt, hedge funds and other “fast-money investors” have liquidated their positions, causing huge swings in emerging-markets currencies. Those economies had already been weakening for some time. Pawlowski points to a notable downturn in developing countries, especially Brazil, India and South Africa, which reported lower-than-expected first-quarter growth. These slumps were all traced to the slowdown in China, a buyer of emerging-markets exports, primarily commodities.
Between the start of May and mid-June, the Brazilian real fell 11 percent against the U.S. dollar, the Polish złoty slipped 2.5 percent, and the Indian rupee dropped 11 percent. The declines were so severe that the Polish and Brazilian central banks intervened to prop up their currencies and the Reserve Bank of India reportedly entered the market in support of the rupee. “We no longer believe there is upside in emerging markets this year,” says Benoît Anne, London-based head of emerging-markets strategy at Société Générale Cross Asset Research. “We have adopted an extreme bear case.”
Simon Derrick, London-based chief currency strategist at Bank of New York Mellon Corp., says a fundamental change of attitude toward the U.S. dollar has been in the works since the second quarter of 2011, with many emerging economies registering declining dollar foreign exchange reserves. Three of the next six quarters saw net outflows from emerging markets’ reserves, while the others averaged net inflows of just $152 billion, versus $313 billion for the second quarter of 2011, Derrick notes.
Are there any emerging-markets FX strategies left for investors? SocGen’s Anne recommends shorting what he calls the laggards. For example, the Hungarian forint eked out minor gains against the dollar while every other emerging-markets currency except the Chinese renminbi was falling off a cliff. The idea is that some currencies have yet to feel the effects of the strengthening dollar but probably will soon. “The recent HUF outperformance is unlikely to be sustainable and is likely to be reversed,” Anne says. Another candidate is the Russian ruble, which he believes is due for a fall.
BBH’s Solot suggests staying away from nearly all emerging-markets plays that involve the greenback. But it’s still possible to make relative-value trades that take the volatility out of the market, he asserts. Such trades involve shorting one emerging-markets currency against another. Solot’s advice: Use the forint and the rand against currencies that aren’t likely to lose as much, such as the Turkish lira or the Indonesian rupiah.
Doing two separate trades is another option. If investors wanted to go long the Mexican peso against the rand, for example, they could go short the U.S. dollar versus the peso and long the dollar against the rand. “You can do the two ends of the trade with the dollar opposing,” Solot says. “You bet against dollar appreciation with one trade and against depreciation in the other.”
BNP Paribas’ Pawlowski favors buying the forint against the złoty because the Hungarian economy still seems to be doing fine. Another relative-value trade he likes is the Turkish lira against the ruble: He thinks the Turkish central bank has deftly handled the economy and that recent unrest won’t lead to a deterioration of the currency.
Even if the Fed doesn’t seriously begin tapering off QE until year-end, emerging markets face a struggle to convince investors that their economies can grow as fast as before. As these markets export less and key countries like China cut back on commodity imports, their currencies appear likely to remain volatile through 2013. • •
