The Turkish lira has been plummeting, with its exchange rate vs the dollar reaching over 10 for the first time. The lira has been a drag on an EMFX space that otherwise held up well with the Federal Reserve set to tighten policy.
Latest news on EM FX
- Turkey has been grabbing the headlines, perhaps weighing on broader EM sentiment as markets bet on the CRBT to continue to ease despite soaring inflation.
- Rising commodity prices have been a differentiator among EM currencies with exporters outperforming importers.
- Most EM currencies have managed to make a comeback this week on a fruitful Biden-Xi meeting as traders position for a reduction in tariffs.
- Additional gains were printed as investors cheered the latest default payment from Evergrande.
- For EM upside to persist, it will need to do so despite relatively upbeat US economic data, including the October retail sales figures.
Emerging market currency index
The MSCI Emerging Market Currency Index chart hints at recovery from the October low and has recently bounced off the 50-day SMA. But it has overall been trading sideways for the second half of the year.
Figure 1 - MSCI Emerging Market Currency YTD Chart (SMA 50D)
The range bound nature of the MSCI EM Currency index in 2021 belies some of the differences in performance between individual currencies.
What drove emerging markets this year?
While most developed central banks are expected to keep rates steady until the end of the year (and well into next), a number of EM central banks - especially in Central and Eastern Europe - have already started the normalisation process in response to rising inflation pressures.
Source: VanEck / Bloomberg
Poland was the first to start the hiking-cycle, the Czech Republic, Romania and Hungary followed suit, and South Africa was the latest to tighten.
In general, EMs ‘carry’ trade is still in place with near zero rates across the developed world but has become less appealing to forex traders as inflation in the US keeps rising, giving rise to expectations of higher US interest rates.
The massive rally in commodity prices created by supply shortages and delayed demand from economies under lockdown has been a boon for exporters but an issue for importers.
Concerns around a slowdown in China have weighed on Asian currencies, including commodity exporters. Commodities and economic reliance on China goes a large way to explain the wide divergence in performance across EMs this year.
Source: Unigestion, Bloomberg (26/10/21)
What matters for EMs now?
Getting through the last Covid spike in winter and possible lockdowns might be needed before it becomes clearer where the policy normalisation will happen quickest. The speed of vaccination rollouts will continue to affect the relative performance within the EM space.
Commodity suppliers continue to be beneficiaries of higher commodity prices. The reduction in supply chain bottlenecks as we move into 2022 should start to weigh on commodity prices, enabling importers to get back into their stride, providing a more straightforward path for the MSCI EM index.
Developed countries’ interest rates have been glacially slow to react to higher inflation and this has put a floor under EM currencies. The rate differential will need to remain high (ie low DM rates) for EMs to extend into a more durable rally. The longer “transitory” actually is, the better from the perspective of EM bulls!
Asia: Supply chain bottlenecks, slow vaccination rates and worries of Covid contagion in China are keeping Asian emerging markets down. This region offers some of the best value on a PPP basis.
Central/Eastern Europe: The environment in central Europe is the most bullish for EMs overall but individual plays on CE currencies continues to offer more opportunity than trading the EM index. Furthermore, Central Europe might act as a trigger for hikes in South Korea, Peru, and even Russia as inflation gets ‘hotter’. Turkey remains the exception with politics opposing the rational economic response to higher inflation.
LATAM: Mexico has been relatively quiet and given the close economic ties with the US, will likely lead any future taper tantrum were the Fed forced into a faster pace of tightening than currently suggested.
Extra EM risk factors
One EM risk is the potential issues between Russia and Ukraine and the rebalancing of crude oil prices in the first half of the year. Another is elections in Chile, the biggest producer of copper, and one of the candidates would like to severely restrict the economy, while the other tries to return to pro-export.
Higher inflation is more likely to be supportive than damaging of emerging markets as developed market central banks are more likely to keep rates low, leaving surging inflation to keep fueling negative real rates. The Fed taper was very well telegraphed so without the tantrum, the premium to invest in EMs is smaller than in DMs.
Any of the main DM CBs quickening the move to tighter policy could get inflation under control. But if they tighten too much or too fast, there could be a correction in the global economy, which would have a bigger impact on emerging markets.