Conscious uncoupling? EM currencies and the dollar

What are the roles that EM currencies play in driving total returns for investors? Nick Robinson & Kieran Curtis sit down to discuss performance of EM currencies, the dollar and the currencies coupled to it.

Transcript

Nick: Hello everybody and welcome to the abrdn Emerging Markets Equity Podcast. I'm Nick Robinson from the EM equity team. In this podcast series, we explore the factors that underpin our thinking on emerging markets. From key individuals to evolving trends, we seek to answer the five W's: the who, what, where, when, and why, that are shaping investment opportunities in the region. 

In today's episode, we're going to talk about the role that EM currencies play in driving total returns for investors. On the equities team was bottom-up investors in emerging markets, which means that we focus on companies themselves, we tend to spend more time thinking about currency as a source of risk within companies, and how to manage that risk. Often in emerging markets, companies will take out debt in US dollars in order to keep their interest costs low and they'll have local currency revenues and that creates the mismatch. Time and time again and a currency devaluation, companies are caught out by this, sometimes even to the extent it bankrupts them. So, it's a big risk to understand and manage within companies. However, it's also important to consider currency exposures from a more top-down perspective. If you have a large country exposure, then you're exposed to that country's currency and that's going to have an impact on return. So, it's another risk angle to consider. So, joining me today to discuss this is an expert on emerging market currencies, Kieran Curtis. Kieran has been with the firm for just over 10 years. He's the Head of Emerging Market Local Currency Debt. So, he's uniquely well placed to talk about this. Kieran, welcome to the podcast. It's great to have you on.

Kieran: Thanks for having me, Nick.

Nick: Great. Well, let's get going. Yeah, it's hard to have a discussion on emerging market currencies without first talking a bit about what they're measured against, the dollar. So perhaps let's begin there before we dive into emerging markets and get your views on the dollar. And given where we are in the rate cycle, the likelihood really of the dollar, and its propensity to strengthen going forward or perhaps weaken?

Kieran: Yeah, so I think the short story is, it's been going up for a decade, and it's now pretty expensive. So, if you look at things like US wages for comparable industries, and you compare to Europe, which obviously has a most similar structure, the economy to the US, then those wages look look pretty high. And, you know, I've got recent personal experience of travelling to the US and I can testify to just how expensive it's become both the goods and services to be travelling there from Europe. So, and I think the other thing about the dollar is, you know, obviously, capital flows are really what sets the price and US investors, they have been bringing money back home, as far as their investments go for a good chunk of the last 10 years. So, if you look through the tick data, that the US authorities released regularly, but what's going on with capital flows, then you see that US investors have been selling overseas securities, and they've been buying US securities. So, you know, they've been tempted just like many other investors have, by the higher rates of return that have been offered over the last decade or so in, in US securities. Both in fixed income, which probably a more recent thing over the last five years or so, but certainly in equities, where the US stock market has been a super strong performer since the global financial crisis. So, I think, you know, personally, I think there's an open question about how long this will continue. And I think there are some signs that that asset allocation is beginning to slow, starting to hear stories about, you know, American investors move for European real estate, for instance. And, you know, certainly we're seeing, you know, I've seen evidence in trips to Europe with just how many Americans who are there are around in major European cities at the moment. So, you know, there's some signals from the real economy, I think, as well as crunching data that shows that the dollar is pretty expensive at the moment. So if the, you know, if the US rate cycle turns before the rest of the world, then and especially before Europe, then there's a good chance that the dollar continues this relatively more recent trend of weakening, and certainly the, you know, the peak in the dollar that we saw, in around October, November last year, timed very nicely with the market pricing in the peak in the relative rate cycle. Because, of course, European interest rate expectations have gone probably up a bit more than the US, since around October, November last year.

Nick: Yeah, and how do you think about the of some of the other influences on the dollar, be it more kind of related to politics, and macro and that we've just had a pretty significant banking crisis in the US with the collapse of Silicon Valley Bank and the Fed stepping in to support the whole banking sector. And then coming up, we've got this debt ceiling negotiation, I think around June, which could have an impact on risk aversion, how do you see the US performing through those particular events?

Kieran: Yeah, I think this is actually a really topical, because historical experience tells you, the dollar tends to go up with it being a, you know, a safe haven, currency. And, you know, in particular, a currency that, that people tend to borrow. So, you know, during periods of volatility, and when these unexpected risks pop up, then people will repay debt and so maybe they need to buy dollars to do that. And certainly, you know, with, say, rest of the world political events, then often you'll find people will build up, build up dollar balances, rather than their domestic currency balances to offset political risk. So, I think we, you know, we have to respect that historic experience. But I also think it's worth looking for reasons why things might not pan out like this, with this immediate juncture. Now that the dollar doesn't always go up in periods of risk aversion, you know, a good chunk of the lead up to the global financial crisis when the credit crunch was going on, then we actually saw a very weak dollar until the summer of 2008. You know, most fixed income investors would tell you that that credit crisis began in the summer of 2007. So, we do sometimes get the dollar falling and, you know, why would, why would the dollar for so one is just that perhaps we're at the peak of the rate cycle. Another is that US investors, after all, of this selling of overseas securities and buying of US securities, that's what's happened over the last 10 years, then US investors have relatively low exposure to non-US assets. And, you know, that means that they don't necessarily need to liquidate those foreign assets in order to reduce risk. And then another important one is that, since the global financial crisis, the Fed has begun a process of extending swap lines with major central banks outside of the US. And that means that central banks have access to US dollar liquidity that they can pass on to their domestic institutions where there are funding crunches. And this was something that was last used kind of in anger during the COVID crisis and was very effective in in reducing the squeeze on US dollar major US dollar borrowers outside of the US and I think that does reduce the upward pressure on the dollar during some of these typical risk events. So yeah, I think, you know, I'm probably not the best person to say, you know, just how high the risks of the banking crisis are, and exactly what's happening with US politics and the debt ceiling. But I certainly, you know, certainly I'm happy to say that the current point in the rate cycle with some of these changes with the Fed swap lines and how US dollar, US domestic investors are positioned at the moment, that perhaps the upward pressure on the dollar, you might see from these risk events will be lower than we've seen during some of the last 10 to 20 years.

Nick: Okay, thanks. And if we, I suppose, switch our focus now to where more of your expertise lies in terms of emerging market currencies. Yeah, I think we've seen quite a divergence in how some EM currencies have performed over the last couple of years, some of which uncoupling a bit from the other weakness that we've seen elsewhere. Perhaps we could just talk a little bit about those emerging market currencies that have been a bit stronger and what's likely to drive them going forward?

Kieran: Yeah. So in certainly in the last 12 to 18 months, the real outperformance have been Latin American currencies. And I think there's been two drivers for that. So, one has simply been commodity prices that obviously have been pretty strong since COVID and then became especially strong after Russia invaded Ukraine. And the other has been that interest rates went up a lot in Latin America and I think, you know, most emerging market bond investors were pretty early to see this pretty early to tell clients that, you know, interest rates going up very early and much earlier than they did in developed markets, and much further than they did in developed markets was going to be a positive for Latin American currencies and that has proven to be the case. So yeah, we we've seen those be the two kind of key pillars of support. Looking a little bit further back post, immediately post COVID, we have pretty strong performance from Asian currencies. And that was much more driven by manufacturing exports, during that global goods consumption boom, that we had. And as that effect has begun to fade, then we've seen a slightly weaker performance from a lot of Asian currencies compared to other emerging market peers. And of course, Asia also suffered much less inflationary pressure. And so, interest rates haven't gone up as much and that means that currencies perhaps not quite so interesting to investors, because the yield gaps got so big, both with the dollar and even more so with other emerging currencies. So, in the last 12 months or so, the performance of Asian currencies has faded a little bit. And, you know, Latam is really where the shine is.

Nick: Great. And I guess one other issue, though, we're certainly hearing a lot more from companies in Asia, is the return of tourism and travel. And certainly, you know, Asia feels like it's been a lot behind Europe and the US in returning to travel post the end of, of COVID. So, yeah, how's that been impacting some of the currencies there?

Kieran: Yeah, so the type artists been the bellwether for the Asian tourism trade, because tourism is such a large part of, of the Thai economy. And, you know, for a long time, Thailand ran a current account surplus with that tourist income being a major component of that. And then Thailand was actually running a current account deficit post COVID. Partly because of the lack of, of tourism influx. So, the reopening of Thailand, and more importantly, the reopening of China, for outbound tourism, has, has really helped this year. Although, you know, it must be said the enthusiasm of investors has faded a little bit. Thailand has very low interest rates. And you know, that, that probably accounts for why that enthusiasm has faded a bit. I think it's worth mentioning some of the rest of the world as well, because, you know, they are small countries, but we've seen quite a bit of strength in in Caribbean currencies, those ones that are not pegged to the dollar. So, places like Dominican Republic and Jamaica, we've seen some quite notable strength from those currencies in in the post COVID environment. And because they didn't have the restrictions on incoming tourism for very long, then the trend started much earlier. And the last thing on tourism that's quite important, has been in Eurasia, countries that have been exposed to or been able to gather tourists from Russia. Obviously, lots of potential destinations for Russian tourists have in various ways been blocked off. And so, countries like Georgia, have an even Turkey actually also benefited quite a bit last year from inflows of Russian tourist money. So, it has definitely in the post COVID era, the ability to take tourists in has been a you know, a big boom for certain countries.

Nick: Thanks, and you mentioned Brazil earlier, and perhaps it would be interesting to dwell on that for a minute, in terms of Brazil probably stands out at the moment as a country where real rates are still very high yet inflation is falling very quickly. And we've also got some quite complicated politics going on at the moment with a return of Lula, do you think you're in the against the backdrop of a dollar, that's has a propensity to perhaps weakened from here, Brazil could still hold up given the rate at which rates are falling, or potentially likely to fall?

Kieran: Yeah, so we still really liked the Brazilian real. And the real rate story is, is, frankly, the biggest support for the currency. And then more recently, that real rate story has been driven by falling inflation rather than bigger increases in interest rates, the interest rate cycle is now more or less over. And even when interest rates begin to fall, then it's very possible we see fixed income inflows, you know, foreign investors looking for capital gains on bonds, continue to support the capital account, and continue to support the evaluation of the real. So, falling interest rates, because they're at such a high level. And because inflation has fallen so far, then it's not necessarily going to be a bad thing in the short term for the currency. I think, you know, what we see in terms of impact of politics on Brazilian currency, and interest rates, it tends to be more short term than in some other emerging markets. The Brazilian domestic investor base is very hedge fund, like, and so they move pretty quickly. Positions go a long way and then they get squared up. And I think the biggest story with politics, frankly, is, is the independence of the central bank. Note that any fiscal concerns just mean, the central bank is more likely to keep interest rates higher for longer. And, you know, that will increase the rate of return on investments in in Brazilian real, just by monetizing those higher interest rates. So I think, ultimately, that that's what the driver is, is going to be. Now has been some discussion about removing the operational independence of the Brazilian central bank, they looks very much to us like this is no grandstanding by Lula in order to retain the option to blame any economic weakness on the central bank, rather than because there's actually a desire to change what's been a pretty successful kind of structural policy in Brazil to have the central bank operationally independent. 

Nick: Yeah. Hopefully, they're looking at the example of Erdogan and Turkey in terms of what happens when central bank independence gets thrown out the window.

Kieran: Yeah, Turkey, you know, obviously, well, you know, Turkey, I think is the, you know, one of those stories, which reminds us that purchasing power parity is very important in emerging markets, because the price level can diverge a long way over time. And so, you know, Turkish monetary policy has been very stimulative of inflation, very low interest rates and lots of micromanagement. And you know that inflation accumulates over time. And so, it means that we will end up with continued devaluation episodes or, you know, fairly rapid trend depreciation of Turkish lira against his trading partners. So, you know, despite the potential, you know, arguably very cheap levels for the lira, then the price level increases so quickly, is basically very difficult to gain any profit from medium to certainly long-term allocations in the lira, unless interest rates were to go much, much higher.

Nick: Perhaps if we go to the other end of the spectrum and talk about those currencies, which are completely coupled still, to the dollar. So those currencies, which are which are pegged, like Hong Kong and the Middle East, do you have any, any thoughts on the likelihood that those pegs are going to continue?

Kieran: So, for those, I mean, certainly for those countries that you mentioned, there's a lot of financial capacity to support those, those pegs in the Middle East, we've got high energy prices at the moment, you know, very high current account balance of payments surpluses. And, you know, in China collectively, then there's also you know, clearly, really strong balance of payments, very, very strong exports, etc, trade, trade surpluses, and also enormous reserve positions in all of these countries as a share of GDP. So, there's, there's really no need for them to remove what's been a very successful policy of pegging to the dollar so, so we wouldn't expect it to happen. Where we have seen pegs come under pressures and pegs and quayside pegs. It has been in frontier markets, where the financial capacity to support them is much more limited. And, you know, perhaps inflation domestically has been higher than in the US. And so, you know, there is some requirement for basically a competitive devaluation. So, yeah, we don't see that trend, ending in the very near term, we still think frontier market pegs can come under quite a bit of pressure. But yeah, for the major, very wealthy countries in emerging markets that are running US dollar peg policies that seems very, very little reason to change that.

Nick: Great. Well, that feels like a good place to draw the podcast to a close. So, thank you, Kieran, very much for joining. It's been a real pleasure having you on.

Kieran: Thanks, Nick. Always good to chat and happy to do it anytime.

Nick: Thanks. And thanks to everyone who took the time today to listen in. If you enjoyed today, then please download our other podcasts from our website, or wherever you normally get your podcasts. Watch out for our next episode and tune in.