Is it time to buy Emerging Markets?

The recent sell-off in many Emerging Market currencies and bonds has led to a sizeable outflow from EM funds. As this article in the FT points out, the bad performance has lasted since 2011 and the JP Morgen EM currency basket which tracks the 10 most important EM currencies has reached new historic lows.

Is this a new secular low and therefore time to pile into EM assets?

Not so fast. While it is true that I have taken the opportunity to accumulate RUB assets in the recent sell-off (here) and I start to see value in places like Brazil, it is also true that many Emerging markets have yet to crash (notably: Turkey, Nigeria, China…). These things usually end with a bang and there has been no bang yet, merely weakness

In other words, I believe this to be a relative value market environment, not a secular bottom which is why I prefer to trade around positions while keeping a sizeable portion of cash.

There are two reasons for my scepticism:

  1. The unresolved external debt problem of many EMs (estimated at USD 9-10 trillion)
  2. The technical market positioning

While there has been much focus on the former and there is no need to dwell on this topic (see my short post from last year) now, the article has opened my eyes as regards the latter.

Just look at this chart,


The red line depicts the development of the spot rates comprising the JP Morgan EM currency index. It is at an all-time low and suggests an undervaluation of historic proportions. As usual, you have more and more “experts” coming out and explaining how this is a “historic” buying opportunity. I have no doubts that many a private banking client is shown a version of this chart by his financial advisor as I write this piece.

The second line (rose/orange) shows the performance of a carry strategy applied to said basket taking the interest rate differentials into account. I observe that despite recent disappointing performance, most carry traders are either sitting on long-term gains or on small losses such that making them up must still feel feasible for most.

Carry trading has historically been a highly volatile strategy. But having a healthy risk appetite is merely a necessary not sufficient condition in investing. In order to be long-term successful, one has to be able to avoid the “permanent loss” disasters such as devaluations and sovereign defaults that characterize many of these markets. It is not to be expected that buying and holding a basket of high yielding currencies will positively compound capital in the long-term, as it has since the start of the millennium. This is consistent with Interest rate parity theory which suggests that on average, no returns from holding high yielding currencies can be expected.

Now we know that as a result of its “success” until 2011, carry trades have gone mainstream with many retail investors and institution piling into financial products promising to escape low DM interest rates in recent years. Experience tells us that these newcomers neither have the stomach for high volatility, nor the ability to successfully differentiate between markets. Most of them are starting to experience the high volatility nature of carry trading. You will know the market has bottomed when permanent losses are realized…



One comment

  1. Dear B,

    An excellent chart indeed, providing useful ‘2nd degree’ context around the ‘1st degree’ outright analysis. But on that point I would urge adding an additional metric which would provide yet another layer of relative value context and make a valuation argument – in as far as one can be made in FX.
    In order to gauge whether the path of carry-adjusted FX rates over 15 years is ‘cheap’ or ‘rich’ or somewhere in between you need a yardstick for the measurement. I would suggest GDP growth rates at PPP, data which can be found here:

    Without looking at actual numbers in detail, my guess is that on that measure a selected basket of EM currencies will look ‘cheap’ relative to GDP growth even after adjusting for carry returns. RUB, BRL, PLN, ARS and some african FX have been at numerically interesting levels in recent months. I believe that a substantiated RV analysis would supply equally strong ‘valuation’ arguments for investing.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s