Five reasons to snap up EM currencies

With developing market exchange rates undervalued, John Stopford, co-head of fixed income at Investec Asset Management, outlines why EM currencies look attractive.

Emerging market currencies fell sharply during September after holding up pretty well through August. Developing market exchange rates even lost ground against the euro, despite Europe being the focus of market fears.

Increased risk aversion and rising pessimism about the global economy drove investors to cut positions, and the lack of market depth exacerbated falls in emerging currencies.

Have exchange rates now moved far enough to be a clear buy? From a longer-term standpoint we think the answer is yes because the structural arguments for medium-term emerging currency outperformance are compelling. They are as follows:

1. Exchange rates are undervalued by about 15% on average using our preferred measure of purchasing power parity.

This valuation discount should gradually unwind over time. The relative cheapness of emerging currencies is underlined by strong balance of payment positions in most cases.

2. Stronger economic growth should also support higher real exchange rates over time. The so-called Balassa-Samuelson effect suggests that emerging currencies will trend higher thanks to their superior growth prospects relative to developed economies.

3. Improving quality versus developed markets should support continued capital flows into emerging markets. Most developing economies have implemented market friendly policies since the late 90s. This is in marked contrast to the developed world where unsustainable imbalances have built up.

Since the credit crisis, old notions that developed markets are safe, their economies sound and the currencies hard have all been called into question. This appears to have accelerated structural portfolio diversification away from the old world towards the new.

4. This process of diversification away from the ‘old’ world and into the ‘new’ still looks to be in its infancy. Core holdings in emerging markets have risen, but from very low levels and do not reflect the growing importance of these economies.

The developing world now accounts for about one third of global GDP and its share has grown by around 70% over the last decade and looks set to increase quickly in coming years. Meanwhile developed economies will likely struggle under the burden of excessive debt levels and poor demographics.

5. Emerging markets also tend to offer a significant real yield premium over developed markets. This reflects compensation for historically higher risk, but in general debt and policy trends suggest relative risks in the emerging world are diminishing.

Reflationary monetary policy in developed markets is likely to encourage investors to reach for yield and to prefer currencies with less expansionary policy settings.