23 mars 2017

What Drives the Emerging Currency Rally?

March 23, 2017, Jean-Jacques Ohana, CFA and Dr. Christian Witt (both YCAP Asset Management)

Against all odds––most notably fears of protectionism––emerging currencies (against the USD) were among the biggest winners at the start of 2017 (see Figure 1). What a change of fortune! No other currency illustrates this trend reversal better than the Mexican Peso (MXN). After Trump was elected US President, the MXN tanked -11.9% over the following three trading days. But since the turn of the year, the currency has risen like phoenix from the ashes. So, have political risks suddenly subsided or is something more fundamental going on behind the scenes?

Subsiding global political uncertainty has certainly played a role––at least in the case of the Mexican Peso. As Figure 2 shows USD strength and the level of uncertainty have been substantially intertwined over the last couple of years. However, the link to political uncertainty substantially weakens once other emerging country currencies are accounted for as well (see Figure 3). Thus, other factors are undoubtedly worth exploring, too.

One such factor is the global business cycle. Since many emerging economies are export-dependent countries, they are an indirect bellwether of global activity. For if global growth stutters, struggling external demand for their products (commodities being one of the most important!) would weigh on emerging currencies more generally. What is more, evidence strongly corroborates this line of reasoning. Figure 4 illustrates that the carry trade return of a basket of eight emerging currencies (AUD, BRL, KRW, MXN, RUB, TRY, ZAR) closely follows the course of the ISM purchasing managers index (i.e. ISM Manufacturing), a popular proxy for the US business cycle. The same basket of currencies also moves in lockstep with an index of spot commodity prices (see Figure 5), another much-loved indicator of global economic momentum. Given the outstanding relevance of the US consumer and commodity exports for emerging countries, both measures support the view that emerging currencies are a mirror of the global economy. If the global business cycle improves (deteriorates), emerging currencies gain (lose).

Another insight from Figure 4 is that emerging currencies offer superior way to invest into commodities––an issue first raised here nearly three years ago. This is because the total return a basket of commodities can generate may be tremendously reduced by a negative roll yield. A smart way to mitigate this undesired property is to construct a « hybrid » portfolio of liquid financial instruments which better tracks the spot price of commodities. One potential substitute is a basket of currencies which is (1) highly correlated with spot commodity prices at all times, but (2) less exposed to lengthy contango periods as commodity futures. In our initial research note, we proposed a « hybrid » solution composed of commodity-related currencies as well as equities to track the performance of commodities. Fast forward to today, we can state the approach has beaten most of our expectations. Our proprietary « hybrid » index has closely tracked the outstanding performance of commodities between 2002 and 2008 during a lengthy backwardation episode just to beat the commodity index by a wide margin during the subsequent contango phase (see Figures 6 and 7). Since our « hybrid » index further closely resembles a basket of emerging currencies both in performance and technical terms, the latter should likewise offer a superior approach to add commodity exposure to investment portfolios.

Taken together, the recent rally of emerging currencies is arguably the result of an accelerating global business cycle. Subsiding political uncertainty may have also played a rule but to a much lesser extent. A by-product of our analysis is the finding, that currencies of commodity-exporters are a superior way of investing into basic resources than commodity futures: similar in performance but cheaper.

Figure 1: Year-To-Date Performance (Total Return) of Major Currencies vs. the USD

Figure 2: USD/MXN Carry Return (blue) vs. Global Economic Policy Uncertainty (yellow)

Figure 3: FX Carry Trade Index of 8 EM Currencies (blue) vs. Global Economic Policy Uncertainty (yellow, inverted)

Figure 4: FX Carry Trade Index of 8 EM Currencies (blue) vs. ISM Manufacturing Index (yellow)

Figure 5: FX Carry Trade Index of 8 EM Currencies (blue) vs. Bloomberg Commodity Indices (yellow/green)

Figure 6: Proprietary « Hybrid » Commodities Index (blue) vs. Bloomberg Commodities Index (orange)

Figure 7: Excess Performance of « Hybrid » Commodities Index (blue)