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Emerging Markets

Emerging Market Monitor: time for a rebound in EM currencies?

Time for EM currencies to strike back?

February 2019

Patrick Zweifel, Chief Economist

The growth deceleration in emerging markets will be much less pronounced than in DM according to our leading indicators. This growth gap in favour of EM supports a recovery in EM currencies.

That sinking feeling...

Developed world GDP growth, although still positive at 2.1 per cent, is trending downward (see left-hand chart). Our leading indicator implies it might fall further in coming months. 
We see a similar trend for emerging markets, but from a higher base of 4.2 per cent and with a less pronounced deceleration.
FIg. 1A: Developed markets leading activity index & real GDP growth / Fig. 1B: Emerging  MARKET leading activity index* & real GDP growth 
Figure1.png

Source: Pictet Asset Management, CEIC, Datastream. Developped Markets (DM) real GDP data from January 1998 to August 2018. Emerging Market (EM) real GDP data from January 1996 to August 1998. DM and EM leading indicators data to 31 December 2018.
* DM leading indicator (left) is weighted average of 14 individual countries leading indicators. EM leading indicator (right) is weighted average of 24 individual countries leading indicators.

Welcome to the new regime...

In the chart below we review all the periods since 1994 when the growth gap has favoured emerging markets to see what we can learn from history.
FIG. 2: EM-DM activity growth differential: periods when EM growth IS HIGHER THAN DM 
Figure2.png
Source: Pictet Asset Management, CEIC, Datastream. Leading indicator data to 31 December 2018.

There are three ways that emerging markets (EM) growth can outperform that of developed markets (DM): 

  1. Both fall, but EM growth deceleration is slower (red bars)
  2. EM GDP growth expands while that of DM falls (grey bars)
  3. Both rise with EM growing faster (green bars)

We are currently in configuration 1.

What does this mean for EM assets?

Our research shows that under all three regimes EM equities have historically outperformed DM equities and EM dollar denominated government bond spreads have tightened. 
Unsurprisingly, both EM equities and bonds have had their strongest outperformance in the third configuration when growth is strong across the board. However when it comes to EM currencies, the best environment has typically been configuration 1, the regime we are currently in.
FIG. 3: Markets performance when em growth IS greater THAN dm
Figure3.png
Source: Pictet Asset Management, CEIC, Datastream, February 2019. *Average of 31 currencies. ** Data for this type of momemtum excludes last phase (Jan 18 to-date). Market performance figures annualised and averaged over the different periods included  in each phase. Any apparent discrepancies in numbers are due to rounding.

So can we expect EM currencies to do well?

Looking at configuration 1 periods over the past two decades shows us EM currencies have appreciated against the US dollar in all but the current period. They have started to revert to trend with a modest recovery in recent months, and we would expect this upward trend to continue.
FIG. 4: Main EM currencies* vs USD & phases of EM-DM GDP growth differential
figure4
Source: Pictet Asset Management, CEIC, Datastream. Currencies data to January 2019. *Unweighted average of 23 EM currencies.

Can we anticipate an end to the seven-year bear market in EM currencies?

We can find further clues by looking at the prevailing macroeconomic conditions in periods that saw EM currencies recover.

Watch for a rebound in commodities

All periods were characterised by declining US growth, falling US 10-year rates and reasonable EM export growth, conditions which are in place today.

One exception has been the recent weakness in commodity prices, which are typically strong in all other periods. But even here there are reasons to be hopeful with an 11% rebound in the S&P GSCI commodity index year-to-date1.

This gives us reason to believe that EM currencies are finally on the comeback trail.

FIg. 5: GLOBAL Macro indicators when em growth greater than DM

Commodities due a rebound?

figure5
Source: Pictet Asset Management, CEIC, Datastream. Commodity prices to January 2019.