beyondbrics

Bulls are currently rampant among the equity and bond investors who roam emerging markets, but there are a few noisy bears in the undergrowth – and one of them has just emerged to attack the idea that EM currencies are a safe haven.

In a short report, Bhanu Baweja, a strategist at UBS, scoffs at the idea that emerging markets have “decoupled” decisively from developed markets. If the global economy sours badly, he says, expect people who are long some emerging currencies to suffer too.

That applies particularly to so-called commodity currencies, such as the South African rand and the Russian rouble, whose fortunes are tied to commodity prices.

Baweja told beyondbrics that he’s going against the grain:

There is a common belief that emerging markets will continue to decouple. We don’t think that EM assets have reached bubble territory yet, but there are some signs of complacency in the EM credit markets and in selected local bond markets.

What’s he seeing that others aren’t? The difference, Baweja says, is that others are ignoring the machinations of the economic cycle.

They focus solely on a long-term structural view of emerging markets, where they see things such as a growing consumer class and rising demand for commodities. And all of that is indeed very positive.

But Bawaja, who emphasises that his point is “tactical”, says:

In our view, the cycle matters as well. At this point there is considerable uncertainty on just how deep a cyclical slowdown we are likely to see, and on whether the global economy does possess elements of self sustaining growth.

The doubts are relevant to all emerging market investors with currency exposure – which is most of them, including portfolio managers and businesses – and could prompt questions about whether or how to hedge it.

Money destined specifically for fixed income markets has made up a big part of capital inflows into emerging markets in recent years, as investors pounce on the attractive spreads between emerging bond yields and those in the developed world.

One of the most enticing is in Brazil (whose real is not a commodity currency), where the yield on a one year fixed income deposit today is 8.6 percentage points higher than the equivalent in the US.

But on the complacency front, Baweja notes that the gap between “implied volatility” in developed and emerging currencies is low by the standards of recent years. That volatility is a sign of how risky investors think things are, and the narrow gap means they don’t see emerging market currencies as all that risky at all.

To some extent that’s understandable, given the surge in liquidity heading to emerging markets, the success of many emerging market central banks in taming inflation, and uncertainty over the unconventional policies of their western and Japanese counterparts.

But as Baweja wrote in his report:

The key point we would make is that this good news seems already priced in.

Related reading:
Guest post: Downbeaten Asian currencies set for bull run, beyondbrics