Australian institutional investors have been urged to consider taking unhedged positions on emerging market currencies in 2017.
“We think it is a good time to switch out of hard currency debt and into local currency debt,” GAM investor director Paul McNamara said.
A hard currency debt issue is when an emerging market nation borrows money in a major developed market’s currency, typically US dollars or euros, to issue a sovereign bond. When a nation issues a bond denominated in its own currency, it is known as local currency debt.
“Since the ‘taper tantrum’ of 2013, hard currency has underperformed for a number of years, but since late last year, the pendulum has really swung back and we think there’s a great opportunity at the moment to buy emerging market currency,” McNamara said.
He argued that the 2013 ‘taper tantrum’ – when emerging market currencies plummeted after United States Treasury yields surged on the news the Federal Reserve would begin scaling back its massive quantitative easing program – reflected a realisation that the narrative of emerging markets powering the world’s growth was “really just a credit surge”.
“What we have seen over the past few years is a period of very slow growth and that is because we have seen an adjustment of this credit cycle,” he said.
Although the changes in the stock of credit every year were positive, changes in the flow of credit were negative and that is why emerging market growth has been disappointing, he said.
“What we have now is improving emerging market growth, as this credit adjustment finishes, and external balance,” he explained. There is no precedent for that not being a great situation in which to buy emerging market assets.”
GAM is bullish on the entire basket of emerging market currencies overall, but the three McNamara and his team particularly favour at the moment are the Brazilian real, the Indonesian rupiah, and the Mexican peso.
Meanwhile, the Turkish lira stands out as the emerging market currency they are “most worried about”.
This is due to the risks the regime of President Recep Tayyip Erdoğan poses to the nation’s civil institutions, as well as concerns about too much leverage in the country’s banking system.
“Turkish banks have borrowed very heavily from foreign sources and they could run into problems paying it back,” McNamara said.
Remove the hedges
London-based McNamara presented his investment hypothesis at the Investment Magazine Fiduciary Investors Symposium, held in the Blue Mountains, NSW, May 15-17, 2017. GAM is a Swiss-based funds management firm with CHF127 billion ($175.2 billion) in assets under management.
He also advised Australian superannuation funds and other institutional money managers to take the currency hedges off their emerging market equity and bond portfolios.
McNamara said it makes sense for investors from the US or UK to hedge the currency risk on their emerging market assets, but Australian institutions don’t need to because (being a commodity exporting nation) the correlation between the local dollar and the basket of emerging market currencies is so tight.
“It’s like putting ketchup on your steak, you don’t need it,” he said. “Everyone knows the Aussie dollar is correlated to emerging markets, but many don’t realise just how closely.”
US protectionism a threat
Despite his enthusiasm, McNamara still sees significant risks to emerging markets, particularly those manufacturing export nations that are most vulnerable to the protectionist trade policy agenda of US President Donald Trump.
“Trump risk number one is that if you reduce globalisation you are going to hit emerging markets,” McNamara said. “The exporting part of emerging markets, especially Asia, which is driven by foreign direct investment, [would take a hit.] If he can successfully reduce the scale of foreign direct investment out of the United States that’s going to be very negative for EM.”
Overall, however, he thinks the investment case for emerging markets is strong.
“We are in that sweet spot where emerging markets are starting to grow faster than developed markets. That tends to be when you want to buy the actual emerging market assets, rather than developed market assets in disguise.”