Over the past decade, emerging market (EM) currencies have weakened significantly and local currency bond investors have seen little exchange rate returns. In fact, EM exchange rates (FX) have been a major source of volatility and negative returns. As shown in the chart below, EM currencies have weakened significantly over the past decade, with the Turkish lira down over 80% and the Brazilian real down almost 70% since the start of 2010. 

EM FX has weakened significantly vs US dollar

Source: Bloomberg. As at 5 November 2020

Have EM currencies now bottomed? And should we now expect a broad-based EM FX rally in the coming decade? 

Even though we see potential for a rally in many of the undervalued EM currencies from improved news flow in the next 12-18 months on global growth as the world recovers from the COVID-19 pandemic, the longer-term EM exchange rate bull case is still not obvious. 

While many EM currencies now look fundamentally undervalued – based on our in-house fair value FX model – there are a number of structural and cyclical headwinds preventing a broad-based appreciation in EM currencies. The risk is that several EM currencies will remain value traps rather than undervalued. 

 

Our fundamental exchange rate model shows EM currencies to be undervalued

Given the exchange rate moves seen over the past few years, the natural question to ask is whether EM currencies have now become too cheap relative to their fair values. 

Unfortunately, exchange rate equilibrium values are hard to pin down. There are many ways to define an exchange rate “fair value” including the best way to model FX equilibrium rates. 

Our preferred framework for assessing currency valuation is our in-house Fundamental Equilibrium Value Exchange Rates (FEVER) model. 

Our valuation framework is partly based on the purchasing power parity concept, which links long-run trends in domestic and foreign consumer prices to long-run currency valuations. But the framework also allows for the possibility that the equilibrium real exchange rate (RER) can shift over time, an important assumption when analysing EM currencies. 

Our framework is therefore able to capture two stylised facts. Firstly, low inflation currencies tend to appreciate over time (e.g. the Japanese yen). Secondly, countries with fast productivity growth will generally experience currency appreciation (e.g. EM currencies in the 1990s). 

The chart below illustrates what our fundamental-based FX fair value model is telling us about current EM FX valuations.

There are two key takeaways: first, EM currencies are now broadly undervalued. This is a big change from 10 years ago when most EM currencies were overvalued. Second, we see a larger valuation divergence among EM currencies today compared to earlier. Some currencies remain slightly overvalued (mainly the Asian currencies including the Chinese yuan) while other currencies now look very undervalued (the Turkish lira, the Brazilian real and the Columbian peso).

Most EM currencies are cheap relative to their fair values

Bilateral fair value calculations relative to US dollars

This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein

Sources: Bloomberg, Capital Group. As at 10 November 2020. TRY = Turkish lira, BRL = Brazilian real, COP = Colombian peso, RUB = Russian rouble, ZAR = South African rand, MXN = Mexican peso, MYR = Malaysian ringgit, HUF = Hungarian forint, CLP = Chilean peso, PLN = Polish zloty, HKD = Hong Kong dollar, INR = Indian rupee, PHP = Philippine peso, RON = Romanian leu, SGD = Singapore dollar, KRW = Korean won, USD = US dollar, CZK = Czech koruna, CNY = Chinese yuan, ILS = Israeli shekel, IDR = Indonesian rupiah, THB = Thai baht.

 

But EM currencies face cyclical headwinds…

Given the pro-cyclical nature of many EM currencies, the overall global growth outlook will determine the strength of any EM FX rally.   

Our latest global growth forecast expects a post-COVID recovery that’s slightly slower than in 2008-09, with 2021 global growth estimated at 5.4%.

 

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
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