As international investors in emerging markets, our focus is on US dollar returns, not local currency ones. This means that an assessment of the outlook for the currency is an important factor to consider (in fact, it is one of the five main drivers of our investment process).
There are a number of ways to assess the over/under valuation of a currency relative to its long-term prospects. One is to use purchasing-power parity (PPP), which assumes that currency fair-values should reflect price differences between countries; the Economist’s Big Mac index is a simple and well-known example of this approach. Another approach, and one which we lean to, is to try to assess how a country’s current-account balance is moving relative to the strength of its economy and the relative prices of its imports and exports. Known as the external balance approach, we think it is of significant use, and is why we pay so much attention to current-account balances (as regular readers will be aware).
Of particular interest to us this month has been the IMF’s 2017 External Sector Report, released at the end of July, which contains IMF staff views on 29 leading economies, including 13 emerging markets. The IMF’s Consultative Group on Exchange Rates have developed sophisticated models that analyse the factors that contribute to a country’s equilibrium current-account balance, from which they can then assess currency valuations.
One of the main conclusions in the report is that the problematic current-account deficits in many emerging markets (particularly Brazil, Indonesia, South Africa and Turkey) have eased, largely on tighter fiscal and credit policies. Also gone, is the excessively large current-account surplus in China with correspondingly looser fiscal and credit policies. These serve to reduce the overall level of risk in emerging markets as an asset class.
Indeed, where the report sees concerning imbalances, it is in the sustained pattern of surpluses and deficits in the developed world. The report notes that fiscal consolidation supported the widening or persistence of excess surpluses in some key advanced economies (such as Germany and Japan; the Netherlands, Singapore and Sweden are similarly mentioned elsewhere), but did little to reduce excess deficits in other advanced economies (Australia, Canada, the UK, the US). The global risks from conflicts around trade and protectionism originate in the developed world.
That is not to say that there is not the potential for large currency moves in some emerging markets. Our analysis agrees with the IMF’s views that the Korean won, Thai baht and Malaysian ringgit remain significantly undervalued and also that the South African rand is overvalued. The signals are more ambiguous on currencies nearer fair value, including the Chinese renminbi and the Indian rupee.
There is one significant risk which is perhaps underplayed in the report and overlooked elsewhere. Our analysis comes to the same conclusion, that the Saudi riyal is substantially overvalued and in need of a significant devaluation. As the currency is currently pegged to the US dollar, any such devaluation could be difficult both for Saudi citizens and for the nation’s financial system. Saudi Arabia is an otherwise interesting frontier market, but our long experience of emerging market investing makes us very wary of overvalued, pegged currencies.
As international investors in emerging markets, our focus is on US dollar returns, not local currency ones. This means that an assessment of the outlook for the currency is an important factor to consider (in fact, it is one of the five main drivers of our investment process).
There are a number of ways to assess the over/under valuation of a currency relative to its long-term prospects. One is to use purchasing-power parity (PPP), which assumes that currency fair-values should reflect price differences between countries; the Economist’s Big Mac index is a simple and well-known example of this approach. Another approach, and one which we lean to, is to try to assess how a country’s current-account balance is moving relative to the strength of its economy and the relative prices of its imports and exports. Known as the external balance approach, we think it is of significant use, and is why we pay so much attention to current-account balances (as regular readers will be aware).
Of particular interest to us this month has been the IMF’s 2017 External Sector Report, released at the end of July, which contains IMF staff views on 29 leading economies, including 13 emerging markets. The IMF’s Consultative Group on Exchange Rates have developed sophisticated models that analyse the factors that contribute to a country’s equilibrium current-account balance, from which they can then assess currency valuations.
One of the main conclusions in the report is that the problematic current-account deficits in many emerging markets (particularly Brazil, Indonesia, South Africa and Turkey) have eased, largely on tighter fiscal and credit policies. Also gone, is the excessively large current-account surplus in China with correspondingly looser fiscal and credit policies. These serve to reduce the overall level of risk in emerging markets as an asset class.
Indeed, where the report sees concerning imbalances, it is in the sustained pattern of surpluses and deficits in the developed world. The report notes that fiscal consolidation supported the widening or persistence of excess surpluses in some key advanced economies (such as Germany and Japan; the Netherlands, Singapore and Sweden are similarly mentioned elsewhere), but did little to reduce excess deficits in other advanced economies (Australia, Canada, the UK, the US). The global risks from conflicts around trade and protectionism originate in the developed world.
That is not to say that there is not the potential for large currency moves in some emerging markets. Our analysis agrees with the IMF’s views that the Korean won, Thai baht and Malaysian ringgit remain significantly undervalued and also that the South African rand is overvalued. The signals are more ambiguous on currencies nearer fair value, including the Chinese renminbi and the Indian rupee.
There is one significant risk which is perhaps underplayed in the report and overlooked elsewhere. Our analysis comes to the same conclusion, that the Saudi riyal is substantially overvalued and in need of a significant devaluation. As the currency is currently pegged to the US dollar, any such devaluation could be difficult both for Saudi citizens and for the nation’s financial system. Saudi Arabia is an otherwise interesting frontier market, but our long experience of emerging market investing makes us very wary of overvalued, pegged currencies.
Disclaimer
Past performance is no guarantee of future performance. The value of investments and the income from them may go down as well as up and you may not get back your original investment. Investors should note that this Fund invests in emerging markets and such investments may carry risks with failed or delayed settlement and with registration and custody of securities. Companies in emerging markets may not be subject to accounting, auditing and financial reporting standards or be subject to the same level of government supervision and regulation as in more developed markets. The information contained herein including any expression of opinion is for information purposes only and is given on the understanding that it is not a recommendation. Government involvement in the economy may affect the value of investments and the risk of political instability may be high. The reliability of trading and settlement systems in some emerging markets may not be equal to that available in more developed markets which may result in problems in realising investments. Lack of liquidity and efficiency in certain of the stock markets or foreign exchange markets in certain emerging markets may mean that from time to time the Investment Manager may experience difficulty in purchasing or selling holdings of securities. Furthermore, due to local postal and banking systems, no guarantee can be given that all entitlements attaching to quoted and over-the-counter traded securities acquired by this Fund, including those related to dividends, can be realised. Issued and approved in the UK by J O Hambro Capital Management Limited, which is authorised and regulated by the Financial Conduct Authority. JOHCM® is a registered trademark of J O Hambro Capital Management Ltd. J O Hambro® is a registered trademark of Barnham Broom Holdings Ltd. Registered in England and Wales under No: 2176004. Registered address: Ground Floor, Ryder Court, 14 Ryder Street, London SW1Y 6QB.
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