During a period of robust inflows and more positive sentiment, emerging markets1emerging markets have outperformed developed markets by a margin of 6%2 to 12%3 year-to-date. This is primarily a function of a rebound in earnings, higher asset prices and a rise in the value of EM currencies against the U.S. dollar. With many emerging equity markets up over 20% year-to-date, the logical question many investors are asking is, “Have I missed the rally?” Using currency foreign exchange (FX) performance as one barometer, we hope to provide greater context for investors considering a strategic shift back to EM assets.
EM FX: A Harbinger of Flows
Over the last several years, we’ve spent a tremendous amount of time speaking about currency risk and analyzing trends in currency markets. We have provided dedicated exposure to EM FX through the WisdomTree Emerging Markets Currency Strategy Fund (CEW) since 2009. In our view, the most significant (and intuitive) driver of EM FX is global demand. When businesses or investors seek to buy an asset or engage in trade in an emerging market, often they convert hard currency into local. If demand for a currency outstrips supply, a currency will tend to appreciate.
Unfortunately for EM policymakers, the opposite of this process had been occurring over the last five or six years (ahead of 2016). When foreign investors seek to liquidate their holdings and repatriate their foreign currency back to dollars, this leads to a decline in the value of these currencies. From the middle of 2011 to the end of 2015, global investors generally shunned EM assets. As a consequence, EM currencies declined dramatically over this period. As shown in the chart below, EM currencies fell by more than 33% over this four-and-a-half-year period. While Asian currencies depreciated by far less, countries with significant exposure to commodities experienced the most significant devaluations. In the case of Russia, Brazil, South Africa and Turkey, these economic difficulties were exacerbated by geopolitics as well.
