Growth is the focus

Gauges of developing-nation currencies and stocks are near 18-month highs even after Federal Reserve chair Janet Yellen's testimony this week spurred increased bets that policy makers may raise rates as soon as March. The benchmark equity index is up almost 10% this year, while the equivalent currency gauge is off to its best start since 2012.

The phenomenon is a bit unusual. Tighter US monetary policy often spells trouble for emerging markets as steeper yields pull traders away from riskier assets.

But investors have known for a while that rate hikes were coming and are instead focused on the idea that a stronger US economy will fuel growth in developing nations, bolster corporate profits and support prices for the commodity exports that many of the countries rely on.

“EM is dirt cheap,” said Jan Dehn, the London-based head of research at Ashmore Group, which oversees about US$52 billion of assets.

“This rotation from developed-market bonds into stocks and emerging markets has triggered a return to positive correlations between EM local markets and US stocks.” Dehn sees conditions similar to the start of the bull market in developing-nation assets from 2003 to 2007, when the MSCI Emerging Markets Equity Index index more than quadrupled and its currency counterpart almost doubled.

A period of uncommonly low volatility also makes carry trades with emerging currencies “very attractive,” according to Andres Jaime, a strategist at Barclays in New York.

Stability makes it easier for investors to borrow in low-interest-rate developed markets and buy local-currency government debt that yields on average about three percentage points more than comparable US Treasuries, according to data compiled by Bloomberg.

Adding to the appeal are accommodative policies by central banks in developed nations and optimistic global expansion forecasts. Growth in emerging economies will accelerate to 4.2% in 2017 from 3.4% last year, according to the World Bank. Commodity prices have risen 20% since reaching a multi-year low in early 2016. Wasif Latif, who helps oversee US$8.5 billion as the head of global multi-assets at USAA, said he's bullish on emerging-market equities because of attractive valuations and improving economic and company fundamentals.

The MSCI Emerging Markets Currency Index has rallied 3.3% in the first few weeks of 2017, and 21 of the 24 developing-nation currencies tracked by Bloomberg are in the green. That came after a selloff in November following Trump's surprise election victory, which briefly sent investors in search of the safest assets. The gauge is down 0.4% at 14:09 on Friday, halting a four-day rally.

Judging from the seven notable emerging currency rallies of the past six years, the current outperformance has legs to continue, Morgan Stanley strategist Gordian Kemen wrote in a note, recommending staying long the Turkish lira, Mexican peso, Argentine peso and Indonesian rupiah.

Currencies from countries with high interest rates such as Russia, Brazil and South Africa have led emerging-market gains this year. Chile's peso also ranks in the top five with support from a metal rally that Goldman Sachs expects to continue. Meanwhile, South Korea, where the won is topping Asian peers this year, has seen a region-best US$4.3 billion flow into its bonds this year.

“The Trump administration seems to suggest they don't like the strong dollar, putting downward pressure on the greenback and in return, supporting the emerging currencies,” said Takeshi Yokouchi, a senior fund manager in Tokyo at Daiwa SB Investments, which oversees almost US$50 billion of assets.

He's overweight Brazil, underweight Turkey and recently brought back his underweight on Mexico to near neutral.



Some analysts remain cautious.

Regis Chatellier, a London-based emerging-market credit strategist at Societe Generale SA, said increased rate-hike expectations may eventually trigger a correction in developing assets. Przemyslaw Kwiecien, an economist at X-Trade Brokers Dom Maklerski SA and the most-accurate developing-nation currency forecaster in the fourth quarter according to Bloomberg's rankings, expects an expansionary US fiscal policy to curb the strength of developing currencies.

Goldman Sachs said in a note this week that global macro risks is a reason to be cautious on emerging-market stocks, and exited its recommendation to go long in Brazil, India and Poland.

And there are some signs that the rally has gone too far. MSCI's currency and equity gauges both have relative strength indices above 70, levels that suggest gains are overdone.

But Enrique Diaz-Alvarez, the chief risk officer of Ebury Partners who correctly predicted a rally in the real last January and a rebound in emerging-market currencies after November's retreat, expects further appreciation this year against the world's major peers.

“If you look beyond an immediate market reaction following a rate increase and concentrate on a bigger picture, you see that the fundamentals in emerging markets are strong,” he said. “Developing markets are better off when developed markets are stronger.”

BLOOMBERG