2015 was an annus horribilis for emerging market currencies. The Argentinean peso and Brazilian real fell by more than 30 per cent against the US dollar and 20 per cent or greater declines were recorded by the Turkish lira, South African rand and Colombian peso. You needed to have a taste for the exotic in 2015 to beat the buck: the Somali shilling and the Bitcoin were among a tiny handful of currencies to outperform.
Anyone under any illusion about the importance of currency in portfolios should spare a thought for emerging market debt investors. In 2015 an investor tracking the JP Morgan Emerging Market Bond index would have eked out a modest gain of 1.23 per cent. By contrast an investor who chose the JP Morgan Government Bond Index – Emerging Markets Global Diversified index as their benchmark would be nursing losses of 14.92 per cent. The difference between these two indices is that the former is made up of bonds denominated in hard currency (the US dollar) and the latter tracks local currency bonds.
Currency markets also had the power to shock. The Swiss National Bank roiled markets in January by abandoning its euro peg. When the People’s Bank of China devalued the renminbi in August the reverberations were felt far and wide. The US VIX index, the so-called fear gauge, jumped by 54 per cent that month. In FX, the CVIX index of three-month implied volatility across nine currency pairs rose last year, having reached record lows in 2014.
The extrapolation into the future of a historical trend is one of the cardinal sins of investing. However, there are sound reasons to believe both that the US dollar can continue to be strong and that FX volatility will stay relatively high in 2016. This will create opportunities for active managers, but will also require careful navigation of markets.
The main driver for the dollar in 2016 is likely to remain the same as 2015: policy divergence. The US Federal Reserve finally raised interest rates by 25 basis points at its December meeting. Though the European Central Bank had disappointed markets by failing to announce more aggressive monetary loosening earlier in the month, the markets broadly got what they had long anticipated: simultaneous Fed tightening and eurozone easing.
The last time the US and the eurozone were heading in different monetary directions was in 1996. In one sense this makes currency investment relatively simple. As long as this divergence is plain, apparent and meeting or exceeding market expectations, the dollar is likely to continue to strengthen against the euro and yen, the currencies of weaker economic rivals maintaining a ‘looser for longer’ stance.
The key metric here is expectations embedded in the two-and 10-year bond yields of the US and eurozone. If they diverge, dollar strength will likely follow, but if data from the eurozone and Japan suggests a more robust recovery than is currently expected and bond yields start to converge, the dollar will be vulnerable. We will be back in a world of synchronised recovery where the relative attractiveness of a currency is far more nuanced.
There are other economic scenarios that could be dollar supportive. For example, if the US economy stalls it is likely to be against a backdrop of generally weaker global growth. That could spell very bad news for emerging markets in general and commodity producers in particular.
A glut of supply has already derailed the commodities super-cycle; a collapse in demand would probably see similarly dire performance from commodity-linked currencies, as witnessed in 2015. The dollar would be likely to prove resilient, buoyed by safe haven flows and an economy highly geared to domestic consumption.
Just as the Fed has said it will be data dependent when deciding on the pace of monetary normalisation, markets too will be poring over the numbers, trying to second guess the actions of monetary authorities.
Given the uncertainty over global growth, the outlook for China and the possibility that the Fed may be behind the curve, the safest predictions for 2016 are that the dollar can strengthen, but FX markets will stay volatile.
Paul Lambert is head of currency at Insight Investment.