Some Thoughts on Differentiation

There has already been a lot of differentiation between currency performance, and more is likely to emerge. Here are three things that can sometimes be overlooked during the recent turbulence, but may be important for longer-term investors:
(1) Commodity price divergence
(2) FX intervention differentials
(3) relative interest rates

There has already been a lot of differentiation between currency performance, and more is likely to emerge. The recent meltdown and its subsequent recovery rally over the last couple of session saw the usual suspects play their higher-beta roles for the cycle (i.e. AUD, NOK, RUB, MXN, MYR and TRY), plus a few more recent entrants, such as the Taiwan dollar. We doubt that markets are about to calm down much, especially with the debate over the timing of the Fed hike still ongoing. In this regard, we think that markets have been a bit too quick in discounting the chance of a rate hike by the Fed in September. Either way, it will only take a couple of weeks of stable (or rallying) markets and a continuation of the recent trend of positive economic data for us to get a reflation of bets for a September or October hike. So despite the recent pickup in risk appetite, it’s best to prepare for a continued volatile environment.

With this in mind, here are three things that can sometimes be overlooked during the recent turbulence, but may be important for longer-term investors: (1) Commodity price divergence, (2) FX intervention differentials, and (3) relative interest rates. Real effective exchange rates are also an important factor for this type of analysis, but we addressed it already in a separate report, see Revisiting REER Trends.

(1) Commodity price divergence: Over the last few months, there has been a huge divergence in the commodity space. The energy sector underperformed, agricultural products outperformed, while precious and industrial metals were somewhere in the middle. For simplicity, here we use the sub-indices of Bloomberg’s commodity index. The implications of these differences are important. Oil exporters like Mexico, Russia and Malaysia are unambiguously worse off in relative terms, while importers such as India and Turkey are better off. Generally speaking, developed countries are bigger agricultural exporters than EM, so they did better in relative terms. Brazil is a notable exception among the larger EM countries, and comes out on top compared with its peers since iron ore and soybeans are its largest exports. Also note a difference between Colombia (big energy exporter) and Chile (a big metals exporter).

(2) FX Intervention differentials: This is a theme we have often discussed in the past and it seems like a good time to revisit it. Just this week, for example, we had two countries stepping up their comments about FX intervention: South Africa and Korea. The BOK vowed to “actively” respond to market volatility, and we see them as relatively credible in this regard. SARB issued a statement saying that it could get involved in FX, but then Governor Kganyogo diluted the announcement shortly after in an interview to the FT. There is a credibility gap between the two countries. Broadly speaking, we see countries like Brazil, Peru and Korea on the more credible side of the spectrum, if they become determined to act. Mexico, India and Malaysia are somewhere in the middle. Countries like Russia, South Africa and Colombia seem to us either less credible or less interested in defending their currencies. Again, these differences often get washed out in day to day volatility, not least because the amount of pressure on each currency varies tremendously at different times. But as we push to more extreme levels of currency weakness, and especially if we get a Fed hike induced selloff, this “intervention differential” is likely to matter more. To be clear, we are not arguing that any of these central banks will have the determination to reverse the trend, but we think their actions can be enough to make a difference in relative performance and volatility.

(3) Relative interest rates: For obvious reasons, carry becomes less relevant in times of elevated volatility. Recent nominal exchange rate moves have been so large that they easily washout even the largest positive carry stories such as BRL (~13%) and TRY (~11%). This is especially the case when thinking of absolute returns. But the story looks different when looking at real (carry adjusted) returns. Over the last 12-months, for example, the difference between nominal and total makes a significant difference in relative performance. For example, in nominal terms, the Indonesian rupiah was the 7th best performer of the sample of currencies below, but when carry is taken into account it’s performance rises to 3rd place. The euro is 5th best performer in nominal terms, but its performance drops to 8th place in real terms. The Japanese yen’s performance worsens from 3rd to 7th; the South African rand’s performance improves from 10th to 6th place.