Currency: US dollars return home in 2009

Volatility and opportunity

Investors with exposure to foreign currencies had one of the most difficult years ever in 2008. After weakening to historic lows versus most of the world's currencies (both developed and emerging markets), the US dollar staged a historic rebound in the third quarter. This rebound erased years' worth of gains for the euro, sterling and many emerging market currencies. The volatility of the currencies, coupled with the sharp declines in non-US equity markets, is a challenge to generally accepted (if not altogether accurate) views of low market correlation. What investors have discovered is that low correlation between equity market returns for different countries may be a product of currency volatility: something professional currency investors have long understood: rather than an inherent diversification of asset markets.

As such, the future direction of the US dollar is quite uncertain. Its strength in early 2009 relies on a number of factors including converging interest rates. US interest rates are likely to fall more slowly than those in the developed and emerging economies as US interest rates are already at an extreme low point. Furthermore, an economic recovery in the developed economies is likely to get started in the US as opposed to Europe.

Repatriation by US investors will also be a positive. The level of US investment flows overseas has been dramatic since 2001, and the recovery of the US dollar and significant falls in developed and emerging market equity markets is likely to cause some significant repatriation of investment. Elsewhere, slowing trade/economic growth will shrink foreign direct investment (FDI) and portfolio flows, reducing capital account surpluses in the receiving countries. This will result in reduced capital outflows towards developing economies.

However, once the solvency and liquidity issues pass, there should be a renewal of US investor interest in non-US markets. Furthermore, a renewed period of reserve diversification is likely as the euro weakens. This could then stabilise exchange rates and allow for some modest recoveries of the euro, sterling and emerging market currencies versus the US dollar.

Further emerging market weakness

During 2008, in the space of about two months, emerging market equities and currencies erased between two and three years' worth of gains and the idea of 'decoupling', in which emerging markets would no longer move in tandem with developed markets, was quashed. Moreover, most analysts are forecasting that, since emerging market economies are highly pro-cyclical, growth will slow sharply in 2009, even in China, India and Brazil.

Our view is that volatility will continue to plague emerging market currencies into the early part of 2009, ending the three-year 'one-way' bet that dominated investment flows. In general, we expect that in the first quarter of 2009, slower global economic growth will displace the liquidity crisis as the dominant cause of emerging market currency and equity weakness. However, there lies significant potential to add alpha and set up for what could be a significant rally in emerging market currencies in the second half of 2009.

Continued withdrawals of portfolio investment, particularly from equity markets, will continue to drive the deleveraging process. Countries with large external financing needs and high levels of corporate and household indebtedness, particularly in foreign currency, are likely to suffer the most. Hard currency demand, for dollars and euros, to meet debt payments will continue to pressure exchange rates and drain central bank reserves. Meanwhile, commodity exporters such as Chile, South Africa and Russia will be affected by the decline in commodity prices triggered by weaker global industrial expansion.

Elsewhere, a general slowdown in the most pro-cyclical economies should cause a reverberating slowdown and investment flow reversal. This will be especially relevant to commodity exporters and countries highly leveraged to global growth – a description which fits most emerging market countries. As such, we expect those countries that can pursue countercyclical fiscal policy (and which have high levels of reserves relative to financing needs) to outperform the rest of the emerging market complex. This includes the likes of China, emerging Asia and Russia.

While the fourth quarter of 2008 is likely to be the most volatile period for emerging market currencies, we are cautious about any recovery before the second quarter of 2009. While significant short-term recoveries (measured in weeks) should follow large drops, we expect that these will be rallies in bear markets.

Developing opportunities

While we expect continued volatility in emerging markets and the possibility of further depreciation of currencies, we see the potential for a significant rally following the deleveraging process. This recovery and rally could begin as early as mid-2009, once there is visibility on the depth and breadth of the global economic downturn. Investment returns are likely to hold up, especially for FDI as marginal returns on invested capital should continue to rise with increased labour productivity and growing internal markets. This should favour larger emerging market countries such as Brazil, Chile, Mexico and much of emerging Asia.

Most countries are better positioned fiscally and financially than in previous economic downturns, and while households and firms in some emerging market countries are leveraged to foreign currency, public and corporate balance sheets are much healthier and more stable in comparison to previous downturns. Meanwhile, interest rates had been rising across emerging market markets in the first half of 2008 in response to rising inflation. Fiscal policy has been much better managed and most emerging market countries did not aggressively expand government spending - this should allow for countercyclical monetary and fiscal policies in late 2008/early 2009 as inflation slackens.

We view 2009 as a mixed year for emerging market currencies, and investors should look for investment strategies that can perform well in bull and bear markets. More importantly, investors will need strategies that take into account the tail distributions of market volatility with strict downside risk control.