EM Local Currency Opportunity for Euro-Based Investors
The recent recovery in the emerging market local currency asset class has two very different realities if you measure in euros or US dollars. Given the asset class’ current lag when measured in euros, coupled with the asset class’ history when measured in euros, we think it may present an attractive opportunity for euro-based investors to invest in emerging market local currency on an unhedged basis.
Setting the Stage
After a solid 2019, the COVID-19 pandemic shocked the emerging market local currency asset class into the third worst selloff in history. So far, the peak to trough is a 19.5% loss in US dollar terms and 18.5% loss in euro terms. However, this was also arguably the fastest shock ever; 75% of the loss occurred in an 18-day period between March 4 and March 22.
You Get What You Measure
The recovery from the COVID-19 shock has paused since mid-June, yet the asset class has experienced a rebound that is faster than the average of the major shocks over the last 17 years. Importantly, there is a large discrepancy in the extent of the recovery depending if measured in US dollar (USD) or euro (EUR). When measured in USD, the asset class has returned approximately 16.2% from the bottom on March 22 according to the JPMorgan GBI EM Global Diversified Index. This is a very robust showing by all historical standards, although the index is still approximately 6.5% below the maximum level of 2020 (reached in early January) and still approximately 12% below the all-time high seen early on in 2013 before the taper tantrum. However, when measuring the recovery in euro, the return from the lows has only been 6.7% and is still approximately 12.7% from the maximum level of 2020.
JPMorgan GBI EM Global Diversified Unhedged USD & EUR
Source: Mellon calculations based on J.P. Morgan data as of September 30, 2020
Since March, the currency performance component has been responsible for this large return differential as emerging market currencies materially underperformed the rally in the euro versus the US dollar over the last seven months. We believe this is a temporary phenomenon. There is a very strong historical correlation between the direction of commodity prices and the JPMorgan GBI-EM Global Diversified Index (GBI) currency component, measured in euro. We believe the rebound in commodity prices over the last five months should support a rebound in emerging market currency measured in euro, and likely in USD as well, over coming months, which presents a potential attractive opportunity for euro-based investors to invest in the EM local currency asset class on an unhedged basis.
Currency Component Versus Commodity Prices (JP Morgan GBI-EM Global Diversified Index)
Source: FX Component data source is Mellon calculations based on J.P. Morgan data as of September 30, 2020. Commodities data source is Mellon calculations based on the CRB Commodity Research Bureau All Commodities as of September 30, 2020. Last 12-month rolling returns.
The Anatomy of a Selloff
The anatomy of historical large selloffs of the GBI measured in euros also argues for attractive returns over coming quarters. The history of this asset class shows a pattern of steep selloffs followed by quick recoveries, which is especially true over the last 10 years. Taking into consideration the 11 worst shocks in the history of the asset class measured in euro, on average approximately 70% of the loss was recovered within three months from the bottom, and within 12 months the asset class had more than fully recovered the losses.
Top 11 Selloffs on Record (JPMorgan GBI EM Global Diversified EUR Unhedged)
Source: Mellon calculations based on J.P. Morgan data as of September 30, 2020.
The recent emerging market local currency selloff rebounded at a surprising speed as global markets continued to reopen following the COVID-19 pandemic. We believe that the historical context of the asset class following selloffs coupled with the ongoing rebound in commodity prices creates a compelling environment for emerging market local currency on an unhedged basis when measured in euros.
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