For a long-term (5+ year) value investing strategy in emerging markets, hedging currency exposure is typically too expensive to be viable. The approach relies on the assumption that when buying into a country under pressure, significant currency devaluation is already priced in, making the high cost of hedging unnecessary.
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Investors have been holding unhedged US dollar assets to capture both high yields and currency appreciation, a speculative strategy traditionally used for emerging market local currency bonds. This parallel indicates a shift in risk perception, where US assets are no longer seen as a pure safe haven.
A paradox exists in emerging market FX positioning. Medium-term structural indicators show that the asset class is not over-owned, suggesting room for growth. However, short-term technical indicators are approaching an "extreme positive threshold," signaling a high risk of a near-term pullback, particularly in currencies highly sensitive to the global cyclical backdrop. This warrants a more selective investment approach.
After being 'shunned by the world for 10 to 15 years,' emerging market assets are benefiting from a slow-moving, structural diversification away from heavily-owned U.S. assets. This long-term trend provides a background source of demand and support, contributing to the asset class's current resilience against short-term volatility.
A decoupling is occurring where EM high-yield currencies are outperforming DM high-beta currencies. Investors are increasingly using DM currencies as funders to capture attractive carry in select EMs like South Africa (precious metals), Mexico (stable carry), and Hungary (improving fundamentals).
During a crisis, equity and loan portfolios can become completely illiquid. However, currency liquidity almost never disappears. Therefore, a deep capability in FX instruments is the most critical risk management tool for an EM investor, allowing them to hedge when other markets are closed.
Citing research from Verdad's Dan Rasmussen, the speaker notes that EM assets perform best when purchased during a crisis that originates in developed markets (e.g., the GFC or COVID). Panicked selling creates widespread mispricing in EM, even though the region is not the source of the crisis, offering a prime buying opportunity.
Despite record-high economic activity surprises, emerging market currencies (EMFX) are fairly valued, not overextended. This suggests near-term upside for spot prices is limited, making carry returns the more likely driver of performance in this bullish cyclical environment.
The strategic value of commodities in a modern portfolio has shifted from generating returns to providing a crucial hedge against two growing threats. These are unsustainable fiscal policies that weaken currencies ('debasement risk') and the increasing use of commodities as geopolitical weapons that cause supply disruptions.
Within any emerging market country, the annual return dispersion between equities, local debt, and hard currency debt is enormous. An investor who can consistently pick the winning asset class, even just over 50% of the time, will generate superior long-term returns due to this massive performance gap.
While FX swaps protect against currency fluctuations, they are short-term instruments. Investors holding long-term assets must continuously roll them over, exposing themselves to liquidity squeezes and rollover risk. This effectively swaps one type of risk (currency) for another less obvious one (maturity).