Recovery of emerging markets moves into spotlight

Emerging-market currencies may be starting to stabilize following the worst quarter in more than four years. The question is which of them will lead the next stage of the recovery.

One place to start is to check out what happened in the aftermath of the global financial crisis, and this suggests investors will focus on value, meaning the Mexican peso and Brazilian real are best placed to prosper. Money managers argue the outcome may be different this time though, with Asset Management One Co. saying China's economy is much bigger, and PineBridge Investments claiming the impact of the pandemic is likely to last longer.

The challenge of identifying which assets will lead the rebound from the virus turmoil has become a debating point as countries around the world achieve some success in limiting the spread of the pandemic. The U.S. has signaled it may start to reopen some parts of its economy, while the process is already advanced in China. Brazil and Mexico have taken different paths. Brazil's President Jair Bolsonaro has criticized social distancing policies, while Mexico's Andres Manuel Lopez Obrador drew criticism last month for moving too slowly to address the crisis.

"Emerging markets today are a real mixture of wheat and chaff," said Satoru Matsumoto, a fund manager at Asset Management One in Tokyo. "When you look at the correlation, there are of course some things you can draw from the historical trend. But in the end, the most important factors to watch for are real yields and the basic balance along with various stimulus policies."

During the initial period of the 2008 crisis, the correlation between the current-account situation and the performance of EM currencies performance was as high as 77%, according to data compiled by Bloomberg. During the second phase however, that dropped back to 22%, while the correlation with value climbed to 39%, becoming the main determinant.

Valuation became the main factor of the second stage of the recovery from the 2008-'09 crisis, outdistancing a number of other variables, including current-account position, credit rating, external debt-to-GDP ratio and foreign-reserve coverage, according to a Bloomberg study of 16 emerging currencies undertaken last week.

The currencies ranked at the top of the likely recovery are predominantly from Latin America, with the South African rand coming in third. The highest-placed from Asia were the Thai baht and Indonesian rupiah, while the Philippine peso and Taiwan dollar were seen at having the worst outcomes.

The 2008-'09 playbook may not apply this time because the presence of China in the global economy is incomparably larger than it was a decade ago and other emerging markets have also changed, Asset Management One's Mr. Matsumoto said.

The Russian ruble, Indian rupee and Mexican peso will probably perform best, while the real and rand are likely to suffer more, he said.

Another difference from the global financial crisis is the role of commodity prices. This week's dramatic collapse in near-dated oil contracts is a reminder of the important part raw material markets may play in a recovery.

PineBridge also perceives the pattern of recovery from the virus pandemic will differ from that following the global financial crisis as the rebound is likely to take a lot longer.

"Absent a major medical breakthrough, economic disruptions in varying forms and intensity, will stay with us for a while," said Omar Slim, senior vice president and portfolio manager in Singapore. "Most containment efforts seem to be working, and there's a light at the end of the tunnel, but that light is a post COVID-19 world that will run at a lower growth regime."

Mr. Slim said there's likely to be a greater dispersion of return between different assets and outperformance by investors will only be achieved by individual selection and investment quality. "Risk sentiment will continue to improve, funding and credit markets will normalize, but the post COVID-19 world will not signal all clear," he said.

The MSCI Emerging Markets Currency index has climbed 0.8% from this year's low set on March 23. The gauge is still down 6.3% this year as the spread of the virus has sapped demand for higher-yielding assets.