Emerging market equities: the currency factor

For foreign investors in emerging market equities, currency risk has always loomed large. During the 12 months to April 22, according to JPMorgan Asset Management, the impact of exchange rates was negative in 15 out of 18 big emerging markets, neutral in two (China and Peru) and marginally positive only in the Philippines (see charts below).

It turned positive returns for local investors into negative ones for foreigners in nine of the 18, including Brazil, Russia and Poland.

But it is a different picture this year. Exchange rates added to returns in four of the markets between January 1 and April 22 and were neutral in three - with the exceptions of Turkey and Brazil, the impact where negative has been much reduced.

JPMorgan broke out returns for foreign investors into four components: dividends, change in earnings per share (in local currency) over the past 12 months, change over 12 months in the ratio of price to earnings, and the exchange rate.

Dividends, naturally, where paid are always positive. In a few cases - China, India, the Philippines and South Africa - the change in both EPS and P/E ratios was positive.

In many others, P/E ratios rose even as earnings per share fell, as investors decided the damage had been done and company performance would pick up from now on.

But in many countries where investors took a positive view on local market performance, the gains for foreign investors were wiped out by the currency.

Investors can take some heart from the turnround so far this year. But the other thing the two charts make graphically clear is the importance of differentiation.

For emerging market equities as a whole, foreign investors have made 10 per cent so far this year, compared with 7 per cent over the past 12 months. So things have picked up, but not by much. Those who got their choices and timing right did much better. Those who got them wrong, much worse.

The past, of course, is a poor guide to the future. Nevertheless, Richard Titherington, chief investment officer for emerging markets at JPMorgan Asset Management, says that if you believe - as he does - that emerging markets are cyclical, then you can expect exchange rates to contribute to positive returns for foreign investors in Russia, Poland and even Brazil at some point in the next few years.

His other tips are to choose shares that will benefit from a recovery in the US economy, such as those of Taiwanese companies, and to keep in mind the headwinds of a strengthening US dollar and a weakening Chinese economy.

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