Introduction

The real effective exchange rates ('REER') of Turkey and Argentina devalued by more than 30% in the six months to August, according to our calculations. What does history tell us about REER devaluations of this magnitude? Should we stay away from Turkey and Argentina, or do they provide pockets of potential opportunities?

To help us answer these questions, we surveyed the history of emerging markets ('EM') since the early 1990s. We  found that: 1) such devaluations were more common than we might have hoped; and 2)the USD returns in equities (ie FX unhedged) subsequent to such gut-wrenching moves were almost universally positive over one and two years, irrespective of the severity of recessions that almost invariably follow.1

Our analysis drew four main conclusions:

  • After such major destruction to asset prices, risk/reward was notably skewed to the upside;
  • Recoveries were uneven: the majority of equity markets began to recover within 3 months of the 30% devaluation, and were up meaningfully over the following six months, but it was not unusual to see a swoon over the subsequent year;
  • Current account deficits may collapse rapidly;
  • Cheaper starting valuations were associated with higher subsequent returns across the sample.

Our Sample Countries and Methodology

We based this work on JPMorgan’s CPI-based REER series, using data starting in 1994 and filtering for countries that experienced a 30%-plus REER devaluation over a 6-month period (the 'trigger date'). Both the time scale and the magnitude are arbitrary, reflecting our view of what constitutes a big move happening quickly.

We excluded countries that are, in our view, without proper equity markets – Uruguay, Ukraine and Vietnam. While these countries qualified in terms of scale of devaluation, they did not have investable, liquid equity markets. We also excluded Egypt, whose 2016 devaluation was too recent to allow us to compare longer-term returns.

It’s notable that Malaysia and the Philippines are absent from our study. Both did experience 30%-plus devaluations, but not within our defined threshold of six months. The experience in these countries was comparable to Indonesia and Thailand, where recovery took longer than other countries in the study, and longer than the other notable Asian financial crisis victim, Korea.

Following the trigger date, we calculated 6-, 12- and 24-month forward returns on the main equity index for each country in USD. The table below shows the results.

Figure 1. Returns of Each Country Index (USD)
Country First trigger date # months to low* 6m 12m 24m
 Mexico Feb-95 0 45.0% 33.7% 73.1%
 Indonesia Dec-97 9 -58.8% -30.3% 27.9%
 Korea Dec-97 0 4.0% 137.4% 349.9%
 Thailand Jan-98 7 -46.1% -13.2% 20.2%
 Russia Sep-98 1 174.7% 169.3% 498.5%
 Brazil Jan-99 0 46.4% 113.5% 116.7%
 Turkey Jul-01 14 26.9% -25.1% -8.6%
 South Africa Dec-01 2 18.0% 23.2% 71.8%
 Argentina Feb-02 3 -45.9% -2.6% 111.4%
 Brazil Sep-02 0 45.5% 110.5% 206.3%
 Poland Jan-09 0 56.5% 80.2% 108.8%
 Russia Dec-14 0 26.7% 0.0% 48.8%
 Average   3 24.4% 49.7% 135.4%
 Positive hit rate**   75% 75% 58% 92%

Source: Man Group database.
* Number of months between the trigger date and the ultimate low in UDS-denominated equities.
** For # of months to low, this measures the proportion of countries reaching a low within 3 months.

We would highlight the following observations:

  • In the majority of countries, equities bottomed quickly after large devaluations: 75% of countries saw lows within three months, and 75% of countries posted positive returns over six months, averaging 24%. We would flag, however, that in the three cases where returns were negative, they were alarmingly so: Indonesia down 59%, Thailand down 46% and Argentina down 46%;
  • It was not unusual to see a swoon between months 6 and 12: this occurred in Mexico, Russia (both 1998 and 2014) and Turkey;
  • Patience may be rewarded: 2-year returns were positive in 92% of the sample, making 135% on average, with only Turkey down over this period. Three years out, Turkish equities were up 66%, but that was a very long and painful wait.

It’s also notable that there was typically very little recovery in the REER following a devaluation of this magnitude. Figure 2 shows the average REER path indexed to 100 at the trigger of -30% over six months, with the largest and smallest post devaluation recovery in REER. The horizontal axis shows six months pre the trigger date up to 24 months post.

Figure 2. The Average REER Path

Source: Man Group database.

The ‘normal’ path of equity recovery is shown in Figure 3, with Argentina and Turkey in 2018 overlaid. Again, equities in USD are indexed to 100 at the trigger date (month 0).

Figure 3. ‘Normal’ Path of Equity Recovery

Source: Man Group database.

The Valuation, External Balance and Policy Context

So, what conditions could have contributed to enduring losses amongst the minority of the sample where REER devaluations did not lead to an upside for asset prices?

First, we looked at valuation. We observe that starting valuation (measured as trailing price-to-book value [P/B]) has a correlation with forward returns – the cheaper the asset, the larger the subsequent gains. For the chart on the left in Figure 4, P/B is on the horizontal axis, and 1-year returns from the trigger date are on the vertical axis. For the chart on the right, we have used 2-year returns, but excluded Russia (where the gains were almost 500%, and inclusion renders the chart unreadable).

Figure 4. P/B Versus 1-Year and 2-Year Returns

Source: Man Group database.

Our observation is that a starting valuation of less than 1x book was preferable over the periods measured, but that over 1-year time periods, cheap valuation isn’t sufficient. For the current crisis countries, Argentina is on a trailing book value of c1.5x, while Turkey is on c1x, according to our calculations. This potentially puts Turkish assets in a more favourable starting point. However, neither is as compelling, in our view, as Russia in 1998, when the index traded at 4% of book value!

Figure 5. Trailing P/B for Turkey, Argentina

Source: Man Group database.

Secondly, the current account context is important. Six months before the trigger date, all but two of the countries in the study were running current account deficits (the exceptions were Russia in 2014 and South Africa in 2002). In all cases, balances improved materially.

We think this is important because the presence of deficits makes it easier for discretionary managers to remain uninvested. Once deficits begin to shrink rapidly, it becomes harder to stick with the previous negative bias. So the shrinking of deficits can help stabilise nominal exchange rates, and bring portfolio flows into assets. Figure 6 shows the average current account balances, from six months before the trigger date up to 24 months after.

Figure 6. Average Current Account Balances

Source: Man Group database.

The third condition is differences in policy context. This strikes us as potentially significant in differentiating winners from losers, at a time when Turkey’s adherence to policy orthodoxy is not quite so clear, while Argentina is treading a more established path of tight monetary and fiscal policy, and an International Monetary Fund ('IMF') program.

The table below (Figure 7) tries to capture the policy framework of each of our crisis countries, with valuation and returns included, and our impression of the lay of the land in Turkey and Argentina now.

Figure 7. Capturing the Policy Framework in Each Crisis Country

Source: Man Group database.

Our tentative conclusions are:

  • Historically pegs appear sub-optimal. Mercifully there are few left, though Pakistan and Gulf Cooperation Council ('GCC') countries cling to them;
  • Capital controls have generally not worked well historically: Two of the three countries that failed to make positive returns deployed them;
  • Policy slippage and unorthodox policy can make life harder, but may be overcome – all three of the countries that failed to make positive returns deviated from commitments or refused to initially embrace orthodoxy. However, so did Brazil (fiscal slippage), Russia in 1998 (money printing), and Poland in 2009 (fiscal expansion and ballooning of national debt);
  • Capital controls appeared more likely to emerge in countries eschewing orthodoxy.

Potential Implications for Turkey and Argentina in 2018

Assuming a country has been unfortunate enough to find itself experiencing a 30%+ REER devaluation, our tentative ideal checklist would be:

  1. A floating exchange rate;
  2. A commitment to orthodox monetary and fiscal policy (which is where the IMF’s presence comes to play);
  3. Avoiding capital controls;
  4. A cheaper starting valuation.

Turkey satisfies (1) and (4), but given the major question marks over (2), we cannot be confident that the country won’t end up pursuing an isolationist approach, like Argentina under the Kirchners.

For Turkey, we will be watching policy very closely into year-end. If the government avoids capital controls, resists the temptation to cut rates, and continues to ensure that debts are serviced, we will start to consider our eligible watchlist stocks for inclusion in the portfolio much more seriously.

Argentina, meanwhile, satisfies (1) and (2). Additionally, our assessment is that the policy commitments we have seen from President Mauricio Macri’s government since the crisis started make (3) more unlikely. The IMF is important in this respect, as the terms of the agreement preclude Buenos Aires from using the central bank to finance government spending, a key heterodox policy that could undermine credibility.

There is political risk, however, and a win by a Peronist at next year’s election could change the landscape considerably. The impediment to buying Argentinian equities ‘indiscriminately’ is that they are not yet cheap enough in our view. This requires us to continue to look very carefully for companies that we believe are being managed sensibly, have strong balance sheets and are materially undervalued. We believe that there are a number of candidates, and intend gradually to increase our exposure over time.

1. Past market performance does not guarantee similar future results.

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