Foreign exchange risk can be a headache for investment advisors. Some clients want no part of it, often missing out on allocation strategies outside of the U.S. Jan Dehn, head of research for the Ashmore Group, has some advice: remind clients that currency weakness versus the dollar does not necessarily equal inflation.
Investors who don’t follow foreign markets close think inflation equals rate hikes and that equals more capital costs for companies. Stocks suffer. It also means that if they are buying bonds, particularly those priced locally, they are losing on the currency.
There’s a word for this connection between currency and inflation: forex pass-through. Dehn says currency weakness can also be deflationary. Outflows can weaken economic growth and thus lower inflation, turning the conventional wisdom on forex pass-through on its head.
What does the data show? Did the 43% depreciation of emerging market currencies between 2010 and 2015 cause inflation rates to rise? Not really, he says. Except in Brazil and Russia where it absolutely did rise, and by quite a lot.
On average, though, inflation declined because economies stunk so bad that no one was spending any money. Or economies like India were stable enough that their central bank rate hikes were not enough to scare investors.
So no one should worry about forex pass-through, right?
Of course Ashmore wants to sell us more emerging market bond funds, and fearlessness on foreign currencies helps. Currencies are complicated parts of the investing equation. They move up, they move down, and inflation is as much a positive as it is a negative to a diversified foreign investment anyway.
“The thesis of pass-through has ambiguous theoretical foundations and the data at both country and index levels reject the thesis,” he says. So why does inflation tend to rise when currencies rise and vice versa? The most likely explanation is that currencies and inflation are jointly determined by a third variable: capital flows. High inflation scares off investors, especially foreign ones who don’t want their gains being chewed up by it.
When foreign capital flows pick up, economic activity immediately responds and inflation rises. And when foreign money leaves economic activity drops due to tighter domestic financial conditions and inflation slows.
“Flows directly affect currencies, so a positive link exists between inflation and currencies,” says Dehn.
This matters most to local currency bond investors. Ashmore thinks currency will provide a nice source of return in emerging market local bonds over the next five years.
The cheapest way into this market is the iShares Emerging Markets Local Currency Bond (LEMB 36,25 +0,19 +0,53%) ETF, up 6.18% this year. But advisors may just want to go active on this one, or pick their spots in countries with stable economies and the cash on hand to keep paying their bills. Ashmore Group Tries Calming Forex Fears
Foreign exchange risk can be a headache for investment advisors. Some clients want no part of it, often missing out on allocation strategies outside of the U.S. Jan Dehn, head of research for the Ashmore Group, has some advice: remind clients that currency weakness versus the dollar does not necessarily equal inflation.
Investors who don’t follow foreign markets close think inflation equals rate hikes and that equals more capital costs for companies. Stocks suffer. It also means that if they are buying bonds, particularly those priced locally, they are losing on the currency.
There’s a word for this connection between currency and inflation: forex pass-through. Dehn says currency weakness can also be deflationary. Outflows can weaken economic growth and thus lower inflation, turning the conventional wisdom on forex pass-through on its head.
What does the data show? Did the 43% depreciation of emerging market currencies between 2010 and 2015 cause inflation rates to rise? Not really, he says. Except in Brazil and Russia where it absolutely did rise, and by quite a lot.
On average, though, inflation declined because economies stunk so bad that no one was spending any money. Or economies like India were stable enough that their central bank rate hikes were not enough to scare investors.
So no one should worry about forex pass-through, right?
Of course Ashmore wants to sell us more emerging market bond funds, and fearlessness on foreign currencies helps. Currencies are complicated parts of the investing equation. They move up, they move down, and inflation is as much a positive as it is a negative to a diversified foreign investment anyway.
“The thesis of pass-through has ambiguous theoretical foundations and the data at both country and index levels reject the thesis,” he says. So why does inflation tend to rise when currencies rise and vice versa? The most likely explanation is that currencies and inflation are jointly determined by a third variable: capital flows. High inflation scares off investors, especially foreign ones who don’t want their gains being chewed up by it.
When foreign capital flows pick up, economic activity immediately responds and inflation rises. And when foreign money leaves economic activity drops due to tighter domestic financial conditions and inflation slows.
“Flows directly affect currencies, so a positive link exists between inflation and currencies,” says Dehn.
This matters most to local currency bond investors. Ashmore thinks currency will provide a nice source of return in emerging market local bonds over the next five years.
The cheapest way into this market is the iShares Emerging Markets Local Currency Bond (LEMB 36,25 +0,19 +0,53%) ETF, up 6.18% this year. But advisors may just want to go active on this one, or pick their spots in countries with stable economies and the cash on hand to keep paying their bills.