Stocks Left on Their Own as Emerging-Market Currencies Trail

(Bloomberg) -- Local currencies are once again acting as a drag on the emerging-market equity rally.

Carry-trade returns have turned negative and the benchmark currency index has erased its monthly gain even as developing-nation stocks scale successive record highs after a 10-month, $11 trillion advance since March. That reverses a trend since October when currency gains were a key pillar of the equity bull market.

The dissonance between stocks and currencies suggests 2021 could be a challenging year for the latter. A low base effect may exaggerate inflation trends, while geopolitical tensions involving China may sap risk appetite. Firmer U.S. Treasury yields may buoy the dollar, sparking capital outflows. That raises the question how long the stocks rally can last without support from currencies.

“Perhaps contrary to initial expectations, 2021 is going to be a very tough year for EM local-currency assets, given the matrix of factors one has to take into account,” said Simon Quijano-Evans, the London-based chief economist at Gemcorp Capital LLP. “Given Federal Reserve policy is the ultimate driver, EM FX will need to be fully focused on U.S. fiscal plans, which will drive Treasury yields and thus the dollar.”

The MSCI Emerging Markets Index, which is heading for a 7.5% increase in January, has risen to the highest level since May 2008 relative to the currency gauge. The growing divergence has reduced the 90-day correlation between the two assets to a three-year low.

Falling correlations between stocks and currencies have acted as indicators of trend reversals in emerging markets. They heralded selloffs in both 2015 and 2018. While the current correlation is still a bit off from those lows, investors may watch the correlation to gauge when the rally will run out of steam.

The emerging-market currency index had a beta of 0.26 relative to stocks in the decade through 2019. That sensitivity to equity moves has waned to 0.16 in the past year, underscoring currency underperformance.

Since March, when an emerging-market rebound began, the equity benchmark has advanced 83%. That suggests the currency gauge was expected to rise 21.6% during the period, based on the beta. It only climbed 11%. In other words, equity investors missed out on a potential return of 10.6% due to currency effects in the past 10 months.

©2021 Bloomberg L.P.