On the flipside, Mexican and Brazilian central banks moved early and have rates around 9.25% and 13.75% respectively. This huge positive carry versus the dollar has helped the Mexican Peso and Brazilian Real to hold up or even strengthen against the dollar this year.
While the carry trade is helpful to explain short term flows in and out of a currency, it tells us little about fundamental value and therefore longer term perspectives. In our view, it is far more important to look at the inflation differential. Inflation, by definition, is the devaluation of money. Higher inflation requires lower exchange rates against currencies with lower inflation. When this doesn’t happen, imbalances are created: in 2011 Brazilians were rushing to buy up Miami properties as their nominal wages had risen faster than those of Americans AND the Brazilian Real had appreciated thanks to the carry trade. Brazilians were rapidly getting relatively wealthier, not as a result of higher productivity but an overvaluation of their currency driven by investor flows. This was of course unsustainable and posed a huge risk to investors in that market.
We like to look at long term inflation differential adjusted exchange rates. These tend to be mean-reverting, which should keep local prices of goods and services, converted into US dollars, at roughly constant levels relative to US prices. On this basis most EM currencies (and probably also developed ones) have dropped well below long term averages over the past year – in some cases to extreme levels. The Korean Won and the Taiwan Dollar are 2.9 and 2.7 standard deviations below their 15 year inflation-adjusted average levels. American tourists in Taipei or Seoul will be astounded at how low prices are. Despite their resilient performance, the Mexican and Brazilian currencies also remain well below historic inflation adjusted average levels. This is partly explained by both these countries enjoying lower inflation than the US – their currencies should actually be appreciating just to maintain constant purchasing power.
Experience shows that the carry trade eventually ends in tears. This may or may not be triggered by rates differentials narrowing. An overvalued currency results in ever larger current account deficits as money flows out in search of bargains abroad. This requires more and more financing from foreign investors to plug the gap – at some point this becomes insufficient to keep supporting the currency and it collapses. This is of course what happened post 2011 to the then overvalued (but still high-yielding) Brazilian Real. By late 2020, even adjusted for inflation differentials, it had declined by 50% against the US dollar – those Miami condos had become expensive.
The US dollar is today’s overvalued carry destination, funded primarily by Asian currencies with lower rates profiles – it remains to be seen how long this cycle lasts. The current account deficit has widened to 4% so far, which is not yet a record level.
Nonetheless, as value investors we see opportunity in the many currencies that have underperformed despite having lower levels of inflation and lower domestic cost of capital. When the dollar cycle eventually turns, the currency headwind in those markets may reverse quite rapidly. Returns from undervalued equities in undervalued currencies could turn out to be quite spectacular.
