(By Jack) Back in late February I gave you an easy way to consider investing in emerging market (EM) currencies. Effectively, it comes down to: Follow the stock market of the local EM that interests you, and the currency will almost always follow.
This isn't how it works in the industrialized market world, you might be thinking. In fact, it seems just the opposite for the U.S.
In the recent cycle we have watched stocks rally while the dollar rises and vice versa. And at other times, we have seen the dollar and stocks move together in multi-month moves. The nagging question: Why in most cases does the price action for EM currencies so closely correlate with their stocks?
The short answer is that in the EM world it is all one big asset market driven by the same theme: Money flow. Specifically, money ebbing and flowing from the center to the periphery and back is the largest detriment of the price action in EM currencies.
I've created an Emerging Market Money Flow model that represents this center-periphery relationship. Here is the basic summary …
Needless to say, there are many moving parts in this flow model. The main point is that EMs are still highly dependent on money flow from the center.
And because the global economy is clearly slowing, as evidenced by the decline in purchasing managers indices in the big three global growth drivers — the U.S., Europe, and China — pressure will continue to build in the emerging market economies and likely push their markets and currencies lower against the U.S. dollar.
One of my favorite long-term ideas, based on the expectations global growth will continue to fade, is shorting the South African rand against the U.S. dollar. South Africa is especially vulnerable for any decline in demand for its raw materials and increasingly dependent on China to keep all the balls in the air. Evidence that South Africa is feeling the pain surfaced this week. Here is the excerpt from Reuters:
JOHANNESBURG, June 21 (Reuters) — South Africa's current account deficit widened in the first quarter, reaching its highest level in more than three years, as exports slumped to debt-ridden Europe, the most important trading partner of Africa's biggest economy.
The current account deficit reached 4.9 percent of Gross Domestic Product in the first three months of the year, the central bank's June Quarterly Bulletin said on Thursday, up from 3.6 percent in the previous quarter.
Export earnings fell 2.4 percent in the first quarter compared with a 6.4 percent expansion in the last three months of last year as prices fell in tandem with a 0.4 percent contraction in volumes, it said.
The rand, which had enjoyed a week of gains against the dollar, fell 1 percent amid expectations of a wider-than-forecast deficit for this year.
The data poured cold water on hopes for an interest rate cut this year after weaker-than-expected inflation figures for May released this week.
A current account deficit is much more dangerous for an emerging market precisely because of their dependence on external money flow to help fund the deficit. And a rising current account deficit is often a precursor to a weaker currency going forward. I think this could be the case for the South African rand.
The most recent low in the South African rand (November 2008) came as a result of the global credit crunch crisis — money flowed quickly from EMs back to the center. The flipside of this was a big rally in the U.S. dollar. If global growth continues to decline, this low could be tested again.
What is interesting about the price action in South Africa — between the currency and the stock market — is the current big divergence. Presently, stocks are outperforming and the currency has been weakening. This isn't exactly following along the lines of my earlier comments suggesting they move together.
We never know for sure who leads or who follows in these relationships. But I am still betting on money flow and believe the stock market will catchup to the currency on the downside.
If you like this idea, there are two ways you can access the South African rand:
The first is a currency ETF available for the South African rand, which you could short. It is the WisdomTree Dreyfus South African Rand Fund (SZR).
And the second, if you are a more aggressive trader, is to trade the South African rand in a standard retail spot forex trading account.
P.S. The South African rand isn't the only currency set for a header. And I've given my World Currency Trader members specific recommendations so they can be nicely positioned when that time comes. To learn how you can trade currencies that offer the greatest profit potential with the least amount of risk, click here.
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