Turbulence and outflows signal emerging markets drawdowns

A new paper by State Street Associates looks at signals for determining emerging markets currency depreciation as part of an overarching theme that concentrates on the enhanced value of combining indicators of risk and behaviour. Amanda White spoke to one of the authors, David Turkington.

In Practice is a new series of papers aimed at providing investment practitioners with concrete insights into how indicators and tools can be applied in practice, a tangible, practical guide to the complex financial-theory based research of the firm. The first was on “Correlations Surprise” and this second paper examines the signalling of emerging markets currency depreciation.

One of the paper’s authors, vice president of the portfolio and risk management group, David Turkington, says no two crises are the same, and by combining a number of indicators it is more powerful than using each in isolation.

In particular this paper looks at susceptibility, investor flow and market dislocation and the roles they play in anticipating currency drawdowns.

“We look at turbulence, and investor outflows as a whole other indicator to seek turning points,” he says. “You can get a good predictor of emerging market currency drawdowns. There is a signal for crisis points by combining fragility and investor holdings with the trigger of shock, no two crises (are) the same so it’s good to have a number of indicators.”

State Street’s research has taken on an overarching theme which looks at the enhanced value of combining indicators, and finds that behavioural and price-based measures are very complementary to fundamentals already used, in that they do come from different sources.

“There are a wide variety of early warning signals and the combination can occur in many different ways. We are not saying to throw everything at the wall but to see how they work together.”

This particular report applies the “absorption ratio” methodology, which quantifies the systemic fragility of a market, to construct measures of systemic risk for 16 emerging equity markets. It goes on to present empirical evidence that the fragility of a foreign equity market is linked to the subsequent return of its currency.

Using State Street’s Foreign Exchange Flow Indicator to provide a unique perspective on the impact of investor behaviour on currency moves, the paper introduces a framework for anticipating currency drawdowns that incorporates three ingredients: susceptibility, investor flow and market dislocation. For example it examines the combined impact of currency outflows and market fragility on subsequent currency performance.

It goes on to present a simple proof-of-concept backtest to show how an investor could use the scorecard approach to selectively reduce exposure to emerging market currencies.

“For all 16 currencies we find that average returns are disproportionately negative following the joint signal compared to those over the remaining sample. We find that both systemic risk and FX flows substantially contribute to this result, and that combining the two series creates a more powerful signal than using either in isolation,” the paper says.

The paper concludes that susceptibility, investor flow and market dislocation play key roles in anticipating currency drawdowns, and that combining multiple indicators is more powerful than using each in isolation.

Turkington is part of the group that has developed a number of new indexes in the past year or so, including the ‘turbulence’ indexes which measure volatility and unusualness of returns, as well as complementary systemic risk index.

The indexes are part of portfolio of risk management tools that can be used by funds managers of all asset classes, or by pension funds at the total portfolio level as a stress test. The aim is they can guide investors in adjusting risk exposures and so improve returns.