Emerging markets (EM) have been all over the news recently thanks to crises in Argentina and Turkey, and EM equities have seen significant drawdowns. Ben Carlson, at Ritholtz Wealth Management, recently wrote an excellent piece about emerging market corrections and bear markets . He discusses how Emerging Markets are ridiculously volatile, with corrections and bear markets outnumbering those in the US by more than 2-to-1. This is in the context of yet another bear market in EM equities this year, with the MSCI Emerging Markets Price Index falling 19.8% from its peak in late January.However, this is in US dollar (USD) terms. In other words, it is the return seen by an investor who uses dollars to buy a basket of emerging market stocks, with the interim step that the US dollar is first converted to local currency. Which introduces currency risk.If you look at the MSCI Emerging Markets Price Index in local currency terms, the maximum peak-to-trough drawdown this year is only -13.9%. On the year, the index (including dividends) is down -2.5% in local currency, compared to -7.7% in dollar terms (as of August 23rd).This led us to compare drawdowns in dollar and local currency terms going back in history. We use Ben Carlson’s piece as a reference for identifying corrections and bear markets since 1994 (the exact periods and numbers may differ slightly because we use monthly data instead of daily data). So the table below is more or less a replication of his table, but with data in local currency included. 
As the data indicates, the price index in local currency has a lower drawdown than its USD counterpart across every correction and bear market but one (Dec 2002 – Mar 2003).The following table compares the volatility of the MSCI Emerging Markets Price Index in dollar terms to its counterpart in local currency. The S&P 500 and Nasdaq composite indices are included for comparison. 
The dollar denominated EM index is more volatile than its local currency counterpart across the entire period and in each sub-period as well. It is also slightly more volatile than the Nasdaq Composite index over the entire period, whereas the local currency EM index is less so.The volatility eats into returns as well, as the next table illustrates. 
Interestingly, over the entire 1994-2018 period, EM equities in local currency terms slightly outperformed the S&P 500, albeit with more volatility. However, EM currencies depreciated against the dollar during this period, taking a large bite out of dollar denominated EM equity returns – to the tune of more than 4% per year. The local currency index outperformed even between 1999 and 2007*, a period that saw the dollar weaken against several EM currencies – including those of China, Malaysia, South Korea and India.Essentially, an investment in EM equities involves two pieces – 1) an investment in the growth and profit potential of companies in these countries, and 2) a macro position in the local currency. The impact of currency on dollar based EM equity investments can be significant and we break it down into three parts: the math of currency-adjusted returns, positive downside correlation and drawdown drag.Related: How Fiscal Policy Worked in the Past, and What’s Different Now
The math of currency-adjusted returns
Which one would you prefer: Asset A with returns of 20% in year 1 and 20% in year 2, or asset B with returns of 50% in year 1 and -10% in year 2? Both assets have a (simple) average return of 20% across two years, but the compounded return is quite different.Asset A:(1 + 0.20) x (1 + 0.20) – 1 = 43%Asset B:(1 + 0.50) x (1 – 0.10) – 1 = 35%Beyond the fact that owning asset A may help you sleep better at night, it also has a higher compounded return thanks to no volatility drag.Currency-adjusted returns essentially have a similar problem as asset B. Say EM equities in local currency gain 40%, but the currency depreciates 10% against USD. The USD-adjusted return is not 40% – 10% = 30%.Instead, it is calculated as(1 + 0.40) x ( 1 – 0.10) – 1 = 26%There are three pieces to understand here:1. Investor made 40% on their actual EM equity investment2. Investor lost 10% on the currency3. Investor also lost 10% of the 40% equity gain = 4%. Call this the geometric piece.Combining the three, we get 40% – 10% – 4% = 26%This works the other way too. Say EM equities (local) gain 40% and the currency appreciates 10% against the dollar. So the investor gains 40% on their EM equity, 10% on the currency and also, the geometric piece is positive since 10% of 40% = 4%. The USD-adjusted return is 40% + 10% + 4% = 44%.However, you can see how EM equity losses can be made worse by a downturn in the currency. As the chart below shows, the geometric piece can more often than not be a drag when calculating currency-adjusted returns.
The question is how often a USD investor finds themselves in the quadrant where there is no drag – local equities gain and the local currency appreciates – and that brings us to correlations.Related: How Monetary Policy WorksPositive downside correlation
A key distinguishing feature between Developed and Emerging Markets is that during a crisis, sovereign bond yields in Developed Markets move down since they are treated as a safe haven. The opposite is true for Emerging Markets. Amid a crisis, economic or political, foreign investors rush out the door – they sell their EM holdings and invest in a safe haven asset class like US treasuries, a process that also involves selling the local currency and buying USD. The EM central bank then raises interest rates to protect the currency, which can make things worse for the local economy.So for EM equities denominated in USD, we typically see a positive correlation between the local currency and local assets during a crisis. So an already volatile asset class, EM equities, is made even more so by combining it with another positively correlated asset class, the local currency, that is also highly volatile.Another problem is that even when EM economies are on an upswing, their currencies can depreciate against the USD due to other reasons.A good example is Brazil this year, where the economy is slowly recovering from the country’s worst ever recession but a political crisis sent capital flowing out of the country. So the Brazilian real saw a sharp depreciation against USD. As a result, the MSCI Brazil Gross Index is down -18.1% on the year in dollar terms (through August 23rd), but is up 0.5% in local currency.Ultimately, post-crisis upswings, in both equities and currency, are not significant enough to make up for large drawdowns that were exacerbated by a depreciating currency.Drawdown drag
The situation in Turkey today is a good illustration of how drawdown math works against a dollar-based investor in EM. The MSCI Turkey Gross Index in local currency is down -20.6% on the year (through August 23rd), whereas in USD terms, it is down -50.7%. To get back to even, the local currency index needs to gain about 126%, whereas the USD denominated index needs to gain almost 203%!We saw earlier that the EM index sees larger drawdowns in dollar terms than in local currency. What we did not show is that since 2002, the dollar denominated index has outperformed its local currency counterpart in every interim bull market between corrections and bear markets. The problem is that recoveries have not been enough to make up for the drawdowns.Take for example the bear market that ran from November 2007 to February 2009, and the subsequent bull run that extended through to April 2010. The table below shows returns during the sub-periods and the overall period.
The dollar denominated index saw a drawdown of almost -63%, compared to a drawdown of -53% for the local currency index. Now, the dollar based index outperformed in the subsequent recovery by more than 30 percentage points (104% to 70%), but it still underperformed over the entire period.To conclude, we are not recommending that investors stay away from Emerging Markets. Investing in Emerging Market equities is an investment in the growth potential of businesses and consumers in those countries, as is an investment in any stock market, including the US – which has been shown to generate long-term wealth for investors.However, it is important to understand that a long-term passive investment in EM, that is denominated in dollars, has a big factor working against it – a simultaneous macro investment in the local currency. EM currencies can be negatively impacted by unpredictable events and exacerbate equity market losses, making recovery even more difficult.*Additional note:The total return table above shows a huge outperformance for EM equities between the late 1990s and the mid-2000s, even as US indices were lackluster. However, this was a fairly unique period for the world. Newly liberalized EM countries saw rapid growth via exports to Developed Markets. So these countries saw a lot of investment and capital flows geared toward building up this export capacity (which also boosted their currencies). After the Great Financial Crisis, a couple of things happened:1) Developed countries have seen a period of slower growth, and2) EM countries hit a potential ceiling on growth via exports to the developed world.So EM countries now have to grow by creating more domestic demand – both from consumers and businesses – and this means that the domestic financial sector has to mature enough to provide the credit required for this growth, as opposed to importing it. This is obviously easier said than done and there may be some growing pains.