EM FX Weekly: A pivotal week for global markets

This is the fourth release of our beta of a new weekly publication covering the performance and outlook for a number of emerging market currencies. We place particular focus on carry adjusted performance as carry is an under-appreciated portion of returns in EM currencies, while the spot exchange rate relative to past levels often provides little perspective, especially for the highest yielding currencies.

This is a pivotal week this week – a “get to know the new Fed chair week”. The backdrop ahead of Chair Jerome Powell’s first major appearance is one of equity markets making an attempt at coming full circle from the massive volatility event from earlier this month. In many emerging markets, equities have roared back to the highs for the cycle, while currency performance over the last week has been generally indifferent to slightly negative. This could prove a pivotal week for all markets as animal spirits attempt to cement their comeback.

The weekly wrap: EM performance mixed at best as global risk appetite bounces back

Emerging market assets posted a mixed week last week as risk appetite ebbed back and forth but then ended the week on a generally strong note. Equity markets in the best-performing EM markets like Brazil and Russia have managed to pull all the way to new highs for the cycle, perhaps in part due to their perceived link with a global reflation theme and the comeback in oil and other commodity prices. Elsewhere, other EM markets merely tracked global risk sentiment one-for-one and EM currencies were broadly indifferent to weak as the US dollar has put up a bit of a fight recently. 

EM currency outlook: Hello, Mr. Chairman

Since peaking last Wednesday, Fed rate hike expectations and longer US yields have come back in a bit after a week of massive issuance from the US Treasury, which provides some relief at the margin for risky assets on the reduced threat to global liquidity (many also question whether rising rates are even that much of a threat at these levels, as financial conditions remain very easy). 

Investors were encouraged on Friday by the Fed’s Monetary Policy Report, where the consensus takeaway is that the report suggests the Fed is not excessively concerned that the tight US labour market is about to trigger an inflationary wage-price spiral. For emerging markets, an easing of the pressure from US yields and the general buoyancy in risk appetite would be supportive.

Last week, beside the general rise and fall in animal spirits we listed our three primary concerns for emerging markets, and these remain:

   • Trade showdown between the US and China: this is the biggest threat to all risk-exposed markets, especially as the timeline is unknown and ad hoc political developments could come at any time. Over the last week, a story citing credible sources circulated that the protectionist and highly China-critical US Trade Commissioner Peter Navarro likely will be promoted to a more prominent position soon. We are also possibly weeks from a decision on whether the US will impose penalties on Chinese steel and aluminium imports. A trade showdown is far and away the most clear and present danger to risk appetite and emerging market assets at the present time and for the foreseeable future.

   • US yields and whether higher rates risk triggering a new cycle of contagion across markets represent another pair of key risks for EM. As this Tuesday sees the first major appearance from newly minted Fed chair Powell, this issue is in play over the coming week as he will deliver his semi-annual testimony on the state of the economy and Fed policy outlook before a House Committee on Tuesday; the January PCE Inflation data are up on Thursday. Even if US yields fall this week, if they do so as the USD rises the latter could be the chief drive of any near term-further EM consolidation risk.

   • EU existential risks and whether these trigger broader contagion. This is long-odds / wild card stuff, but we will watch for any fallout from the March 4 Italian election and possibly more dramatically from the same day's German SPD party vote on whether to approve the new “grand” coalition with Merkel’s CDU/CSU as polls show support for the SPD rapidly collapsing on the SPD party elite’s post-election manoeuvres. There are only very modest signs of any worry on this front, but stay tuned.

Chart: Global Risk Index

The chart below is a Global Risk indicator which offers a perspective on the short-term risk appetite level relative to the longer-term backdrop. The comeback in risk we noted last week has not gathered much pace. Some market volatility measures have continued to improve, but the improvement in risk spreads in EM and corporate credit has largely stalled.