The EM currency space has stumbled badly on the outbreak of the coronavirus in China, which has impacted risk appetite, but many select commodities even more so since the story picked up attention in the market starting less than two weeks ago (using copper as our benchmark – and even if it feels like this story has been driving the narrative for even longer). We really don’t know where this situation will take us, but the issue is the most important one in the driver’s seat until it is firmly behind us. On that note, a couple of points are foremost in our mind.
Coming into this virus outbreak, the EM complex and financial conditions could not have been more complacent, suggesting rather significant risk that significantly more volatility awaits if the concerns and fallout from the issue worsens. Secondly, conditions themselves, especially emerging market credit spreads (still near post-GFC tightness), are only beginning to show a bit of concern here and there, even as select commodity prices are flashing deep red - so again, the market has mostly downshifted from extreme levels of complacency and isn’t yet showing any pronounced risk aversion. On that note, we upgrade our concern level for now and urge a very defensive stance on EM-related risk.
YTD EM Carry trade performance in 2020.
Below is a snapshot from a Bloomberg tool for measuring FX carry performance, a snapshot we will release with every update this year for a sense of how carry trades have performed in broad terms. Of course, the given basket here is for the most liquid of the higher yielding EM currencies and is more than a bit light on China-exposure, the most important theme of the moment. Still, our other performance snapshots below should give an idea of what themes are out- and underperforming.
For this basket, we chose the four highest yielding of the more liquid emerging market currencies at the beginning of the year versus the four lowest yielding G10 currencies. This basket returned nearly 15% in 2019 due to that year starting at a very low point for global risk appetite. After a strong start to 2020 on an extremely supportive backdrop in financial conditions, today is seeing the basket turn negative (-0.7% as per the blue line) on the year. Note that we used the MSCI EM equity index in USD terms as the benchmark – a benchmark that looks high beta in return terms relative to the basket so far this year.