The models are broken
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Chief Investment Officer
Head of FX Strategy
Global investors shifted into a risk-positive move over the mid-summer weeks, strongly bidding up some emerging market assets. Our question this week is whether the bounce has much hope of lasting when Chinese markets are clearly in a deep funk and amid the open question of whether China will allow a major devaluation of its currency. As well, the weakening in the Turkish lira has taken on added urgency and could provide a degree of contagion across EM assets.
Introducing: this week’s bias
Stronger: INR, IDR
Weaker: KRW, CLP
As a new feature for this week, we highlight currencies within our EM universe where we look for out- and underperformance. We look for more IDR and INR relative strength as the market may be overly concerned about India’s inflation problem relative to the rest of the world. As for the IDR, the strong improvement in Indonesia’s credit spreads has not yielded as much relative improvement in the currency as we would expect.
On the weak side, we express China concern via KRW, with the Korean economy so leveraged to exports to China and to the trade war theme. Nor do we like CLP, where still-low copper prices – even despite a recently announced Chinese stimulus – should be weighing more on the currency’s fortunes.
EM developments over the last week
Since our early July update, conditions have been largely favourable for emerging market currencies on a resurgence in global risk appetite but performances have still varied widely, particularly the relative weakness in Asia, where the clear driver over the summer so far has been China’s yuan devaluation move.
CNY: The Chinese yuan deserves more attention than any other currency at present, EM or otherwise, as China has engineered a significant weakening in the yuan over the last couple of months that now sees the currency pushing on major inflection points like 8.00 in EURCNY, which was the high of the range since 2014. As well, the yuan is within one percent of the low versus the official CFETS basket of currencies that was established back in 2017. Any move below that level in particular, or any move above 7.00 in USDCNY suggests something bigger is afoot and the market is complacent on China’s intentions.
Let’s recall the wild experience of 2015, when China’s change to its FX policy regime triggered enormous concern. At least one Chinese official has recently vowed that Beijing won’t pursue devaluation as a policy option. Next Tuesday sees the release of the latest China reserves data, with very different implications if reserves have risen (more intentional devaluation and more blatantly 'hostile' from the US trade war perspective) versus if they are unchanged or have dropped.
Chart: EURCNY and the official RMB index
We highlighted the weakening CNY in our last update from early July and continue to view China’s policy intentions as one of the most important factors for EM as further CNY weakness tends to make the USD stronger and could destabilise risk appetite as was the case during the 2015 experience (note that that the official RMB index is only updated weekly).
In the chart below, the EURCNY rate in black is inverted and the prior highs are outlined with the horizontal line (right axis). The weekly updated RMB basket could match the lows for the cycle this week (blue line – last data point being July 27 before additional CNY weakness this week).
MXN: the Mexican peso has undergone a strong resurgence and MXN is the strongest performer in our EM universe over the one- and three-month timeframes. The market has decided that newly elected left-populist president Obrador is making sufficiently market-friendly noises on his intended policy mix once he assumes office to remove the discount of the peso that had built ahead of the July 1 election. Still, the wait for the beginning of his term of office in December is a long one. And at least one announced policy goal of investing some $10 billion in PEMEX refineries and exploration and production raises our concerns that Mexican deficits are set to rise after a promising reduction to -1% of GDP in 2017 after ranging between -2.5%-3.5% in the prior several years.
In short, Obrador’s comforting rhetoric and history as a pragmatic mayor of Mexico City, as well as a recent broad improvement in most emerging market credit spreads, were solid reasons for a MXN bounce, but we see little further upside potential for the peso from the 18.50 level achieved in USDMXN over the last week.
Chart: USD-denominated bonds spreads for selected EMs
Most EMs with USD-denominated sovereign debt saw a strong improvement in their credit spreads over the summer after an episode of generally worsening the weakest levels since the early 2016 lows for EMs. Given the trade war theme and the macro backdrop, we don’t look for a further strong improvement in EM risk spreads from here – the chief risks are economic slowdown from the local currency increase in oil prices and the slowing of growth from the lagged effect of the slowed credit impulse from China’s deleveraging.
INR: the Indian rupee's bounce versus the US dollar is fading fast even as the Indian Central Bank moved to hike rates again this week in response to rising inflationary pressures. It appears the market remains concerned that inflation in India could continue from here and keep real interest rates low. As well, inflation concerns have been stoked by the imminent local election cycle and next year’s national election, which have prompted officials at the local and national level to launch generous handout schemes like the recently announced increase (averaging some 15% from last year, according to Goldman) in the minimum support price (MSP) for a number of food crops.
Given the recovery in EM currencies and risk spreads recently, however, we feel that the rupee is being a bit unfairly singled out – certainly in relative terms. As well, India is far less vulnerable than the Asian exporters or commodity producers globally should global growth concerns pick up from here as it is generally a net importer.
TRY: The Turkish lira plumbed new depths as USDTRY rose above 5.00 for the first time. New downside momentum has come as the US announced sanctions on Turkish government officials on Turkey’s handling of a US pastor on Turkish soil.
Turkish president Erdogan is striking the usual defiant stance – no surprise there. Concerns on the viability of Turkey’s finances given the political landscape (the risk of Erdogan interfering with central bank decisions, signs of nepotism in appointing his son-in-law as finance minister, etc.) and the structural backdrop of Turkey’s foreign currency-denominated exposure could continue to drive TRY weaker, and default odds have ratcheted to new highs this morning with Turkish sovereign CDS’ trading near 340 points at a time when other EM credit spreads have seen considerable relief.
Some Turkish corporates are trying to restructure their foreign-denominated debt, a move that could further damage confidence in Turkish assets. Still, the biggest risk is a default at the sovereign level, an event that could would likely feed a wider contagion scenario across EM assets.
Chart: Global Risk Index headed into positive territory
The summer has witnessed a sudden thaw in risk conditions that has taken us by surprise. Volatility has dropped in equities and G10 FX, but most importantly, the corporate and especially EM credit spreads have improved sharply before weakening again slightly just ahead of this week’s publication.
For the first time since the launch of this publication in early February, our Global Risk Indicator rose briefly into positive territory before dipping back lower.
EM Currency Outlook: CNY, Japanese and US bond yields in the spotlight
We identify a further CNY weakening as one of the more pressing risks for EM currencies, particularly those in Asia as China is the mother planet around which its economic satellites orbit. As well, the Chinese economic trajectory is a concern as China attempts to do the impossible of deleveraging its economy while claiming it can continue to grow.
Recent signs point to a new stimulus effort to ward off the risk of a crunch, but there is a long lag between changes of direction in policy and economic outcomes. Measuring China’s economy has always been a frustrating exercise given the questionable reliability of official data. But indirectly, China’s recent move to weaken its currency and ease policy speaks volumes about the de facto weakness in the economy – a weakness that will only be aggravated by a further trade confrontation.
Therein, however, does lie the potential for a very large one-off rally if Trump strikes an “Art of the Deal” stance as he did with North Korea and suddenly makes friendly with China. Until then, our concerns outweigh our hopes and a weaker CNY and stronger USD are applying negative pressure for EM.
On a side note, the most recent Bank of Japan meeting is seeing a stronger JPY, which could add some pressure on EM at the margin if the JPY likewise strengthens on the view that the cautious new policy tweaks represent a move, however ponderous, in the direction of tightening.
EM currency performance: Recent and longer-term, carry-adjusted
Chart: weekly spot and one-month carry-adjusted EM FX returns versus USD
Short-term performance over the last week has shifted back to the negative side as the US dollar has recovered, while the one-month performance (the bottom bar of each bar pair) shows a wide variety of moves from individual EM currencies, particularly positive for MXN and BRL. It seems MXN moves the LatAm universe to a degree as the region’s most liquid currency, as BRL and CLP moves look more like relief rallies in EM credit spreads and correlation with MXN rather than due to any notably positive catalysts. Turkey’s strong negative divergence stands out rather clearly.
Chart: Three- and 12-month carry-adjusted EM FX returns versus USD
Turkey stands out clearly on the longer-term performance chart, but note China’s currency posting the second-weakest performance in our universe for the last three months, and dragging the low-yielding exporters THB and KRW with it. It’s a bit odd to see the degree of divergence between Asia and Latin America in recent weeks as many Latin American countries have very large exposures to China if the latter’s demand for key commodities imports weakens – especially BRL, PEN, and CLP. Colombia has far less exposure to China than its other tradeable peers in South America.
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