Head of FX Strategy
Summary: Exporters into China and commodity-linked EM currencies were already under pressure recently on the fallout from the coronavirus outbreak, but risk conditions are now even more broadly hostile for EM, even as we have yet to see a major adjustment in EM credit spreads. If the latter come under pressure, EM pain could intensify.
The initial phases of the global market reaction to the coronavirus fallout were somewhat limited to those countries with the most direct trade exposures to China and to commodities, due to China’s domination of the demand mix for many commodities. The reaction among EM currencies, largely followed suit, with EM Asia heavily impacted – particularly the heavy exporters into China like Malaysia and Korea or countries like Thailand who have seen a total cessation of Chinese tourism into the country and are seeing arrivals from elsewhere in the world likewise reduced.
But over the last week, we are seeing an intensification of the reaction to the coronavirus outbreak as the market realizes the implications for global supply chains already baked into the cake and the risk that a global pandemic risk beyond China’s borders will sustain the slowdown in demand for commodities as travel is reduced and activity in general curtailed, even as portions of China are beginning to return to work. This second wave has struck EM currencies more broadly, as can be seen in the performance statistics below.
While we maintain a strongly cautious stance here, many currencies have sufficiently weakened for us to argue that the longer term risk/reward for long exposure has become far more compelling than at any time in the recent past and we are sympathetic with beginning to build 25-30% of an eventual long EM allocation here as the policy response is likely going to arrive in a big way in the weeks ahead and one vector of stimulus could be a US (read: Trump administration) effort to weaken the US dollar.
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 which themes and regions 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, the basket is now bumping along in sideways fashion, down very slightly on the year (-0.7% as per the blue line showing the Total Return). This is actually rather respectable, given the benchmark – the MSCI EM equity index in USD terms – dropping some 5% YTD. Some of the lack of further downside has been due to a weak EUR and SEK funding currencies.
Short term EM currency performance
The below shows the 1-week and 1-month carry-adjusted performance of the EM currencies in our universe and really paints a picture of how deeply EM currencies have corrected here in the short term, with red across the board and deeply so in most cases, particularly for heavy commodity exporters like Russia and Brazil. The only currencies looking a bit less affected are those with tighter exchange rate controls like SGD, TGWD and HKD and importers of commodities like INR and PHP. The Mexican peso has played the most catch-up to the downside over the last week after amazing posting new cycle highs versus the USD as recently as last week.
Chart: Saxo Bank Global Risk Indicator
No surprise, given where equity markets are as we are publishing today’s report, and given the short-term performance of EM currencies versus the US dollar, that the backdrop of global risk conditions is not friendly for EM carry trades. Our measure of global risk has quickly plunged deeply into the red only over the last couple of days. It is interesting, however, that the least marked contributor of the components we use to comprise the indicator has been EM credit spreads, which remain relatively complacency relative to the action in the EM currencies themselves and relative to recent moves in corporate credit stress indicators.
EM Credit Spreads
The chart below shows six examples of developments in EM credit spreads and the very different picture, depending on the currency. Mexico, Turkey, Brazil and Russia are seeing their credit spreads on USD debt (the dark blue lines) rising from a very low levels, while South Africa’s credit is blowing to a new wide level – suggesting higher risk of more pain for ZAR, while Chile is nearing critical levels as well.
Carry trade performance*
The chart below shows the longer term performance of the US dollar versus the lowest yielding funding currencies. While the most recent few days of market action have seen the EUR and JPY pulling back against the US dollar, the USD is still higher than all of the lowest yielders relative to a month ago, to varying degrees.
EM currency performance continues to vary widely in the longer term, even as we noted the near universal weakness in the short term above, particularly over the 1-month time frame, also shown in the chart below.
Current carry available*
The chart below simply shows the forward carry for owning the USD versus funding currencies and the returns on higher yielding EM currencies versus the US dollar. Given sharp weakness in EM FX, we will be surprised if EM central banks don’t begin to change their tune on the outlook for further rate cuts.
*Note that all performance calculations are done as carefully as possible to include trade spread costs and market conditions at the time but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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