This is the third 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.
The weekly wrap: Emerging markets on the defensive after sudden equity meltdown
Last week we noted concerns that the bout of global risk aversion could lead to further weakness in EM currencies. But over the past week, risk appetite has come roaring back in global equity markets and EM currencies have broadly performed well, too. As also noted last week, perhaps the most remarkable feature of this entire recent bout of volatility was the degree to which EM currencies themselves, as opposed to the underlying equity and bond markets, saw very little of the contagion – it appears that equity market contagion is very high-risk in the event of a sudden meltdown like the one at the beginning of this month, but credit, whether corporate credit measures or sovereign credit measures in EM, saw a far more muted response and the latter has been rather quick to calm.
EM currency outlook
Volatility has settled considerably over the last week, though the recent episode was sufficiently violent to make many, including ourselves, wonder if we are entering a new era of higher volatility now that this event has discouraged self-reinforcing volatility selling as a viable investment strategy after absurdly successful returns for the prior two years. As well, the fairly aggressive lifting of the entire US yield curve is a new twist that has to increase uncertainty and volatility at the margin in our debt-addled global economy.
The narrative for emerging market assets is rather difficult here. Normally, the rising US yields would be a strong warning signal for emerging markets as an indicator of tightening liquidity for the world’s dominant reserve currency, with trillions in USD-denominated exposure the world over. But this time around, higher US rates are accompanied by a weakening US dollar, reflecting concerns about a worsening US current account deficit under Trump’s new tax regime. That is a palliative to the rising rates concern, though at some level we suspect a persistent rise in yield would upset the entire apple cart of risk, as we discuss below.
A few observations that are occupying our attention for the coming few weeks and makes us reluctant to signal the all-clear for diving back into emerging markets:
• Last week saw a higher than expected US CPI release that some worried would trigger both higher US yields on the fear of an even more hawkish Federal Reserve, and weaker risk appetite due to the risk that higher yields are seen as anathema to equity multiples. The reaction was rather interesting, as bond yields did rise rather sharply and to new highs for the cycle, but risk appetite quickly recovered. This is of course encouraging for risk-takers in EM and otherwise, but we are getting close to a key inflection point on the US 10-year yield benchmark – the six-year high just above 3.00%. At some yield level, higher yields will matter very much. And this week is an interesting one for the US treasury market, as the US will auction enormous allotments of two-, five-, and seven-year treasuries. Strong auctions could suppress US yields, but now that the market response has gone upside down on the reaction function to higher US yields, would a strong US Treasury auction see a stronger USD/weaker EM for the near-term on the flow implications?
• We are closely monitoring the US-China trade rhetoric as the Trump administration has circulated ideas on imposing tariffs on Chinese steel and aluminium. Regardless of the specific size of these imports into the US, any strong sign that we risk a dangerous showdown over trade issues is a massively negative event for global risk. Our spotlight currency this week on that note is the Chinese yuan (see below).
• EU existential concerns have been well off the radar since the Dutch and French elections of last spring, and perhaps deservedly so. But a small dose of caution is perhaps warranted until the market navigates to the other side of the Italian election on March 4th and potentially far more important, the March 4th German SPD vote on whether to approve the SPD party leadership’s Grand Coalition deal with Merkel’s CDU/CSU. The latest polling show the SPD with its weakest showing ever. A German political scene that is suddenly thrown into disarray could be Germany’s "Trump/Brexit" moment and lead to a bit of soul-searching in the longer term, even if the immediate implications aren’t entirely obvious or dire. This is a wild card, but deserves mention.
Otherwise, if market conditions continue to settle and the US long yields remain relatively tame, the conditions for renewed strength in EM currencies would remain favourable.
Chart: Global Risk Index
The chart below is a Global Risk indicator which offers a perspective on the short-term level and momentum of risk appetite. At present, we are seeing a sharp recovery in the index as market conditions have calmed considerably in the wake of the recent eruption of risk aversion. FX volatility is the Global Risk Indicator input that has calmed the least, however, perhaps as USDJPY crossed below a big level recently, sparking a rise in JPY volatility.