Head of FX Strategy
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.
EM currency performance: Recent and longer term, carry-adjusted
Chart: weekly spot and one-month carry-adjusted EM FX returns versus USD
EM performance over the last week and months is mostly flat to negative as it was precisely one month ago that risk appetite peaked dramatically in late January before beginning a sudden unwind.
Emerging markets were less affected, though some correlation remains. Note the weak performance for the last month for our spotlight currency this week, the Brazilian real, and note that the South African rand has continued its remarkable relative strength over the last week as incoming president Ramaphosa’s team presented the latest budget proposal, which included a 1% sales tax hike aimed at signaling fiscal prudence.
Long-dated South African bonds have seen tremendous returns over the last few weeks in foreign currency terms as South African yields have plunged and the ZAR has soared.
Chart: three- and 12-month carry-adjusted EM FX returns versus USD
In the three- and 12-month perspectives, note that save for the top four performers (at the bottom) in the three-month horizon, the bulk of the EM appreciation over the last 12 months (darker bar) was due to stronger performance in the prior nine months.
Spotlight currency this week: Brazilian real
Our spotlight currency this week is the Brazilian real, which has been one of the EM laggards over the last year. The underperformance comes despite a roaring stock market rally which reflects the underlying strength in many of Brazil’s large commodity-linked companies, from Petrobras to Vale SA. As well, the Brazilian economy is estimated to have grown as much as an annualised 2.5% in Q4, its best performance in years, and unemployment is falling after peaking last year. The current account gap has also largely closed since worsening to below 4% of GDP as recently as 2015.
The critical factor holding back the BRL and Brazilian government bonds, however, is the ongoing mismanagement of government finances. Most of the staggering government deficit of 9% of GDP is due to the country’s excessively generous and unsustainable public pension system, which is in need of massive reform to place it on a fiscally sustainable footing. Heaping uncertainty on the situation is the long wait for the next election in October of this year and lawmakers playing coy about whether they will vote on unpopular pension reform until after that election has taken place.
Ratings agencies are taking note. The S&P ratings agency downgraded long-term, domestic and foreign currency Brazilian government debt in January and Fitch joined them in doing the same on Friday – both have Brazilian government paper at three notches below investment rating.
Uncertainty may be slow to clear as the man leading the presidential polls, former populist president Lula, has been convicted of corruption and sentenced to 12 years in prison. The currency strengthened on his conviction in late January, but the popular Lula has refused to back down.
Chart: Brazilian Real versus crude oil and Vale SA stock
Brazil is a large commodity producer and the BRL has a long-established correlation with key commodity prices, as is rather clearly visible in this chart’s comparison of the BRLUSD exchange rate (black line), the price of Brent crude (blue line), and the share price of Brazil’s mining giant, Vale (orange line).
The lagging performance of the currency relative to commodities has appeared twice in recent years, once in 2013 via the Bernanke “taper tantrum”, when EM currencies and economies peaked and began their long descent after the long period of over-stimulus of USD-credit into EM economies due to the Fed’s very easy policies in the wake of the global financial crisis. This time around, the clear lagging performance in BRL is down to investors’ reluctance to allocate to Brazilian debt or FX exposure until the political situation clears up, particularly the issue of the unsustainable fiscal dynamics linked to the pension system.
As well, with the Selic target interest rate collapsing from 14.25% in late 2016 to 6.75% today as Brazilian inflation does likewise, it has become much cheaper to hedge exposure to Brazilian assets. The road to any real recovery for the real is a long one this year. If Lula were to stand aside and designate a successor with a credible and realistic message from left of center on the need for pension reform, the BRL could rally hard if the global backdrop is supportive. But no reform or prospects thereof and a popular uprising linked to Lula’s fate could mean ongoing uncertainty and underperformance, especially if commodities slow their advance or worse.