- The dollar remains under broad-based pressure despite rising US rates
- This is really a weak dollar story for EM
- We continue to see greater divergence between EM equities and EM FX
- Our 1-rated (strongest fundamentals) grouping for Q1 2018 consists of SGD, THB, CNY, TWD, and PEN
- Our 5-rated (weakest fundamentals) grouping for Q1 2018 consists of ZAR, EGP, LKR, TRY, and ARS
- Our next EM FX model quarterly update for Q2 2018 will come out at the beginning of April
EM FX OUTLOOK
The dollar remains under broad-based pressure despite rising US rates. The US 2-year yield of 2.09% today is the highest since September 2008. The US 10-year yield of 2.67% posted earlier today is the highest since May 2014. Markets are finally pricing in more than two Fed rate hikes this year, which moves the market closer to the Fed’s Dot Plot of three in 2018.
The greenback was already under pressure before US Treasury Secretary Mnuchin’s comments. As such, there appear to be other factors behind the dollar weakness. Some talk about rising twin deficits in the US, others about the improved outlook for the rest of the world. Whatever the drivers are, we believe that the momentum against the dollar will be difficult to reverse near-term.
This is really a weak dollar story for EM. We suspect that the Real Effective Exchange rates (REER) for most EM countries will not strengthen that much given that the currencies of major trading partners are also seeing similar gains against the dollar. Still, don’t be surprised if EM official jawboning against FX gains picks up in the coming weeks. With the dollar in a broad-based swoon, however, we don’t think the impact will be significant nor lasting.
We should continue to see divergences within EM FX. As such, we still believe it is very important for investors to continue focusing on country fundamentals. Hedging out currency risk does not seem so important now for US investors in this weak dollar environment.
Our FX model is meant to assist global investors in assessing relative FX risk across countries in the EM universe. A country’s score reflects the relative fundamentals. This in turn should tell us something about the likelihood that its currency will outperform the rest of our EM universe over the next three months. We now include the Sri Lankan rupee (LKR) in our model universe, replacing the Uruguayan peso (UYU).
We favor the currencies of Asia and, to a lesser extent, EMEA, while Latin America should continue to underperform. Our 1-rated (strongest fundamentals) grouping for Q1 2018 consists of SGD, THB, CNY, TWD, and PEN. CNY improved from 2 to 1. This pushed down KRW from 1 to 2.
With global financial markets likely remain volatile, we continue to recommend focusing on fundamentals as opposed to high carry. Note that six of the ten top currency picks for Q1 2018 are in Asia. This lines up with our long-held view that Asia is best-placed fundamentally in the current environment. Two of the top ten are from EMEA (ILS and RUB), while PEN and BRL are the two representatives from Latin America.
Our 5-rated (weakest fundamentals) grouping for Q1 2018 consists of ZAR, EGP, LKR, TRY, and ARS. Note that four of the worst ten currency picks for Q1 2018 are in EMEA, while three are in Latin America. The three representatives from Asia are MYR, IDR (which worsened from 3 to 4), and LKR (which enters our model universe at a 5). Other notable movements are MXN (from 5 to 4) and PLN (from 4 to 3).
Our next EM FX model update for Q2 2018 will come out at the beginning of April. However, we will provide monthly performance updates throughout Q1.
Since our model was last updated on October 18, those currencies with VERY STRONG (1) fundamentals have gained an average of 4.3%, while those with STRONG (2) fundamentals have gained an average of 2.9%. This compares to an average gain of 4.0% during the same period for those with WEAK (4) fundamentals and an average gain of 0.3% for those with VERY WEAK (5) fundamentals. Lastly, an average gain of 1.2% was posted by those with NEUTRAL (3) fundamentals.
For this past quarter, it appears that currency performances reflected the underlying fundamentals. That’s the way it should be. Still, we note that there were outliers in some groupings. A subpar performance for BRL (0.4%) dragged down the performance of the 2 group. On the other hand, outsized gains for MYR (8.7%) and COP (5.8%) pulled up the performance of the 4 group. Likewise, ZAR (13.1%) pulled up the performance of the 5 group.
Our FX model covers 25 countries, with each country’s score determined by a weighted composite ranking of 15 economic indicators that are each ranked against the rest of our model EM universe for each category. Categories are external debt/GDP, real interest rates, short-term debt/reserves, import cover, external debt/exports, current account/GDP, export growth, GDP growth, FDI/GDP, nominal M3 growth, budget deficit/GDP, inflation, percentage deviation of the spot rate from Purchasing Power Parity (PPP), political risk, and banking sector risk. A country that is typically ranked first in many of the categories will end up with a low composite score (the lower the score, the better the fundamentals).
The 10 countries that are at the top of our table have VERY STRONG (rated 1) or STRONG (rated 2) fundamentals relative to our EM universe, while the 10 at the bottom have WEAK (rated 4) or VERY WEAK (rated 5) fundamentals. Those five in the middle have NEUTRAL (rated 3) fundamentals. These scores do not imply a greater return for those countries with a higher ranking. Rather, our models simply seek to identify those currencies that are backed up by better underlying fundamentals compared to their EM peers. We stress that the composite rankings contained in this model are a relative measure, not an absolute one.
Furthermore, we are making no assertions about the actual currency returns to investors, as that will involve differences in yield across all the currencies. We are simply identifying which currencies have strong fundamentals and which have weak fundamentals.