- The broad-based dollar rally stalled out in Q1 following the more dovish market take on the Fed
- However, the dollar has been getting some more traction of late as US rates rise
- Developments elsewhere are also dollar-supportive
- We believe markets are vastly overestimating the Fed’s capacity to ease in 2019
- Our 1-rated (strongest fundamentals) grouping for Q2 2019 consists of CNY, TWD, THB, KRW, and RUB
- Our 5-rated (weakest fundamentals) grouping for Q2 2019 consists of ARS, ZAR, TRY, RON, and PKR
EM FX OUTLOOK
The broad-based dollar rally stalled out in Q1 following the more dovish market take on the Fed. Recession fears took hold then, pushing US rates sharply lower and taking some wind out of the dollar’s sails. The Fed Funds futures strip began pricing in solid odds of a rate cut this year and another next year.
However, the dollar has been getting some more traction of late. The US economy looks to be in much better shape this year than previously thought. That in turn has pushed US interest rates back up. Today’s 10-year yield of 2.59% is the highest since March 20, likewise for the 2-year yield of 2.41%.
Meanwhile, developments elsewhere are also dollar-supportive. Just today, ECB comments, Brexit risks, and RBA minutes all support our view that other central banks are getting more dovish even as the Fed stays on hold. We believe that any notions of Fed easing this year are way overdone.
We believe markets are vastly overestimating the Fed’s capacity to ease in 2019. When market expectations readjust to a more hawkish take on the Fed, the dollar rally should gather more steam. A higher US rate outlook will be a major headwind for EM, as are ongoing global trade tensions and signs of slow global growth.
EM currencies are mixed against the dollar so far in 2019. The worst performers YTD are the high beta group ARS, TRY, RON, KRW, and BRL. On the other hand, the best performers YTD are largely commodity-linked and benefitting from the bounce in oil and copper. This group includes RUB, CLP, MXN, and COP. With US rates likely to march higher and trade tensions likely to ratchet up, we believe EM FX is likely to remain under pressure well into H2 2019.
We see continued divergences within the asset class. On top of idiosyncratic political risk, we also believe it is very important for investors to continue focusing on country-specific fundamentals. Hedging out currency risk has become much more important because we strongly believe that this current dollar rally has legs.
Our EM 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 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 Q2 2019 consists of CNY, TWD, THB, KRW, and RUB. KRW and TWD both improved from 2 to 1, which helped push MYR down from 1 to 2. INR and PHP both improved from 3 to 2, which helped push PEN and BRL down from 2 to 3. MXN jumped two notches from 4 to 2, while MAD comes into our model universe at 2.
With global financial markets likely to turn more volatile, we continue to recommend focusing on fundamentals as opposed to high carry. Note that seven of the ten top currency picks for Q2 2019 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 in EMEA (MAD and RUB), while MXN is the lone representative in Latin America.
Our 5-rated (weakest fundamentals) grouping for Q2 2019 consists of ARS, ZAR, TRY, RON, and PKR. LKR and CLP improved from 5 to 4, which helped push ZAR down from 4 to 5. UAH comes into our model universe at 3, while PKR comes in at 5. Lastly, PLN fell a notch from 3 to 4. Note that five of the worst ten currency picks for Q2 2019 are in EMEA, while three are in Latin America and two in Asia.
Our next EM FX model update for Q3 2019 will come out in July. However, we will provide monthly performance updates throughout Q2.
Those currencies with VERY STRONG (1) fundamentals have gained an average of 2.2% YTD, while those with STRONG (2) fundamentals have gained an average of 2.4% YTD. This compares to an average gain of 2.1% YTD for those with WEAK (4) fundamentals and an average loss of -3.3% YTD for those with VERY WEAK (5) fundamentals. Lastly, an average gain of 1.0% YTD was posted by those with NEUTRAL (3) fundamentals.
So far this year, currency performances generally reflect the underlying fundamentals. Still, we note that there were outliers in every group. Relatively weak showings for TWD and KRW pulled down the performance of the 1 group. Likewise, relatively good performances for ZAR and PKR boosted 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, nominal M3 growth, budget deficit/GDP, inflation, percentage deviation of the spot rate from Purchasing Power Parity (PPP), political risk, and banking sector risk. We have replaced FDI/GDP with a country’s Net International Investment Position (NIIP/GDP). 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.
We have tweaked all our models to better conform with MSCI methodology. As such, we have moved SGD and ILS to our new DM FX model and eliminated EGP from this EM FX model due to its pegged nature. Replacing them in this EM FX model will be UAH, MAD, and PKR.