Given what we see as an ongoing long-term bearish move in EM FX, we believe our EM FX model can add some valuable insight for investors. Our FX model is meant to assist global investors in assessing relative FX risk across countries in the EM universe. Read more here.
EM FX OUTLOOK
The medium-term bear market for EM FX remains intact as Fed lift-off approaches. In addition, the resumption of the broad drop in commodity prices has significant implications for EM and will impact Latin American economies the most. On the FX side, it’s no coincidence to us that long-term charts are pointing to many exchange rates going back to 2002 or even pre-2002 levels. In our view, that’s when the commodity super-cycle began. That boom fuelled GDP growth and exchange rate appreciation for the commodity exporters. Now that the boom has ended, we have to look for further adjustments in the exchange rates.
On the other hand, Asia and Eastern Europe generally benefit from lower commodity prices, and so these regions are likely to continue outperforming. However, the dollar has resumed appreciating against the majors and this renewed greenback strength should continue to spill over into all of EM. We retain a defensive posture with regards to EM, and we recommend investors to focus on fundamental factors. In such a negative EM environment, we feel that high carry will do very little to protect those vulnerable currencies.
Given what we see as an ongoing long-term bearish move in EM FX, we believe our EM FX model can add some valuable insight for investors.
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 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 Q3 2015 consists of SGD, PHP, THB, CNY, and ILS. Conversely, our 5-rated (weakest fundamentals) grouping for Q3 2015 consists of ARS, EGP, TRY, RUB, and IDR. Our next EM FX model update for Q4 2015 will come out at the beginning of September.
Our FX model had very good success in identifying the likely underperformers and outperformers since the last update. Since our model was last updated on July 8, those currencies with VERY STRONG (1) fundamentals have lost an average of -3.9%, while those with STRONG (2) fundamentals have lost an average -2.3%. This compares to an average loss of -6.7% during the same period for those with VERY WEAK fundamentals and an average loss of -9.1% for those with WEAK fundamentals. Lastly, an average loss of -2.6% was posted by those with NEUTRAL fundamentals.
We note that the VERY STRONG (1) grouping was skewed lower by a -5.3% drop in THB, while the STRONG (2) grouping was skewed lower by a -4.5% drop in KRW. On the other hand, the VERY WEAK (5) grouping was skewed higher by a flat reading for EGP, while the WEAK (4) grouping was skewed higher by a relatively small -4.0% loss in INR. We will continue monitoring and reporting our model performance in the coming months.
With global financial markets coming under stress again, we recommend focusing on fundamentals as opposed to high carry. Note that four of the five top currency picks for Q3 2015 are in Asia (SGD, PHP, THB, and CNY). This lines up with our long-held view that Asia is best-placed fundamentally in the current environment. Three others in the top ten are also from Asia (TWD, KRW, and PKR), along with one each from EMEA (HUF) and Latin America (PEN). Notable positive movements include PHP (2 to 1), ILS (2 to 1), HUF (3 to 2), CZK (4 to 3), and ZAR (5 to 4).
The five worst currency picks are ARS, EGP, TRY, RUB, and IDR. Others in the bottom ten are heavily weighted towards Latin America (BRL, COP, and CLP), and also include ZAR and INR. Notable negative movements include TWD (1 to 2), MYR (1 to 3), RUB (4 to 5), and BRL (3 to 4).
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.