- While EM FX had gotten some traction in early Q4, we believe that the medium-term bear market is back on track
- The dollar’s appreciation against the majors had stalled in early Q4 as Fed lift-off expectations were pushed back by the markets, but the pendulum is swinging the other way
- We favor the currencies of Asia and, to a lesser extent, EMEA, while Latin America should continue to underperform
- Our next EM FX model quarterly update for Q1 2016 will come out at the beginning of January
EM FX OUTLOOK
While EM FX had gotten some traction in early Q4, we believe that the medium-term bear market is back on track. Commodity prices have resumed their slide, and this will continue to have significant implications for EM, impacting Latin American economies the most. On the other hand, Asia and Eastern Europe generally benefit from lower commodity prices, and so these regions are likely to continue outperforming.
The dollar’s appreciation against the majors had stalled in early Q4 as Fed lift-off expectations were pushed back by the markets, but the pendulum is swinging the other way after the strong US jobs report last week. As such, we retain a defensive posture with regards to EM, and we recommend investors to focus on fundamental factors. With a negative EM environment intact (slow global growth, low commodity prices, rising US yields, strong dollar), we feel that high carry will do very little to protect those currencies that are most vulnerable. Indeed, SARB hiked November 19, and USD/ZAR is up almost 6% since then. Similarly, Colombia is in the midst of a tightening cycl, and yet we area seeing new all-time highs for USD/COP, up a staggering 20% since November 4.
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 Q4 2015 consists of SGD, THB, PHP, CNY, and ILS. Conversely, our 5-rated (weakest fundamentals) grouping for Q4 2015 consists of ARS, UYU, RUB, TRY, and CLP. We have replaced the Egyptian pound (EGP) with the Uruguayan peso (UYU) in our model. Our next EM FX model update for Q1 2016 will come out at the beginning of January.
Since our model was last updated on October 14, those currencies with VERY STRONG (1) fundamentals have lost an average of -1.7%, while those with STRONG (2) fundamentals have lost an average -1.7%. This compares to an average loss of -5.3% during the same period for those with VERY WEAK (5) fundamentals and an average loss -5.2% for those with WEAK (4) fundamentals. Lastly, an average loss of -1.7% was posted by those with NEUTRAL (3) fundamentals.
We note that the VERY STRONG (1) grouping was skewed slightly lower by -2.4% drops in both SGD and PHP, while the STRONG (2) grouping was skewed slightly lower by a -4.1% drop in PEN. On the other hand, the VERY WEAK (5) grouping was skewed higher by a 0.2% gain for UYU, while the WEAK (4) grouping was skewed higher by a flat reading for BRL. We will continue monitoring and reporting our model performance in the coming months.
With global financial markets likely to come under stress again, we recommend focusing on fundamentals as opposed to high carry. Note that four of the five top currency picks for Q4 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 (KRW, TWD, and PKR), along with two from EMEA (ILS and RON) and one from Latin America (PEN). Notable positive movements include RON (3 to 2) and IDR (5 to 4).
The five worst currency picks are ARS, UYU, RUB, TRY, and CLP. Others in the bottom ten are heavily weighted towards Latin America (BRL and COP), and also include ZAR, IDR, and INR. Notable negative movements include HUF (2 to 3) and CLP (4 to 5).
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.