Review of Views

Our big-picture calls about the Trade War, the dollar, and global yields have largely gone our way, while in EM our relative value trades are performing better than our directional calls. The path to a completed Phase One deal between the US and China has been bumpy, as we had predicted, but it’s moving in the right direction.

We stand by our view the US Congress and the Democratic presidential contenders represent a greater market risk than Trump for now (see A New Stage of the US-China Conflict). Also as we had expected, the dollar has been trending higher over the last few weeks, and markets continue to price out Fed cuts (see EM Risk Map). However, the impact of these developments in EM assets have been mixed, and some specific events have played out differently than what we had expected. Below is an update on some of our key views.

 

Turkey

President Erdogan turned on the S-400 missile system. Unsurprisingly, this is making NATO members very uncomfortable and will raise the risk of sanctions, re-opening this downside risk for Turkish assets. Recall that the US removed the sanctions imposed in mid-October as the dust settled on the Syrian border. Those sanctions were on the mild side, even though they included a doubling of steel tariffs. But at the end of October, the US House passed a far more punitive bill against Turkey, which went through with 403 votes to 16. This one would ban arms sales, freeze assets of senior officials, and target state-run banks.

 The ball is in the Senate’s court, and the risk is that it will pass a bill with a veto-proof majority. We stick to our premise that Trump has moved into a buffering role of protecting Turkey (and China) from legislative offensives. The problem is that US lawmakers have been able to forge broad cross-party agreements on foreign policy issues, as seen by the Hong Kong bill. This means that Trump may not be able to do much. It looks like the Senate could bring a bill to vote in early December, but it’s hard to say how severe it will be compared to the version approved by the House.

 

Mexico vs. Brazil

We think political noise in Brazil will increase from here, as well as the risk of social unrest, but it will be nothing like what we have seen elsewhere in the region. The release of former President Lula from prison will serve as a catalyst for action by leftist and anti-Bolsonaro groups. These political forces may draw inspiration from protests around the region and see this as an opportunity to disrupt the government. Indeed, Lula defended a polarization strategy when speaking in the Workers Party (PT) congress last week. We don’t expect anything near the scale of what happened in Chile, Ecuador, or Colombia, but it’s important to realize that there are some key risk events still to come. A Brazilian court is set to decide today on one of the pending accusations against Lula (the Atibaia case), which will be important in determining whether he will be sent back to prison. Moreover, the Supreme Court is still due to decide whether to overturn the decisions by former judge Sergio Moro on the grounds of political bias. It’s unclear when and if this will happen, but if it does, it means that Lula could run for President in 2022, likely causing a negative knee-jerk reaction in local markets. And if it doesn’t happen, it could galvanize his supporters and fuel social unrest. Either way, it will get a bit bumpy.

 The real’s move to all-time highs against the dollar has been orderly, but it brings the risk of FX intervention (started yesterday) and it could also raise questions about how much COPOM will cut in the December meeting. As outlined in our piece Mexico vs. Brazil Outlook in late October, we correctly assumed that cyclical factors would be a drag on the real’s relative performance against the peso (the pair is up over 4% since then). But we did not foresee the failed oil-field auction in Brazil or that external forces would become such a strong headwind on EM FX, thus we got wrong the directional call for both currencies to appreciate against the dollar.

Going forward, we expect the real to begin stabilizing and reiterate our long peso call, though we recognize that it may take longer to materialize. We think the real will be caught in the crosscurrents of stable risk appetite (positive) and risk of FX intervention (positive) vs. political risks (negative) and low carry (negative). For the peso, we think it’s just a question of time until it gains traction and we see USD/MXN moving lower towards the 19.00 level. The country’s high carry and good enough fundamentals still offers one of the best prospects for playing risk-on trades.

 

South Africa

We were wrong about our call for a rate cut by the SARB in the last meeting, but we still hold on to our view that South African assets offer a poor risk-reward. The risk of a downgrade by Moody’s (probably in February) is well understood by the markets, but this doesn’t mean that it won’t weigh on asset performance. It’s unclear how much getting kicked out of the FTSE World Government Bond Index will cost the country in terms of flows. Just this year, non-residents sold nearly $10 bn of local stocks and bonds (mostly stocks), already the highest figure since 1998, when data was first available. We recognize that South Africa still offers a relatively high yield and that high liquidity makes it a good candidate for broad risk-on bets, but we prefer to stay on the side-lines. There are just too many headwinds between a deteriorating fiscal position, rating events, the troubles with Eskom and energy supply, and South Africa’s weak fundamental position.