EM currencies are being hit hard again. 2014 is likely to be another tough year for EM FX: structural problems remain and valuations are still not appealing. But investors may start to differentiate, leading some EM currencies to recover. We avoid ZAR and TRY as their fundamentals remain challenging.
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January EM FX sell-off different to the one in summer 2013
EM currencies came under broad-based pressure in the second half of January, prompting many to compare the recent sell-off to events of the last summer, when they also weakened across the board. However, there are key differences between the situation now and then, in our view.
The recent sell-off was caused by EM specific factors
Last year’s sell off in EM assets was largely caused by the market suddenly repricing the outlook for US monetary policy normalisation and the consequent sharp rise in US longer term yields (for example, the 10-year US treasury yield rose by 100bps within two months). In contrast, the EM jitters this time around appear to have a bigger “local” component, ranging from concerns about the EM growth outlook (exacerbated by the below-consensus Chinese PMI reading on 23rd January) to more idiosyncratic factors (for example the 12%-13% depreciation of the Argentina peso). The negative sentiment unsurprisingly punished the currencies of the most vulnerable economies: Turkey and South Africa, with their currencies down by 6% and 7% respectively so far this year.
Are EM currencies out of the woods yet? Not necessarily. Market sentiment remains particularly downbeat and despite material adjustments in EM currencies across the board (the equally weighted index of EM currencies is down by 2.4% against USD so far this year and by 6.6% since May 2013 – Figure 1), structural problems remain and valuations are still not necessarily attractive in general.
Valuation adjustment may not be over yet
Figure 2 shows that despite their pronounced fall since May last year, EM currencies as a whole did not cheapen enough to make them a clear buy. Of course, there are differences among them. As Figure 3 depicts, the rand (ZAR) has seen a substantial fall, and does now look inexpensive (the currency has fallen by 25% against USD since 2013). But even here, as always, valuation alone does not make a convincing investment case.
Even after the recent sell-off, EM currencies are not cheap
Not only has ZAR been punished for its reliance on external funding in 2013 (along with other current account deficit countries such as Turkey (TRY), Brazil (BRL), India (INR) and Indonesia (IDR)), but a lack of structural reforms, a reluctance to hike rates (until this week) and ongoing political risk (due to labour disputes) has caused it to decouple (along with TRY) from the other deficit currencies which have made some progress. India for example has materially improved its current account deficit and its new Central Bank governor has restored the Bank’s credibility, whilst Brazil has embarked on a rapid tightening cycle to tame inflationary pressures and has rolled out a programme to intervene against excessive BRL weakness.
The lack of tangible measures, without the backing of attractive interest rates or carry (even after the latest 50bps rate hike), still makes ZAR vulnerable going forward. As Figure 4 shows, ZAR’s implied carry is not high enough relative to its fragile peers, and does not provide sufficient prospective returns to offset the potential risk.
Higher rates and carry are not a panacea
Of course, higher interest rates are not a complete remedy. While higher rates make long positions in the currency in question more attractive (as one benefits from the tailwind of high rates) and shorting the currency more expensive (as one needs the currency to depreciate by an amount equal to the interest rate differential in order to at least break even), they do not deal with root cause of the problem (structural vulnerabilities). Indeed, they merely buy time for reforms to be implemented. They also do not come for “free”. The obvious side effect is a further slowdown in growth, which is of course not desirable in an environment already characterised by market worries about a slowdown in EM growth. But a hangover comes after the party ends, and there are no easy fixes.
While higher interest rates may ease selling pressure on currencies, it is not a long term solution
Moreover, the effect of rate hikes may be muted when they are coupled with mixed messaging from the central bank. Turkey is a case in point: although it materially hiked interest rates in January (425-550bps across its main policy rates), the bank changed its policy framework once again, raising eyebrows among market participants. Under these circumstances, such hikes look like a hasty response to market tremors, rather than a careful and considered policy decision.
Turkey’s travails provide a good reminder that nothing should be taken for granted. Not so long ago (in late 2012 to early 2013), the Central Bank of Turkey (CBT) was acting to prevent excessive appreciation of the trade-weighted TRY (indeed, TRY was in fact the currency with the lowest volatility in the CEEMEA region – Figure 5). A few short years back the Brazilian real also was facing pronounced upward pressure. This merely underscores that the party cannot last forever, and that the end often comes from out of the blue.
2014 will be a tough year for EM currencies again...
Looking ahead, we retain our view that 2014 is likely to be a challenging year for EM currencies. As we have seen in recent weeks, structural issues remain among some EM economies (and are becoming more prominent after the taper-related indiscriminate sell-off in EM assets last year) while the positive effects of reforms, if implemented, will take time to materialize.
Our expectations of a stronger USD and rising core G10 yields do not bode well for EM FX either. Higher USD funding costs will be particularly problematic for countries that benefited from a credit-fuelled boost in consumption over past years, accumulating foreign liabilities as a result.
Moreover, and unlike their G10 FX peers, the EM FX segment remains highly correlated with risk, making it vulnerable in times of stress (as Figure 6 shows, the drop in EM FX correlation with risk has lagged G10 FX).
... yet, things may not be as bad as many think
Is another crisis like the one that hit Asia in 1997 looming? Perhaps not. We think that the EM bloc as a whole is in a qualitatively better position than it was then. Among other things, EM countries have lower external deficits and the overall EM current account balance is in better shape (Figure 7). Balance sheets generally are in better shape now.
Moreover, we do not see the worries that triggered the latest EM sell-off as revealing anything new: the structural slowdown of the Chinese economy is not new news, while Argentina is a frontier market whose woes are well-known. Moreover, although EM currencies look expensive on the whole, some regions are more attractive than others. As Figure 8 shows, Asian emerging currencies are now close to their fair value, as opposed to those in EMEA, which look dear.
We think that EM economies are in better shape than in 1997
The outlook for structurally weak economies and their currencies is not favourable, particularly if drivers change away from the DM-induced “one size fits all” sell-off (as QE tapering is now partly priced in) to differentiation between individual EM economies by investors. However, the prospect for differentiation provides scope to identify the potential winners and losers among EM countries. Looking at fundamentals, ZAR and TRY still look vulnerable (despite recent moves by their central banks), whilst the outlook for INR has materially improved (having markedly decoupled from the poor performance of the first two currencies). On the other hand, MXN should eventually benefit from its economic reform programme (structural reform being something which many EM countries have yet to engage with). Yet the overall shift is clear: EM currencies are no longer a one way bet, and DM currencies are regaining ground, USD and GBP in particular. While we can’t pretend to have foreseen the suddenness of the New Year EM sell-off, we have been positioned for DM FX outperformance.