Changing the itinerary: EM commodity currencies

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Investors in search of exotic destinations this summer may find the slopes of Sochi more attractive than the beaches of Copacabana. Of the three main EM commodity currencies (BRL, ZAR, RUB), RUB has better fundamentals.

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Emerging market (EM) currencies have been under selling pressure since May amid mounting expectations that the Fed would start tapering its quantitative easing programme sooner than previously expected. This has led to a rise in US yields and stoked concerns about the pace of flows into EM assets. Moreover, the year-to-date fall in commodity prices, the decoupling of this asset class from equity markets and calls about the end of the commodity super-cycle led investors to review the return expectations on commodity currencies. In EM FX, this currency segment is represented by Russia’s rouble (RUB), the South African rand (ZAR) and the Brazilian real (BRL).

In our view, it is not prudent to put all commodity currencies in one basket. Not all commodities are likely to embark on a structural downtrend (such as those RUB is exposed to). Moreover, differentiation will matter more from now on and there are differences in the domestic outlook and fundamentals of the three currencies.

Beyond the commodity angle, we are less optimistic about the prospects of the EM currencies as we move towards an environment of USD strength and rising US yields. Against USD, ZAR is most at risk; BRL is somewhere in the middle; RUB remains a currency with potential support. All three should, however, perform better against the Swiss franc (CHF), the euro (EUR) and the Japanese yen (JPY) than against USD.

ZAR: From global beta to domestic alpha

ZAR – previously a high-beta currency with an ability to benefit from benign global sentiment – has been battered by ongoing domestic uncertainty, such as labour strikes. Despite being the worst performer in EM FX this year (down by 15% against USD), we do not see its current weakness as a buying opportunity.

Figure 1: RUB looks the least vulnerable of the three to liquidity concerns, while ZAR is the most exposed

First, we think that the period of rapid GDP growth is over and that South Africa will only marginally outgrow the US both this year and next. Second, the prospect of the Fed tapering asset purchases is haunting EM assets and makes ZAR particularly vulnerable, given its external funding needs. With one of the largest current-account deficits in the EM space (Figure 1) – and a history of large portfolio inflows (bonds, in particular) – ZAR may weaken further should concerns about the provision of global liquidity intensify and investors further scale down their positions in EM assets.

Thirdly, the commodity angle is not particularly upbeat either, both in terms of global supply-demand dynamics or the domestic outlook. While the country has plenty of geological potential, it faces significant problems due to the increasing instability in the mining sector. In particular, clashes between supporters of the two main labour unions may continue to hamper the production of precious metals in the years to come.

We think that gold prices (South Africa’s main commodity export – 10% of total) may trend lower as global economic growth picks up: the sharp fall seen already following the FOMC’s June meeting is a reminder of how exposed it is to monetary normalization. The outlook for platinum prices (9% of SA exports – Figure 3) looks much more constructive to us given its stronger end-user fundamentals, but even there South Africa’s industrial unrest may constrain mining output and its ability to capitalise on that strength. The favourable medium-term outlook for iron ore and coal output could also be disrupted by strikes and political uncertainty in the short-term. Moreover, for iron ore, increasing supply capacity from other regions (such as Australia) should cause prices to decline in the coming years. Ongoing demand from Asia should underpin coal prices, however.

As a result, ZAR remains one of our least favourite currencies in the EM space. This remains the case despite its more attractive valuation (which is no surprise given its fall over the past quarters). As Figure 2 shows, the trade-weighted rand is cheap. But a weak economy, risks associated with its external funding needs, the generally soft outlook for its commodity exports and political risks make the ZAR outlook challenging.

BRL: The carnival is over

The big party on the beaches of Copacabana is over. BRL, in line with most of the EM currencies, sold off during the recent EM FX meltdown and would have probably been even weaker had the local authorities not intervened.

Figure 2: ZAR cheapened, but for good reasons, while RUB and BRL look expensive

Figure 3: Historical world platinum price

Figure 4: Brazil's and Australia's global ore exports

The Brazilian economy appears to be running of out steam. Following its average growth rate of around 4% between 2002 and 2010, output slowed sharply to 2.7% and 0.9% in 2011 and 2012 respectively. Although growth is expected to pick up to 2.7% this year, the recovery is not strong. Among other things, stubbornly high inflation (a notable factor in a world where inflation is generally falling) continues to eat into domestic real incomes. As seen over recent weeks, rising prices have translated into domestic protests.

One reason for the high inflation is a loss of credibility of the Brazilian central bank which, over the course of the last year, cut rates despite price pressures. On a positive note, the central bank has now taken steps to regain its credibility – it has hiked rates by 0.75 basis points so far this year and further tightening is likely to come. Although this has been positive for the bank’s credibility, the move is likely to limit economic recovery.

Moreover, due to uninspiring growth and large public spending, the fiscal situation has been deteriorating. As a result, our economists see a high probability of Brazil being downgraded early next year – this is not likely to add to the attractiveness of BRL.

The outlook for Brazil’s commodity exports is mixed. Iron ore (Figure 4), oil and soybeans account for nearly 30% of Brazil’s total export values. While we expect Brazilian iron ore exports to modestly rise over the coming years, the rising global supply and modest rate of demand growth from China makes the outlook for ore prices fragile. Brazil’s oil supply has risen substantially over the past decade and may increase in the medium and long term. However, we expect Brazil to be a key component for demand growth, and rising domestic consumption will likely weigh on
Brazil’s overall impact on the global oil market going forward. For agricultural commodities, Brazil’s soybean production accounts for about 31% of global supply, making it the world’s biggest producer. Given that it accounts for such a large proportion of global soybean output, the increasing frequency of adverse weather locally could pose upward risks to prices. Demand from China (importing about 70% of Brazil’s soybeans) should also remain robust.

All in all, the uninspiring growth, deteriorating fiscal situation, current account deficit (though not as high as in South Africa or Turkey) and the mixed outlook for its commodity exports makes us cautious on BRL. BRL is not cheap based on an inflation-adjusted basis (Figure 2) because of the high inflation of the past years. However, rising interest rates and the recovering central bank’s credibility may limit its downside.

“Normalisation of US monetary policy will make life for EM currencies a lot harder”

RUB: Not amazing, but better than others

In many respects, Russia could be seen as the flip side of Brazil. While the Central Bank of Russia (CBR) was the only big EM central bank to hike rates in the second half of the last year, Brazil was easing. This year, the roles have reversed and, with Brazil hiking rates, the CBR is expected to cut. While a fall in real wages weighed on Brazilian domestic growth, domestic consumer demand is currently one of the key drivers of Russia’s output (with real wage growth in positive territory).

The outlook for commodity exports for both countries is different: while we retain a constructive outlook on oil (Russia’s main export), iron ore prices are likely to trend lower as noted. Moreover, unlike Brazil and South Africa, Russia is running a current account surplus (largely attributable to oil). This makes RUB the least exposed of the three major
EM commodity currencies to concerns about global liquidity.

In terms of its commodity exposure, oil and oil-product exports account for over 50% of total export values. Russia’s oil production accounts for nearly 12% of global supply. While oil output has increased over recent years, domestic demand has also risen, causing net exports to increase only modestly. Looking ahead, Russian net oil exports may actually decline in the coming years as domestic consumption continues to pick up. This may tighten the global market balance. In the medium term, we remain positive on oil prices as supply growth is unlikely to match the increase in demand.

Russia’s fiscal position is not a concern for RUB (compared to BRL), but rising spending on social security is offsetting rising revenues: the budget balance is broadly neutral.

Although we expect RUB to struggle against USD as investors remain concerned about EM assets in general, we see scope for it to outperform both ZAR and BRL (Figure 5). From the commodity angle, prospects for Russian exports are brighter. Russia has a current account surplus, faces fewer political risks and is in a relatively better fiscal position than South Africa or Brazil (at least for now).

It is not only about which currency to buy...

Once investors find an EM currency (commodity-driven or not) on which they have a degree of conviction (a difficult task amid the current EM sell-off), their work is not over. In our view, the choice of which developed currency to sell is becoming more important. We believe the trend of recent years – for USD to be used as a funding currency – is over.
The robust US economy, rising US yields and attractive funding costs elsewhere argue for a shift. We prefer funding EM longs via CHF, EUR or JPY in the G10 FX space due to their low funding costs and expected depreciation. That said, we do not see an urgent need to go long EM FX as a bloc given the current market volatility.

Figure 5: RUB looks the best positioned among the major commodity currencies