- EM FX has gotten some traction in recent weeks, as markets have pushed out Fed tightening prospects
- The dollar’s appreciation against the majors remains stalled despite the strong June jobs data
- Our 1-rated (strongest fundamentals) grouping for Q3 2016 consists of SGD, THB, CNY, RON, and KRW
- Our 5-rated (weakest fundamentals) grouping for Q3 2016 are RUB, COP, ZAR, UYU, and ARS
- Our next EM FX model quarterly update for Q4 2016 will come out at the beginning of October
EM FX OUTLOOK
EM FX has gotten some traction in recent weeks, as markets have pushed out Fed tightening prospects due to a combination of soft US data and Brexit risks. For now, the markets are in a perceived sweet spot. The strong June jobs data suggests the US economy remains in good shape, but not good enough to warrant imminent tightening. The July 27 FOMC is seen as too soon for a rate hike, which puts September 21 as the next possible meeting.
The dollar’s appreciation against the majors could remain stalled for much of the summer then, despite the strong June jobs data. Dollar weakness has spilled over against EM as well. However, we remain constructive on the US outlook and believe that market expectations (via the Fed funds futures strip) are too dovish with regards to the Fed.
Indeed, we believe markets are underestimating the capacity of the Fed to tighten this year. As such, we will retain a defensive posture with regards to EM as the September 21 meeting approaches. We still recommend investors to focus on fundamental factors. With a negative EM environment likely to ultimately prevail (slow global growth, low commodity prices, rising US rates, and a strong dollar), we feel that high carry will do very little to protect those currencies that are most vulnerable.
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 2016 consists of SGD, THB, CNY, RON, and KRW.
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 Q3 2016 are in Asia (SGD, THB, CNY, and KRW). This lines up with our long-held view that Asia is best-placed fundamentally in the current environment. Two others in the top ten are also from Asia (PHP and TWD), along with three from EMEA (RON, ILS, and HUF). PEN is the sole representative from Latin America in the top ten.
Notable positive movements include CNY and KRW (both from 2 to 1), as well as PEN (from 3 to 2). IDR also improved (from 4 to 3), as did TRY (from 5 to 4).
Our 5-rated (weakest fundamentals) grouping for Q3 2016 are RUB, COP, ZAR, UYU, and ARS. Others in the bottom ten are heavily weighted towards Latin America (MXN, BRL, and CLP), and also include PKR and TRY.
Notable negative movements include ILS and PHP (both from 1 to 2). CZK worsened (from 2 to 3), as did PKR (from 3 to 4). Lastly, RUB worsened (from 4 to 5).
Our next EM FX model update for Q4 2016 will come out at the beginning of October. However, we will provide monthly performance updates throughout Q3.
Since our model was last updated on April 27, those currencies with VERY STRONG (1) fundamentals have lost an average of -1.0%, while those with STRONG (2) fundamentals have lost an average -0.6%. This compares to an average loss of -0.5% during the same period for those with VERY WEAK (5) fundamentals and an average gain of 1.3% for those with WEAK (4) fundamentals. Lastly, an average loss of -0.7% was posted by those with NEUTRAL (3) fundamentals.
We have found that during times of extended EM rallies, many currencies see gains of similar magnitudes. This held true this past quarter, with most groupings down around -1% (with the exception of the 4 grouping). However, we note that there were some significant outliers in the 4 grouping. CLP, RUB, and BRL saw outsized gains of 1.4%, 1.8%, and 7.8%, respectively.
We think that many of the outperformers during this period will revert to being underperformers again when EM turmoil returns. We will continue monitoring and reporting our model performance in the coming months.
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.