EM FX MODEL FOR Q3 2017 – UPDATE

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  • Soft US data and delays to fiscal stimulus plans from the Trump administration has led to further softening of Fed tightening expectations
  • The US 10-year yield has fallen to 2.06% to the lowest since November 2016
  • Our 1-rated (strongest fundamentals) grouping for Q3 2017 consists of THB, SGD, CNY, KRW, and PHP
  • Our 5-rated (weakest fundamentals) grouping for Q3 2017 are CLP, MXN, EGP, TRY, and ARS
  • Our next EM FX model quarterly update for Q4 2017 will come out at the beginning of October

EM FX OUTLOOK

Soft US data and delays to fiscal stimulus plans from the Trump administration has led to further softening of Fed tightening expectations.  Markets no longer view another hike in 2017 as likely.  Indeed, less than one hike is currently priced in for 2018 followed by less than one in 2019.  Some investors believe the Fed is done tightening.

The US 10-year yield has fallen to 2.06% to the lowest since November 2016.  Fundamental and technical developments suggest it could fall further.  The benign global liquidity backdrop helped propel most risk assets higher, not just EM.  These include global equity markets as well as spread products.

As the global backdrop hopefully clears up in the coming months, we still believe it is very important for investors to continue focusing on country fundamentals and on hedging out currency risk whenever feasible.

SUMMARY

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.  With the recent float of the pound, we now include EGP in our model universe, replacing PKR.

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 2017 consists of THB, SGD, CNY, KRW, and PHP.  THB, KRW, and PHP all improved from 2 to 1.  These three pushed out TWD, PEN, and ILS, all of which worsened from 1 to 3.

With global financial markets likely remain volatile, we continue to recommend focusing on fundamentals as opposed to high carry.  Note that seven of the ten top currency picks for Q3 2017 are in Asia.  This lines up with our long-held view that Asia is best-placed fundamentally in the current environment.  Two of the top ten are from EMEA (ILS and RUB), while PEN is again the sole representative from Latin America.

Our 5-rated (weakest fundamentals) grouping for Q3 2017 are CLP, MXN, EGP, TRY, and ARS.  ZAR and UYU both improved from 4 to 5, and pushed out CLP and MXN, both of which worsened from 4 to 5.  Note that six of the worst ten currency picks for Q3 2017 are in EMEA, while four are in Latin America.  None are in Asia.

Our next EM FX model update for Q4 2017 will come out at the beginning of October.  However, we will provide monthly performance updates throughout Q3.

Win model

MODEL PERFORMANCE

Since our model was last updated on July 18, those currencies with VERY STRONG (1) fundamentals have gained an average of 0.9%, while those with STRONG (2) fundamentals have gained an average of 1.0%.  This compares to an average gain of 1.1% during the same period for those with WEAK (4) fundamentals and an average gain of 0.4% for those with VERY WEAK (5) fundamentals.  Lastly, an average gain of 0.9% was posted by those with NEUTRAL (3) fundamentals.

This past quarter, all five groupings on average saw very similar performances, except for the VERY WEAK category.  With markets piling back into EM on the softer Fed outlook, most EM currencies have benefitted from a rising tide.  However, we note that there were outliers in all the groupings.  Subpar performances for KRW (-1.3%) and PHP (-0.4%) dragged down the performance of the 1 group.  On the other hand, outsized gains for CLP (+5.6%) and TRY (+2.8%) pulled up the performances of the 4 and 5 groups.  Lastly, the 3 group was pulled up by a big gain for COP (+2.9%).

MODEL DESCRIPTION

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.