The dollar has gotten some traction since late January as the Fed outlook has shifted. Despite Powell’s bullish take on the US, some cracks are appearing in the global growth outlook. We should see greater divergences within EM FX.
EM FX OUTLOOK
The dollar has gotten some traction since late January. The equity sell-off provided the spark, but rising US rates appear to be the ongoing fuel for ongoing dollar strength. The US 2-year yield of 2.28% today is the highest since September 2008, while the US 10-year yield of 2.95% posted last week is the highest since January 2014.
The Fed outlook has shifted. Markets have finally fully priced in a third Fed hike this year and puts it right at the Fed’s Dot Plot for three hikes in 2018. Thus, it seems that the markets are taking new Fed Chair Powell’s word over former Fed Chair Yellen’s even though the basic message remains the same.
Despite Powell’s bullish take on the US, some cracks are appearing in the global growth outlook. The US, eurozone, Japan, and China have all reported disappointing economic data in early 2018. If sustained, this would be negative for EM FX. So too for lower commodity prices. It’s too early to sound the alarm, but this trend bears watching as we near Q2.
We should see greater divergences within EM FX. As such, we still believe it is very important for investors to continue focusing on country fundamentals. Hedging out currency risk will not seem so important for US investors if the weak dollar environment comes back in play. However, hedging will become more important if this dollar rally has legs.
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 now include the Sri Lankan rupee (LKR) in our model universe, replacing the Uruguayan peso (UYU).
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 Q1 2018 consists of SGD, THB, CNY, TWD, and PEN. CNY improved from 2 to 1. This pushed down KRW from 1 to 2.
With global financial markets likely remain volatile, we continue to recommend focusing on fundamentals as opposed to high carry. Note that six of the ten top currency picks for Q1 2018 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 and BRL are the two representatives from Latin America.
Our 5-rated (weakest fundamentals) grouping for Q1 2018 consists of ZAR, EGP, LKR, TRY, and ARS. Note that four of the worst ten currency picks for Q1 2018 are in EMEA, while three are in Latin America. The three representatives from Asia are MYR, IDR (which worsened from 3 to 4), and LKR (which enters our model universe at a 5). Other notable movements are MXN (from 5 to 4) and PLN (from 4 to 3).
Our next EM FX model update for Q2 2018 will come out at the beginning of April. However, we will provide monthly performance updates throughout Q1.
Since our model was last updated on January 24, those currencies with VERY STRONG (1) fundamentals have lost an average of -0.4%, while those with STRONG (2) fundamentals have lost an average of -1.7%. This compares to an average loss of -1.7% during the same period for those with WEAK (4) fundamentals and an average loss of -0.6% for those with VERY WEAK (5) fundamentals. Lastly, an average loss of -0.4% was posted by those with NEUTRAL (3) fundamentals.
For this past quarter, it appears that currency performances did not necessarily reflect the underlying fundamentals. We’ve found that during times of excessive bearishness or bullishness, EM currencies are closely correlated. Still, we note that there were outliers in some groupings. A subpar performance for BRL (-3.2%) dragged down the performance of the 2 group. On the other hand, a decent gain for ZAR (+0.7%) pulled up the performance of the 5 group. Same goes for CLP (+1.5%) in the 3 group.
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.