Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Chief Macro Strategist
Summary: Exporters into China and commodity-linked EM currencies were already under pressure recently on the fallout from the coronavirus outbreak, but risk conditions are now even more broadly hostile for EM, even as we have yet to see a major adjustment in EM credit spreads. If the latter come under pressure, EM pain could intensify.
The initial phases of the global market reaction to the coronavirus fallout were somewhat limited to those countries with the most direct trade exposures to China and to commodities, due to China’s domination of the demand mix for many commodities. The reaction among EM currencies, largely followed suit, with EM Asia heavily impacted – particularly the heavy exporters into China like Malaysia and Korea or countries like Thailand who have seen a total cessation of Chinese tourism into the country and are seeing arrivals from elsewhere in the world likewise reduced.
But over the last week, we are seeing an intensification of the reaction to the coronavirus outbreak as the market realizes the implications for global supply chains already baked into the cake and the risk that a global pandemic risk beyond China’s borders will sustain the slowdown in demand for commodities as travel is reduced and activity in general curtailed, even as portions of China are beginning to return to work. This second wave has struck EM currencies more broadly, as can be seen in the performance statistics below.
While we maintain a strongly cautious stance here, many currencies have sufficiently weakened for us to argue that the longer term risk/reward for long exposure has become far more compelling than at any time in the recent past and we are sympathetic with beginning to build 25-30% of an eventual long EM allocation here as the policy response is likely going to arrive in a big way in the weeks ahead and one vector of stimulus could be a US (read: Trump administration) effort to weaken the US dollar.
YTD EM Carry trade performance in 2020.
Below is a snapshot from a Bloomberg tool for measuring FX carry performance, a snapshot we will release with every update this year for a sense of how carry trades have performed in broad terms. Of course, the given basket here is for the most liquid of the higher yielding EM currencies and is more than a bit light on China-exposure, the most important theme of the moment. Still, our other performance snapshots below should give an idea of which themes and regions are out- and underperforming.
For this basket, we chose the four highest yielding of the more liquid emerging market currencies at the beginning of the year versus the four lowest yielding G10 currencies. This basket returned nearly 15% in 2019 due to that year starting at a very low point for global risk appetite. After a strong start to 2020 on an extremely supportive backdrop in financial conditions, the basket is now bumping along in sideways fashion, down very slightly on the year (-0.7% as per the blue line showing the Total Return). This is actually rather respectable, given the benchmark – the MSCI EM equity index in USD terms – dropping some 5% YTD. Some of the lack of further downside has been due to a weak EUR and SEK funding currencies.
Short term EM currency performance
The below shows the 1-week and 1-month carry-adjusted performance of the EM currencies in our universe and really paints a picture of how deeply EM currencies have corrected here in the short term, with red across the board and deeply so in most cases, particularly for heavy commodity exporters like Russia and Brazil. The only currencies looking a bit less affected are those with tighter exchange rate controls like SGD, TGWD and HKD and importers of commodities like INR and PHP. The Mexican peso has played the most catch-up to the downside over the last week after amazing posting new cycle highs versus the USD as recently as last week.
Chart: Saxo Bank Global Risk Indicator
No surprise, given where equity markets are as we are publishing today’s report, and given the short-term performance of EM currencies versus the US dollar, that the backdrop of global risk conditions is not friendly for EM carry trades. Our measure of global risk has quickly plunged deeply into the red only over the last couple of days. It is interesting, however, that the least marked contributor of the components we use to comprise the indicator has been EM credit spreads, which remain relatively complacency relative to the action in the EM currencies themselves and relative to recent moves in corporate credit stress indicators.
EM Credit Spreads
The chart below shows six examples of developments in EM credit spreads and the very different picture, depending on the currency. Mexico, Turkey, Brazil and Russia are seeing their credit spreads on USD debt (the dark blue lines) rising from a very low levels, while South Africa’s credit is blowing to a new wide level – suggesting higher risk of more pain for ZAR, while Chile is nearing critical levels as well.
Carry trade performance*
The chart below shows the longer term performance of the US dollar versus the lowest yielding funding currencies. While the most recent few days of market action have seen the EUR and JPY pulling back against the US dollar, the USD is still higher than all of the lowest yielders relative to a month ago, to varying degrees.
EM currency performance continues to vary widely in the longer term, even as we noted the near universal weakness in the short term above, particularly over the 1-month time frame, also shown in the chart below.
Current carry available*
The chart below simply shows the forward carry for owning the USD versus funding currencies and the returns on higher yielding EM currencies versus the US dollar. Given sharp weakness in EM FX, we will be surprised if EM central banks don’t begin to change their tune on the outlook for further rate cuts.
*Note that all performance calculations are done as carefully as possible to include trade spread costs and market conditions at the time but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)