EM Currencies Remain Vulnerable As Pessimism Returns
The following is a post by Marc Chandler, head of Brown Brother Harriman’s Currency Strategy Team. For more of BBH’s currency views, visit the website here.
On our site please find our Weekly EMView, a one page table of driving forces and capital market trends for the EM currencies in the week ahead.
EM FX remains vulnerable to ongoing concerns about Greek contagion. One of the key drags on the markets remains the Greek situation. Greek 2-year yields are still up roughly 14 bp on the day after recovering from early selling. A key driver today appears to be a Market News International story revealing that a draft of a joint report by the EC, ECB and IMF find that the Greek budget plan falls almost 5 bln euros shy of what is needed to reduce the deficit by 4 percentage points this year. Of the 5 bln euros, 1 bln is due to higher debt servicing costs. The draft thinks that Greece is too optimistic in thinking that cracking down on tax evasion can raise 1.2 bln euros. The report also says that Greece may be exaggerating the funds it will get from the EU budget. Separately, Greece has been working on another 3.5 bln euro savings, but seems reluctant to match the entire shortfall the report identifies. The report may be released Friday, and markets will remain nervous. In addition, both S&P (BBB+) and Moody’s (A2) this week warned of further downgrade risk to Greece.
- Currency performance this week: Only EM gainers vs. the dollar this past week are PLN, HUF, MXN, THB, CLP, and RON, while biggest EM losers vs. the dollar this past week are ZAR, TRY, BRL, KRW, CZK, COP, and INR. We remain constructive on EM FX, but believe that the newly resurgent risk off trade could still remain in play over the next several weeks as the Greece situation continues to bubble.
- Fundamental outlook for EM remains good…..: Asia has posted some very impressive (as well as stronger than expected) Q4 growth numbers this past week, and highlights the divergence in fundamentals between EM regions. Malaysia GDP grew 4.5% y/y vs. -1.2% y/y in Q3, Hong Kong grew 2.6% y/y vs. -2.2% y/y in Q3, Taiwan rose 9.2% y/y vs. -1% y/y in Q3, Indonesia grew 5.4% y/y vs. 4.2% y/y in Q3, and Thailand grew 5.8% y/y vs. -2.7% y/y in Q3. Base effects certainly played a role, but the region is clearly leading the rest of EM in terms of recovery. Contrast this to EMEA, where Latvia contracted -17.7% y/y vs. -19% y/y in Q3, Czech contracted -4.2% y/y vs. -4.1% y/y in Q3, Romania contracted -6.6% y/y vs. -7.1% y/y in Q3, and Hungary contracted -4.0% y/y vs. -7.1% y/y in Q3. The picture in Latin America is mixed, with Mexico contracting -2.3% y/y vs. -6.1% y/y in Q3 and monthly data suggesting that Peru grew almost 4% y/y vs. -0.6% y/y in Q3 and that Chile grew 2% y/y vs. -1.6% y/y in Q3.
- …but hasn’t helped EM equities or FX: MSCI EM is -6% year-to-date and compares to -1% for MSCI US and -3% for MSCI Developed (-5% MSCI Developed ex-US). Given what we view as strong EM fundamentals and improving growth numbers, we are disappointed to see such weak EM equity market performances so far this year. When risk aversion clears up, we believe that the fundamental basis for a strong EM equity rally could be made for the rest of 2010. However, much will depend on what’s going on in the US markets, as the correlation remains strong. Daily correlation between MSCI EM and MSCI US is at .884, very high but down from a peak of around .9800 in late 2009. This correlation has broken down from time to time during the financial crisis, with the recent weakening of the correlation coming as the US market outperforms EM so far this year.
- Rating agencies are positive on some EM credits like Brazil…..: Moody’s said that Brazil’s Baa3 rating (equal to BBB-) may be reviewed for an upgrade next year if Lula’s successor continues policies that improve the country’s debt profile. The rating has a positive outlook, but it appears that the agencies want to see how the Oct elections unfold before committing to an upgrade. In that regard, we repeat our recent concerns that the market may be positioned too one-way with regards to the upcoming presidential election. No one in the market is worried about the transition, and while we too are of the belief that orthodox policies have been institutionalized in Brazil, we are concerned that markets are all set up one way. If we had to pick a risk for the upcoming election, it would be that Rousseff somehow veers to the left away from orthodoxy. We do not put much weight on this risk, but are simply pointing out that the markets may be too complacent about the potential outcomes. Overall, we remain positive on Brazil but acknowledge that volatility is likely to pick up as we move closer to Oct. Our rating model has Brazil at BBB/Baa2 and so we think an upgrade is warranted now, but the deterioration in the public finances during the crisis has made the agencies a bit wary. However, we do think upgrades will be seen over the next year.
- ….and Turkey: S&P upgraded Turkey’s long-term foreign currency rating to BB from BB- and kept the positive outlook, which suggests the likelihood of additional rating increase. S&P says this can happen in the next year or two. Our proprietary model shows Turkey as a BB+/Ba1 credit and so further upgrades are warranted based on fundamentals. The reduced debt burden and the stability of Turkish banks were behind the S&P decision. This upgrade was before the recent rise in political risk. Turkey has been hurt this week by jitters over numerous detentions of former senior military officers in connection with an alleged coup plot. Prime Minister Erdogan confirmed that at least 40 people have been detained in a probe of an alleged plot to overthrow the government. Those arrested include senior military officials such as the former heads of the Turkish navy and air force. While media reports are putting more emphasis on the potential role of ultra-nationalist group Ergenekon (that is trying to provoke a military coup) rather than it being a military coup plot itself, a warning response from the military has ratcheted up tensions. Clearly, tensions between the secularists and the Islamists are set to continue, but we believe a peaceful solution will eventually be seen and so our favorable TRY outlook remains intact.
- TRADE RECOMMENDATIONS: We continue to focus on cross-EM plays in this choppy risk on/off trading environment. We think recent MXN outperformance will be hard to sustain. We maintain our longCOP/MXN as this currency pair should continue to fall from its Dec 2009 high around 160. High Mexico interest rates (4.5%) compared to Colombia (3.5%) means investors will give up some modest carry costs, but we think this will be offset by COP appreciation. We have already hit our initial target of 149, and the current pullback above 150 provides a good opportunity to go long COP for a move to 146.46 (62% retracement of the Oct-Dec rised in MXN/COP) and then the 2009 low around 138 (stronger COP). For similar reasons, we are maintaining our long ILS/CZK recommendation that targets the 2009 high around 5.6929 (strong ILS), and the current pullback towards 5.0 provides a good opportunity to go long ILS. Israel rates of 1.25% are higher than Czech rates of 1.0% and so investors get some modest carry. We note that the former is expected to continue hiking even as the latter is likely to stand pat for much of this year.
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