Morgan Stanley: Stay short on emerging market currencies

Emerging market equities are in a bear market as of today. So, right now, everyone seems to be talking about contagion in the emerging markets. As the day began, the US dollar was posting gains against most currencies, emerging market and developed market alike. And the MSCI Emerging Markets Index was off 1.6%, bringing it to six sessions on the trot. There’s no reason for the entire EM complex to get hit like this unless you talk of contagion.

What are traders saying?

So how does contagion work? Let’s see what EM analysts are saying.

  • According to Morgan Stanley, this month won’t provide relief to EM. James Lord, Morgan Stanley’s global head of EM fixed income strategy said in a note to investors they recommend staying short currencies from Brazil, Indonesia, India, Mexico, the Philippines, South Africa, and Russia against the dollar, the euro and the yen.
  • JPMorgan Private Bank’s Meenal Patel, EMEA head of FX, commodities & rates in London says, “We’re not yet ready to enter into these markets.” He also says “the market is very much focused on those currencies with large amounts of external debt.”
  • Kay Van-Petersen, global macro strategist at Saxo Capital Markets: “It has to get a lot worse before it gets better.” He says “when you get full contagion, everything gets thrown out, and we’re not there yet.”
  • Sameer Goel, the head of macro strategy for Asia at Deutsche Bank in Singapore told Bloomberg TV  It’s “no longer just about EM fundamentals.” He also said the worry is “increasingly about contagion, which largely happens because of cross-holdings and the pressure of redemptions.”

All that commentary makes the contrarian in me want to go long EM!

But that last comment does get to the heart of it: you sell what you can, not what you must when you get redemptions. And we are at the point where fund outflows is creating contagion across the EM universe.

Real economy contagion starting to hit

In yesterday’s daily, I quipped, ” When Turkey falls out of bed, there’s no reason for it to have any impact on South Africa or Brazil. Those countries are not inextricably linked. And when Argentina announces several new austerity measures like closing ministries and grain export taxes, this has nothing to do with Turkey or India. Yet, when these measures were announced, we saw pressure on EM currencies across the board.”

But the reality is that when currencies plunge and rates go up, it has an impact. Look at the Philippines today for example. Due to the weak peso, Philippines inflation is rising, with the August inflation report released today showing a surged to 6.4% from 5.7% in July.  The consensus Bloomberg forecast was for 5.9%. At 6.4%, inflation has doubled since the beginning of the year. It’s also at a nine-year high.

What does the Philippines do then? The traditional approach is to jack up rates. But that slows the economy. And Argentina has done so. But the pressure on their currency and economy remains unrelenting.

Final thoughts

We’ve seen convulsions in EM over the past several years without long-term damage. The taper tantrum comes to mind. But this shock is actually the longest since the Great Financial Crisis. Bloomberg noted earlier today: “for stocks, it’s 222 days. For currencies, 155 days. For local government bonds, 240 days.”

The natural question then is: when does this end and how? Unfortunately, the pre-conditions for an end to the pain aren’t there because a lot of it is based around monetary policy in developed markets.

Indonesia’s Rupiah, for example, is trading at its lowest level since 1998. That has to have serious economic consequences. Moreover, the South African rand fell to a record low after data on Tuesday showed the economy had contracted for the first time since 2009. This contagion is now in the real economy.

As much as I would like to buck the bearish sentiment, I continue to see EM as an underweight, in currencies, bonds and equities.

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