Emerging Markets: FX Model for Q3 2019

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Win Thin
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The broad-based dollar rally remains intact despite the market’s overly dovish take on the Fed We still believe markets are vastly overestimating the Fed’s capacity to ease in 2019 and 2020 What’s clear is that the liquidity story is not enough to sustain EM MSCI EM FX is on track to test the September 2018 low near 1575 and then the April 2017 low near 1568 Our 1-rated (strongest fundamentals) grouping for Q3 2019 consists of TWD, PHP, CNY, THB, and KRW Our 5-rated (weakest fundamentals) grouping for Q3 2019 consists of COP, ZAR, TRY, RON, and PKR EM FX OUTLOOK The broad-based dollar rally remains intact despite the market’s overly dovish take on the Fed.

Emerging Markets FX Q3 2019 - Click to enlarge

Developments elsewhere support our view that other central banks are getting more dovish too, which offsets much of the impact of the Fed’s expected easing in terms of interest rate differentials.

What’s clear is that the liquidity story is not enough to sustain EM. With the Fed, ECB, BOJ, and other major central banks in easing mode, global liquidity should remain plentiful. What’s missing is the global growth story, as the US-China trade war continues to take a toll on the global economy.

Furthermore, we still believe markets are vastly overestimating the Fed’s capacity to ease in 2019 and 2020. Fed Funds futures contract are pricing in 50-75 bp of easing by year-end followed by another 50 bp in 2020. This seems too aggressive given the current state of the economy. When market expectations readjust to a less dovish take on the Fed, the dollar rally should gather even more steam against the majors and EM.

MSCI EM FX peaked near 1658 on July 19. It has since fallen 4% to trade at levels not seen since November. It is on track to test the September 2018 low near 1575 and then the April 2017 low near 1568. If the EM sell-off continues as we expect, then the March 2017 low near 1546 should come into focus. Given our negative outlook on EM, we believe MSCI EM FX could eventually test the 1492 low from November 2016.

EM currencies are broadly weaker against the dollar so far in 2019. The worst performers YTD are the high beta group ARS, TRY, KRW, ZAR, and BRL. On the other hand, the best performers include THB, RUB, IDR, and PHP, the only ones up YTD against the dollar. With the USD likely to march higher and trade tensions still ratcheting up, we believe EM FX is likely to remain under pressure well into H2 2019.

We see continued divergences within the asset class. On top of idiosyncratic political risk, we also believe it is very important for investors to continue focusing on country-specific fundamentals. Hedging out currency risk has become much more important because we strongly believe that this current dollar rally has legs.

SUMMARY

Our EM 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 global financial markets likely to remain volatile, we continue to recommend focusing on fundamentals as opposed to high carry.

Our 1-rated (strongest fundamentals) grouping for Q3 2019 consists of TWD, PHP, CNY, THB, and KRW. PHP improved from 2 to 1, which pushed RUB down from 1 to 2. Note that seven of the ten top currency picks for Q3 2019 are in Asia. This grouping 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 (MAD and RUB), while MXN is the lone representative from Latin America.

Our 5-rated (weakest fundamentals) grouping for Q3 2019 consists of COP, ZAR, TRY, RON, and PKR. ARS improved from 5 to 4, which pushed COP down from 4 to 5. Note that five of the worst ten currency picks for Q3 2019 are in EMEA, while three are in Latin America and two are in Asia.

Our next EM FX model update for Q4 2019 will come out in October. However, we will provide monthly performance updates throughout Q3.

MODEL PERFORMANCE

Since our model was last updated on April 16, virtually every EM currency has weakened, the exceptions being THB, MAD, and PKR. During this time, those currencies with VERY STRONG (1) fundamentals have lost an average of -2.8%, while those with STRONG (2) fundamentals have lost an average of -2.0%. This compares to an average loss of -5.7% during the same period for those with WEAK (4) fundamentals and an average loss of -6.2% for those with VERY WEAK (5) fundamentals. Lastly, an average loss of -2.9% was posted by those with NEUTRAL (3) fundamentals.

For this quarter, currency performances have reflected underlying fundamentals. We have found that our EM FX model works particularly well during periods of risk off sentiment, when markets punish those currencies with weak fundamentals. Still, we note that there were outliers in every group. Relatively weak showings for CNY (-6.3%) and MXN (-5.9%) pulled down the performances of the 1 and 2 groups. Likewise, relatively strong performances for LKR (-2.8%) and RON (-1.1%) boosted the performances of the 4 and 5 groups. Same goes for IDR (-1.2%) within the 3 group.

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, nominal M3 growth, budget deficit/GDP, inflation, percentage deviation of the spot rate from Purchasing Power Parity (PPP), political risk, and banking sector risk. We have replaced FDI/GDP with a country’s Net International Investment Position (NIIP/GDP). 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.

We have tweaked our models to better conform with MSCI methodology. We have moved SGD and ILS to our new DM FX model and eliminated EGP from this EM FX model due to its pegged nature. Replacing them in this EM FX model are UAH, MAD, and PKR.