EM FX Monthly: Modestly constructive against a wall of worry

The big picture

There is no question that EM face a long list of structural challenges: less favourable demographics, narrower EM-US growth differentials, weaker terms of trade, structurally slower global trade growth, and a China that appears far less willing to be the fiscal stimulator of last resort.

That said, once we normalise for all these forces, we find EM FX is rather undervalued. Furthermore, most of the weakness in the latter half of 2018 can be laid at the doorstep of one variable in particular: trade-related uncertainty.

Accordingly, in view of our base case scenario for some de-escalation of trade-related uncertainties, we are modestly constructive on EM FX. Stabilising EM-US growth differentials and our expectation of a weaker USD should help deliver better EM FX spot returns.

Geographically, we believe Asian currencies should perform better as the region benefits from modestly improving global growth and a firmer CNY. LatAm is the most undervalued, but political risks are hampering visibility. CEEMEA should register a more mixed performance.

In Asia, the CNY and MYR are our top picks. Admittedly, the CNY has been the currency most impacted by the ratcheting up of tariff threats. There is quite a sizeable divergence between USDCNY and the broader USD, somewhat similar to the picture in late 2018. That experience demonstrated that once trade tensions abate, the USDCNY can re-align quite quickly with the broad USD. Such a re-alignment would get the USDCNY closer to 6.80. Meanwhile, the MYR is a currency that ticks many boxes: large undervaluation, improving growth profile, a strong increase in external balances, and a high sensitivity to an improvement in global trade. Among the high-yielders, we prefer the IDR to the INR.

Within LatAm, we favour the MXN, but remain more cautious on the BRL. The MXN is extremely undervalued, should benefit from improving external balances, and offers high carry. In contrast, the BRL is not yet providing value convincingly, will likely suffer from a wider current account (C/A) deficit, and the lower carry will work against a strong recovery. CLP is cheap, but a political risk premium will likely stay with us until April at least. Until then, we prefer the PEN. We remain cautious on the COP given its twin deficits.

Finally, in CEEMEA, among the high-yielders we like the RUB, but are cautious on the TRY and ZAR. The RUB is undervalued and will likely face appreciation pressures on any loosening in fiscal policy. Among the low-yielders, we fancy the ILS, and believe it can do well in both risk-off and risk-on environments. In CEE, we are cautious on the HUF, but are warming up to the CZK.

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¹Central & Eastern Europe, Middle East and Africa

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