El Nino and EM Macro
26th May 2023
This week I discuss
Outlook, market moves
Macro developments
Central banks
Market Monitors
El Nino and EM Macro
This week’s ranges gave an opportunity for more active trading in EMFX. These moves served as a prompt for me to recognise a deteriorating sentiment towards EM risk. This shifts my bias regarding taking profits on strong moves. It seems unlikely that the cocktail of fears the market is grappling with will evaporate quickly (outside of the debt ceiling charade), and it makes sense to have the capacity to add risk in the moments when those fears cause adverse moves. With many EM FX themes having already performed so well on the year, it doesn’t feel like prices are going to run away from you if you sell strength. I haven’t done enough of this recently, so when USDMXN, for example, went against me this week, selling into the bounce was a more lively experience than it could have been. I end the week still with the same core positions, but have tactically added more USDMXN short and have reduced the USDCNH long after what I see as an outsized move.
While investors are being distracted by the debt ceiling charade, the more medium-term risk profile has been shifting. The pendulum that swings between US recession fears and fears over the pace of disinflation has been moving towards the latter. Perhaps my anticipation of what the BoE will likely do to my borrowing costs here in the UK is leading me to exaggerate the risks, but it certainly seems that the risks around the Fed are shifting. This process has impacted EM FX but is yet to have a dramatic effect on my main themes.
Part of this story from the perspective of the USD, is the soft start to Q2 apparent from China. Worries that data out of China will continue to come in soft after a bumper Q1 driven by the end of zero-Covid will worry EM investors more profoundly. EM FX enjoys periods where growth outside of the US is improving especially if they come alongside policy easing in the US (or at least the end of a tightening cycle). I am a little concerned that on the resolution of the debt ceiling, this dynamic might cause turbulence in EM, and so my propensity to take profits on a positive risk move is strong.
Macro data
US May Flash PMI reports from S&P reinforced recent trends. We saw a continuation of a rise to the composite reading, with a further accentuation of the outperformance of services over manufacturing.
Also in the US, initial claims fell back to the bottom of the recent range with a downward revision. This moved the 4-week average down to 231.75k. It turns out we’ve been spoofed by fraud in Massachusetts inflating claims.
Taiwanese export orders were weak, reversing the recovery in March. Mexican inflation data surprised to the downside with the year-on-year rate falling to 6%. In Brazil, the latest focus survey shows a more evident trend of gently rising 2023 growth expectations and falling inflation forecasts.
Central Banks
We saw action from the central bank in Hungary this week as they began the process of normalising their rates structure by lowering the interest paid on optional reserves, and the one-day quick deposit rate by 100bp, from 18 to 17 per cent. It also lowered the O/N collateralised lending rate which represents the top of the interest rate corridor by 100 basis points to 19.5 per cent. This seems warranted, given the persistence of HUF strength. The expectation will be for further normalisation at coming meetings. If the backdrop deteriorates, or HUF volatility rises significantly they can always pause this process.
In South Africa, the SARB hiked rates by 50bps to 8.25% I wrote about South Africa’s woes a couple of months ago and things haven’t turned brighter. Persistent underperformance of the Rand looks more structural than cyclical, and with South Africa’s weak fiscal position investors in the Rand are demanding higher compensation.
The BoK left rates unchanged, and see policy as restrictive, but necessary to bring inflation gradually back to target. On the currency, they noted, “the Korean won to U.S. dollar exchange rate has fluctuated considerably due to trends in the trade balance, expectations of an end to policy rate hikes by the U.S. Federal Reserve, and negotiations on the U.S. debt ceiling.”
In Indonesia, BI left policy unchanged. The bank is successfully guiding the IDR gently stronger through its volatility-reducing interventions. As I discussed a few weeks ago, a stronger-than-expected balance of payments performance reinforces the favourable currency dynamic, which is aiding the disinflationary process.
Rates were also left unchanged in Turkey because Erdogan believes the current policy is already perfectly calibrated, and there don’t look to be sufficient dissenting voices. (see last week’s note on the impending currency crisis).
Market Monitors
Correlation
Further decoupling of Latam, together with HUF and PLN from the broad USD. These are trading more with the EUR TWI. Some mean reversion combined with optimism over a turn in tech exports has driven a decoupling of USDKRW with the rest of USDASIA.
Trend
CNY trend weakness against the USD is very strong in the short term. I judge this as unsustainable and have reduced my position. ZAR weakness is also notable, although this is working against rising carry. There are very few EM currencies trending stronger in the short term, which is unsurprising given the anticipated event risk and the strength of the USD.
Carry
Declining EURHUF carry/vol doesn’t displace it as the most attractive pair.
How a 2023 El Nino might impact EM, and potentially change longer-term perspectives.
The subject of climate change and its impact on EM is too big a topic to go into in this note, but I did want to touch on the potential impacts of an El Nino this year. Emerging markets investors might have noted the central banks in several countries, including the Philippines, mentioning the potential impact.
For the uninitiated, El Niño, which means Little Boy in Spanish was named by South American fishermen who noticed periods of unusually warm water in the Pacific. Dave Borlace delivers a concise and entertaining explanation of the El Nino Southern Oscillation (ENSO) on his excellent channel. El Niño 2023 could be a monster!
Even under the recent triple dip La Nina, we experienced 3 of the warmest years ever recorded. So what awaits us in during the next El Nino should be a serious cause for concern. According to the World Meteorological Organization, There is a 60% chance for a transition from ENSO-neutral to El Niño during May-July 2023, and this will increase to about 70% in June-August and 80% between July and September WMO Update
A recent study in Nature <Quantifying the human cost of global warming> highlights how global average temperature rises have a disproportionate impact, as the population of the world is not distributed evenly across the planet. The paper discusses the issues of warming in terms of a ‘human climate niche’ which it expresses as a certain set of mean annual temperatures. The report suggests that 600 million people are already living outside of that niche due to climate change, and of course, that number is rising.
The maps below show the regions exposed to unprecedented heat at different levels of global warming with shaded regions being those exposed to mean average temperatures above 29 degrees C.
The right-hand charts show the distribution of the population of the world in terms of mean average temperatures. These show the impact on that large and growing population that already lives with high temperatures.
Outside of the short-run economic impacts that could arise from an El Nino period, it’s important to note how much of the emerging world might find 2023 a reality check moment for their way of life.
The IMF produced a report in the aftermath of the strong 2015 El Nino, which contained some useful studies on the macroeconomic impacts. El Niño: Good Boy or Bad? The study shows higher growth and inflation on average with some notable winners and losers.
They note that the inflation impact reflects mainly higher fuel and nonfuel commodity prices. It also has historically been a result of policies implemented to risk manage the worst effects, such as the management of agricultural supply. With food prices the largest transmission mechanism, they show the relationship with the weight of food in the CPI basket.
An ECB working paper on the broader topic of warming on inflation (europa.eu) also focused on food price inflation as the clearest mechanism, with the associated volatility of weather systems more difficult to model.
You can read about the typical impacts on different areas in this article from the National Atmospheric and Oceanic Administration (NOAA) NOAA Climate.gov. As you can see from the right-hand chart below, one relevant consequence for later this summer might be an unusually dry period for India. This is a period that coincides with the monsoon rains that typically represent 80 per cent of the total annual rainfall. With the Central Water Commission (CWC) reporting depleted reservoir levels already and with wheat stocks apparently at a 6-year low there is already cause for concern.
In addition to food price shocks, lower levels of rainfall across Asia could have an impact on hydroelectric power generation, leading to higher power prices. This will be particularly difficult if combined with greater demand for air conditioning. Higher power prices and lower water supply will also impact industry in the region. After the pandemic and the Ukraine war, EM economies are poorly positioned to absorb the fiscal impact of further subsidising domestic energy prices. In Indonesia, the government has already made proactive efforts to increase rice stocks by committing to import 2 million tonnes.
An extensive study by the Dallas Fed Fair Weather or Foul? contains the following notable takeaways:
Drought in Indonesia can push up world prices for coffee, cocoa, and palm oil, among other commodities. The mining industry relies heavily on hydropower, this can hit nickel production.
A hot and dry summer in South Africa hits its agricultural production which is material to GDP.
Stormy winters in Chile can reduce access to mountainous mining regions impacting the production of copper.
Lower rainfall in Northern Brazil would hit the production of coffee, sugar, and citrus fruits. Likely higher rainfall in south-eastern Brazil can compensate.
Below-normal rainfall in the Philippines is usually mitigated by action by authorities.
Fewer hurricanes on the east coast of Mexico and more hurricanes on the west coast would bring greater stability to the oil sector and boosts exports.
As discussed, impacts will vary by country, but the severity of the El Nino event will certainly be a risk factor to watch closely as EM countries struggle with their growth/inflation trade-offs. What could be more impactful for longer-term investors might be the psychological impact of record temperatures and what they tell us about the likely trajectory in the coming decade. There could be a reassessment of how sustainable certain activities are in at-risk areas, particularly in the Indian subcontinent. This could have consequences for longer-term capital flows.
Signing off
As I mentioned last week, I enjoy writing these notes to help me engage with markets and increase the frequency of my personal trading. However, it’s my longer-term intention to return to a firm and enjoy the combined benefits of interesting colleagues, better data access, and a pay cheque. If readers know of any opportunities, please reach out.
I’m away next week as it’s the half-term holiday for UK school kids. Having worked hard for what seems like 5 weeks, my children have been deemed to require a break.
As always, please share the note with anyone you feel might enjoy it.
In the meantime, if you’re trading, be disciplined and be lucky,
Stephen