EM FX Macro Review

Reflecting on a strong first half

Photo by Erol Ahmed

30^th June 2023

At the end of H1 and with some holiday time coming up I want to review this year so far, reflecting on earlier thesis, with the hope of gaining insight into which views are still valid and which have had their time. I’ll do that after a brief review of the past week's markets and macro.

Weekly review

It suits the purposes of this note that we’ve had a quiet week and we have. Investors are digesting a higher-for-longer outlook for DM rates, wrestling with the same mysteries that have been present for much of the year. Post-pandemic, post-energy-spike economic forecasting seems unusually difficult, particularly for advanced economies where the level of government intervention was so extreme and the impact on households so divergent. Somewhat in contrast, EM economies have a more conventional look where strong and timely central bank responses look to have been effective in the main and will begin to be unwound later this year. If I were at a fund, I would expect to be more active in EM rates than in most other areas. As it is, I remain very lightly invested at this juncture in EM FX Carry in the ways discussed in prior notes.

At the end of the month, we begin to get BoP data from EM economies.  We saw the normalisation of the Brazilian current account (lower) and a wider-than-expected trade deficit in Thailand. Taiwanese industrial production improved on the month which gives encouragement to hopes of a regional pick-up in manufacturing activity. We had an upside surprise from Mexican GDP data, and broadly in-line inflation data from Brazil. US initial claims came in lower after a run of higher prints, again muddying the picture. In China, we had the NBS PMIs. In May, the Manufacturing print was starkly lower than the Caxin equivalent, and the June reading bounced only 0.2 points to 49. The services measure fell 1.3 points to 53.2.

The supply of inactive EM central banks is sparse, with none meeting this week at the time of writing. In the coming days, we have meetings in Colombia, Poland and Malaysia where policy rates are expected to be unchanged in all three countries.

H1 review

At the start of the year, I laid out a thesis for the start of the year that was bullish on EM FX. This was based on a collection of contributing bullish views. I’m going to run through these, with some updated discussion and charts. Many of these are overlapping dynamics so excuse any repetition.

• Bearish view on an expensive USD

• Anticipation of the end of the US hiking cycle

• Bullish growth impulse from China

• Expectations for mean reversion in US fixed income and risk parity

• Hawkish EM Central Banks and High e-ante Real Rates

• Strong Carry, and high relative EM FX Carry

Bearish view on an expensive USD.  The USD had negative momentum at the start of the year on a journey from overvaluation. At the start of the year, I cited the overshoot compared with the US commodity terms of trade, the elevated REER, and the current account deficit below the post-GFC average.

The dollar had a choppy depreciation so far this year, with a more uncertain outlook for H2. USD is a mid-yielder within DM and despite pricing in some significant cuts at certain points this year, the Fed now looks more likely to be hiking than cutting in H2. Additionally, quantitative tightening lies ahead.

Anticipation of the end of the US hiking cycle. In January we looked close to the end of the cycle and were anticipating a pause from the fed. As you can see from the Fed Funds Chart (where price declines reflect higher rate expectations), sticky core inflation prints and a robust labour market saw expectations rise. A sharp repricing followed the collapse of SVB bank, but after some consolidation, we have normalised back towards the highs of implied rates. The US TWI which was weakening at the turn of the year recovered on stronger US data and fading recession risks, before declining as the market anticipated a Fed pause. Recent weakness from a soft CPI print and rising US claims doesn’t look like the start of a trend to me.

Bullish growth impulse from China. The end of the zero-Covid policy in China gave a strong boost to expectations of activity both within China and more broadly. There was always caution over the composition of growth as I noted at the time: With respect to the China recovery theme, it’s important to note potential shortcomings of analysis based on historical growth upswings. The historical relationships are dominated by episodes of stimulus-led growth in China, which were characterised by high levels of fixed asset investment. This type of growth was commodity-intensive and in turn, benefitted commodity exporters. The anticipated China upswing this year will be driven by excess savings and pent-up demand that has been artificially created by covid and the zero-covid policies.  As a result, consumption will be a relatively more significant component than in past upswings with potentially different investment consequences.  

The expected growth upswing duly delivered in China for Q1, but Q2 has looked considerably more mixed so far. Taken in aggregate H1 data has been strong, but the recent trajectory has been a significant concern for markets. The housing market in China, a source of strength for the last 2 decades will come under increasing focus as pent-up demand for services fades.

Despite current reservations, the combination of a strong growth impulse from China, and expectations of easier monetary policy ahead from the US was a reliable historical cue to be long EM assets which had benefited in the past from easing policy in the US and strengthening growth in China and Europe.

Expectations of mean reversion in US fixed income and risk parity.  As I wrote in my first note in January, the odds favoured a 2023 rebound in bonds and risk parity:

EM FX performance can be heavily influenced by portfolio flows. After a terrible couple of years for bonds more broadly, there is undoubtedly scope for inflows into the asset class.  Local EM bonds often perform like a hybrid version of risk parity, with the EM country risk premium combining with the duration side of the bet.  Risk parity has had a decline of historically notable size, so all else equal one should be expecting a rebound….Bonds have never had 3 consecutive down years, and 2021/22 was the first back-to-back decline since the 1950s.

We’ve seen some normalisation here, but this has yet to be a powerful driver of returns in EM FX so far in 2023.

Hawkish EM Central banks and e-ante Real Rates.

Central banks that had broadly hiked earlier and more aggressively than DM central banks were generally near the end of their cycles as 2023 began. These remain cautious despite disinflationary forces. Higher post-pandemic debt levels bring greater fragility necessitating higher real rates to maintain currency stability. I have written regularly about the theme of investing in the currencies of countries with the highest ex-ante real rates with these differing markedly from spot real rates. I still maintain this bias.

Carry, and relative EM FX Carry

We’ve watched carry in vol adjusted terms all year and below we see the setup going into H2. Despite the normalisation process underway in Hungary, vol adjusted carry is still the highest in liquid EM FX, with over 1% annualised carry per vol in the one month.

Tracking Themes

Carry and Ex-Ante Real Rates have been two of the themes I have attempted to track this year by building relative value indexes that I describe in an earlier note. As I mentioned at the time, the purpose is to have a time series to track the themes rather than to create an investable index. I exclude Turkey and Russia, as they pollute the thematic analysis excessively, despite frequently qualifying as longs. The indexes are reweighted monthly with 5 longs and 5 shorts for each theme. Below you can see the longer-term time series I populated, next to this year’s performance. This has been a historically fruitful phase for these themes, which must concern one as to the potential for a pullback.

Below we see the environment we have enjoyed in H1 with relative levels of EM FX Carry at 5-year highs only beginning to decline in recent weeks. This decline comes from policy action in Hungary, along with evolving policy expectations in Mexico, Brazil and Chile. I base this analysis on 3-month forward implied yields. The decline in carry along with the outsized recent returns should make us cautious heading into H2.

Value

Below we see how we stand on longer-term Real Effective Exchange Rates (REERs) and as discussed in the past I like to look at these vs trailing average levels. This measure of valuation implies room for the Brazilian Real to appreciate over the medium term, but CEE currencies look to have already strengthened significantly. The recent depreciation in Malaysia and Korea can persist, but one has to justify increasing levels of undervaluation which I find especially difficult in the case of Korea, for reasons discussed in my note some months ago. For China, historical manipulation makes these trailing-average-based analyses more dubious.

Correlation

We have been tracking correlations this year to identify switching narratives and changing dynamics.  If we look at H1 as a whole we see distinct themes, with Asian currencies and the rand correlating most with the USD TWI, and the higher carry FX correlating most with US equities.

Returns and Sharpe

All year we’ve been watching EM FX performance for trends that we might want to participate in or challenge.

In this high carry environment, we see the impact of the forwards on the total return, this is particularly notable for the Turkish lira with more than 100% of the carry-adjusted loss taking place post-election. The low realised vol in CNY makes the Sharpe ratio of long USDCNY similar to that of long USDTRY.

Finally…

As we reflect on H1, please feel free to browse the bottom section of some of my previous notes where I cast a more medium-term eye. Archive - EM FX Macro (substack.com).

• In January I discussed Brazil, Chile, and the theme of Carry.

• In February I discussed South Africa, The US Dollar outlook, and the impact of Real Rates.

• In March I discussed South Korea and the theme of value.

• In April I discussed the IMF outlook, China, and the potential benefits of long BRLCNH.

• In May I discussed Asian FX, El Nino and Turkey

• In June so far, I’ve written a longer piece about the outlook for India.

I look forward to tackling some more countries and themes in the coming 6-months.

After publishing next week’s note on the outlook for H2, I’ll be taking some holiday time and might publish more sporadically over the UK school holidays. As discussed in past notes, the purpose of my writing is for me to re-engage with markets with the aim of finding a more lucrative outlet in time. Operating outside of the flow and with more limited tools is a useful exercise and I’m learning from it, but it has its frustrations. If you know anyone who is interested in facilitating my return to a fund or a bank, I’m all ears.

Thanks for your attention so far this year, any engagement is welcome. As always, if you’re trading be disciplined and be lucky.

Stephen