EMFX Macro Mid-Year Review

Are we at a tipping point in this market regime?

Image from DALL-E.

It’s been an eventful first half of 2024 with lots to discuss, as we seemingly move towards the start of the easing cycle in the US, and with 6 months since my last note, it seems a good moment to take stock.

As I mentioned at the beginning of the year, these notes will be few and far between, given my commitments at Argo. I wrote a weekly update for a time, but that came to an end late last year when I joined Argo Capital Management, an EM-focused Hedge Fund. With their consent, I will write occasional personal views on the market. Argo invests in a range of EM assets from liquid macro-driven EM investments, similar to those I discuss in these notes, to distressed debt. FX is not a dominant asset class at Argo, and my activities cover a broader range of investments, but for these notes, I will continue to stick to EM FX.

In this note, I will discuss:

• Review of H1 2024

• Outlook

• A brief note on Trump

• A framework for the current EM FX environment

• IIF CEE Trip

Review

2024 began with an aggressively discounted Fed easing cycle with 7 cuts in the price, and some expecting that to begin as soon as March. By April, barely 1 2024 cut remained in the curve, as Q1 delivered consecutive upside inflation surprises in the US, along with a solid growth outlook. Today we once again have aggressive easing priced, but this time it’s a response to a notable softening in the US labour market, together with a reversal of the Q1 inflation surprises.

The recent repricing has come with significant market turmoil, including an equity correction and an unwind of FX carry trades - most notably those funded in Japanese JPY. The Japanese played a key role in the magnitude of the shock. The multi-year JPY weakening trend had become a concern for authorities in Japan, enough for them to begin trying to introduce jeopardy into the carry trade with FX interventions. They understood that while the large rate differentials between the US and Japan persisted, all they could materially impact was the vol-adjusted carry. They succeeded. After the most recent soft US CPI number the MoF elected to get behind the USD weakening impulse and deliver more intervention flows. This was the beginning of a 12% move down in USDJPY, which had repercussions for FX carry trades across EM - with the Mex Peso the largest victim. The carry shock came with a pullback in the outperformance of tech and large-cap US equities relative to the rest - this was another source of instability.

Meanwhile, on the macro side, we were comfortably into a run of negative data surprises in the US, Europe and China. US labour market data had been gently softening for months before a stinker of a payroll report triggered the tediously oft-quoted Sahm rule and the market lurched into full blown recession fears.

This recent period has been particularly challenging for EM FX. Prior to July, EM FX had been characterised by weakening low-yielders and volatile high-yielders. EM FX Carry had performed well for periods punctuated by selloffs. The Q1 US CPI surprises culminated in an April sell-off. In May/June we had an EM election-driven VaR shock, where 3 surprising election outcomes were enough to trigger liquidations. These were all characterised by USD strength, and losses on Carry were due to positioning factors and the higher beta of high-yielders. In this recent episode, low-yielders and high-yielders have moved in opposite directions, as the Asian currencies traded with a JPY beta. Below I compare the sell-offs.

Navigating these events was critical to managing EM FX risk in H1. After each unwind there were attractive levels to buy high-yielders, whereas the trend weaker in the low-yielders was more stable.

Looking at the performance of the nominal effective exchange rates in H1 we can see winners and losers in all 4 of the categories I split EM FX into. Among the low-yielders CNY outperformed due to its close management against the USD, causing a strengthening of the NEER. MYR belatedly outperformed significantly. In LatAm, the high-yielders underperformed, although there was less divergence prior to the elections in May. In CEEMEA, the positive election outcome and optimism over centrist policy led to the outperformance of the ZAR. PLN also outperformed with high real rates supported by an intransigent central bank head. Poland also benefits from a favourable flow story, notably substantial EU funds. Of the Asian mid-yielders, only INR performed, under a stable USDINR exchange rate in a strong USD environment.

A Brief Note on Trump.

After the debate, and prior to Biden stepping down, the market had a strong and uncomfortable look at what a Trump presidency could mean. The odds have now shifted, but Trump is still a plausible winner, and should his odds increase focus will return to the impact of deglobalisation policies, such as tariffs directed towards China. However, even if we think we know their direction, Trump's policy specifics are unclear. The details matter significantly when it comes to tariffs. If they are selective and of low magnitude, their impact can be quantified and small growth and inflation adjustments can be anticipated. However, 60% tariffs would seem impossible to model and could lead to compounding effects. Having sought FX stability of late, Trump’s policies may prompt the Chinese to allow the FX depreciation they have so far resisted this year. I’ve been bearish on CNY throughout H1, and this risk will keep me bearish through H2. US political noise resulting from a close election with divergent policy outcomes will create unhelpful volatility, as might any anticipation of a contested outcome. This volatility would naturally damage the appeal of the FX carry trade.

Outlook

There could scarcely be a more dangerous time to opine on the outlook than now. We could be at an inflection point for the US cycle, with significant ramifications for the USD and EMFX. Despite the unwelcome volatility, what’s unfolding does have the potential to create market conditions both more and less favourable than what we’ve experienced recently. Future paths can include those that are strongly EM bullish. For example, if soft inflation continues, it could allow a significant easing cycle in the US. It would require strong communication from the Fed that quickly convinces markets that easing will be aggressive in covering recessionary tail risks. In this case, capital might feel safe enough to exit the US in search of higher yields, leading to a USD downtrend. This could signal an end to what has been a bear market for EM flows.

The other side of the scale is more intuitive: if the slowdown gathers pace, it will continue to alarm investors, causing sufficient risk aversion for capital to flow back to the US and low-yielding DMs (like Japan). The USD would remain strong but volatile for a period, making EM treacherous.

My bias is that we’re not at an inflection point. I feel the current fears of a sharp growth slowdown are overblown, and some mean reversion could easily tip us back onto the path of a steadier slowdown. If the path is gentle, and US rate cuts are modest, the USD will retain its position as a mid-yielder. In this outcome, we are still likely to want EM FX Carry trades on an RV basis. This environment still gives room for idiosyncratic stories that are compelling enough to overcome the noise and be held as structural trades. One example would be the Turkish Lira, where a prolonged period of orthodox policy and high yields has resulted in sizable inflows. With spot relatively stable and no longer on a trend depreciation path, there seems to be a window to enjoy most of the 40+% carry available in the forwards. Policymakers seem to believe that the benefits of REER appreciation (disinflation and capital inflows) outweigh the costs. Short CNH also looks set to remain a structural trade that can be held in the medium term. The prospect of a Trump presidency adds a potential kicker there but is not a necessary condition for the trade to perform.

EM FX framework.

Given the high uncertainty over which regime we will occupy, I thought it worth devoting time to outlining the framework I’ve been operating under. This framework breaks if US rates are eased so much that the USD becomes a funder, and/or the slowdown is sharp enough to cancel ‘goldilocks’.

The fundamental baseline, I believe, is that we have been in a structural EM bear market, defined by weak Chinese growth and high US rates. The positive countervailing dynamic has been the ‘goldilocks’ US growth/disinflation balance which has calmed market volatility to such an extent that the higher yields in EM can look attractive on this ‘vol-adjusted’ basis. This dynamic has been good for EM credit and periodically good for the FX carry trade.

The Dragon-Greenback Squeeze

EM assets have spent many years responding to the rhythm of Chinese growth and US monetary policy. Chinese growth impacts global trade dynamics, commodity prices, and overall economic sentiment, which in turn affects capital flows and investment in EMs. US rates have a significant impact on the flow of capital into higher-yielding EM assets. Lately, we have had weak growth in China and tight US policy. This unhelpful combination is something I’m going to call the “Dragon-Greenback Squeeze” (DGS).

The Dragon

Since last year, the medium-term outlook for Chinese growth has remained subdued. I recall writing at the time that I thought the previous growth model had hit the buffers. Housing and infrastructure investment carried the Chinese economy for years and both were well-functioning stimulus taps that could be turned on easily to smooth a downturn. These vehicles are fundamentally impaired now. Housing requires a lengthy period of real price declines to restore affordability and to work through inventory. During this period construction will be lower by necessity. The pace of infrastructure development simply needs to slow to reflect the stock. Over the past 2 decades, China has advanced to a position where it boasts some world-leading modern infrastructure. Further capital investments there will be ever less efficient. The rapid development has affected intertemporal transfers and the pace will have undoubtedly delivered many projects which will become a drag on the regions they are in. In an attempt to replace some of the output from these growth engines, China turned back to manufacturing and has successfully developed world-leading capacity in high-value exports such as EVs. However, this source of growth already looks impaired, some industries are hitting demand constraints and speeding along trade wars with the West. All considered, it’s hard to be constructive on Chinese growth for the foreseeable future.  Due to these faltering policy levers, we can’t even get optimistic about stimulus-induced upswings as we have in the past. Below you can see the negative real estate contribution to GDP and Fixed asset investment (orange line).

To monitor the progress of the China growth factor we can monitor the evolution of consensus forecasts and their drivers. As you can see from the below – growth is expected to fall below 5% this year and to 4.5% in 2025. 2024 expectations have risen somewhat since the start of the year. On the inflation front you can see expectations for this year and next declining steadily.

The trajectory for China's growth forecasts has been fairly flat this year after downgrades last year. This axis doesn’t look particularly dynamic at present without access to such effective policy tools the chances of game-changing stimulus look low.

The Greenback.

H1 this year began with 7 fed cuts priced by the market after a soft run for inflation in Q4 last year. Q1 turned that trend sharply into reverse with sticky ‘last-mile’ inflation concerns which briefly turned to fears of a reacceleration. Q2 inflation data came in softer, with some signs of weakness in the labour market emerging of late.

The pandemic gave way to highly unusual business cycle dynamics making it difficult for economists to gain conviction on the outlook. For example, there has been an unusually large divergence between goods and services demand. The hiking cycle in the US and the structure of the mortgage market have had the effect of freezing the housing market. Labour mobility is impaired and the goods purchases that often coincide with moving house are not occurring to the same extent. This consumption instead is transferred to services, exacerbating this divergence.

The best we can do here is follow the narrative for plausible trends and monitor pricing, data and the evolution of forecasts. As you can see in the above trackers, 2024 US growth forecasts have risen substantially since Q4 last year. 2024 inflation forecasts also rose in response to the Q1 data and have begun to moderate late in the past month. Based on the most recent data, US growth and inflation risks look skewed to the downside.

Bear Market for EM Flows

The Dragon-Greenback squeeze has contributed to a bear market for EM flows. The appeal of generic EM local bond performance has suffered from material allocations to low-yielding bonds in Asian markets such as China and Thailand, this depresses the overall yield especially when compared to an elevated US risk-free rate.

On the Equity side, the AI-led tech boom has helped crowd out other equity markets. The share of the US within MSCI World has been driven up to 70%, with each of the US Mega caps around 5%. This ‘US mega-cap exceptionalism’ has been part of a trend that has driven non-tech EM stocks to strikingly cheap valuations. Below we see the underperformance of the Brazilian index vs the tech-heavy Taiwanese index and the Nasdaq.

Goldilocks on-Goldilocks off

Up until the recent bought of EM weakness the rhythm of performance was dictated by a Goldilocks on-Goldilocks off (GOGO) factor. Strong activity and upside inflation prints took us beyond the comfort zone of markets in April, weaker growth and rising recession risks could take us to the other side of the equation. The dark scenario for EM assets would be a stagflationary outcome, which has remained sufficiently discounted all the time US growth has been robust. These fears might become more tangible as growth slows.

Low Vol and the EM Carry trade

Market volatility is a key mechanism through which the GOGO factor affects EM asset prices. “Goldilocks-On” depresses volatility thereby improving the vol-adjusted carry available to investors. This recent period of goldilocks-on has been positive for EM credit for much of the year so far and has laid the foundations for an EM FX Carry trade. As we have seen recently, as sharp rise in vol does significant damage.

In the charts below, you can observe that the level of EM FX yields over USD yields are not at especially attractive levels, however, the carry differential between EM high-yielders and low-yielders is notable. It’s not as striking as at the beginning of 2023, but is still elevated, and attractive in an environment of low volatility.

There have been two main approaches to carry trading in EM FX this year. The first is the basket/EM pair trading approach, which has been recommended in these notes (and elsewhere). The second is to find less correlated sources of FX carry in places where the yields vs USD are high in absolute terms. Two favoured examples are Turkey and Egypt.

Examining the basket approach we can see that 2022/2023 saw the best returns for this strategy. 2024 has been more challenging, relying more on the carry for total returns for much of H1 and recently experiencing a significant drawdown. One of the issues with the 2022/2023 phenomenon is that many of the higher carry currencies became more expensive as the lower carry currencies cheapened. These valuation mismatches create vulnerabilities to the trade and increase the risks of deeper corrections. One can avoid the most overvalued candidates when constructing a basket, and indeed I did so in the case of the Mexican Peso – as noted at the start of the year. An absence of MXN exposure in the recent episode of volatility was certainly an advantage.

These carry strategies are deployed partly in default of anything better to do in EMFX. Simply shorting the low-yielding Asian currencies has been a superior sharp ratio trade until recently, although many of these currencies became cheap adding fuel to the recent correction. Holding USD shorts dampens the USD volatility, but introduces more exposure to the GOGO. Additionally, it requires one to have a basket of high-yielders, and it is difficult to avoid either expensive currencies, currencies with poor fiscal positions, or both.

Fiscal Woes in Emerging Markets

Global government debt levels have been significantly impacted by the pandemic and energy price shocks. Emerging Market (EM) governments faced substantial deficits, first to support their populations and economies during prolonged lockdowns, and then to shield consumers and businesses from surging energy prices. This situation has been exacerbated by high global and domestic interest rates, increasing the cost of servicing the newly accrued debt. As more budget resources are diverted to interest payments, essential spending is being crowded out, further straining public finances.

Looking ahead, transitioning to greener energy sources presents another major fiscal challenge. The necessary investments are substantial, and many EMs are already struggling to secure the required funding due to their weakened fiscal positions. Additionally, the rise of populism has led to increased social spending as governments attempt to appease their electorates and fend off more radical populist challengers. This trend is evident not only in fringe political movements but also in mainstream parties, leading to broader fiscal indiscipline.

We can monitor the evolution of forecasts for major EM budget balances to identify where expectations are deteriorating or improving. However, determining market sensitivity to fiscal slippage, or failure to legislate for improvements, is more challenging. The expectations data may not be sufficient for a rigorous study, so we must read between the lines and watch for asset price underperformance relative to peers. Brazil serves as a case study this year. Despite only minor forecast deterioration, the market punished the currency to an extent that seems disproportionate to other factors.

Stronger External Balances

Recent years have seen significant improvements in the external balances of many EMs, unlike during the 'Fragile Five' era of the taper tantrum. Countries previously reliant on external debt have stabilized their accounts, supported by steady foreign direct investment flows. Higher commodity prices have bolstered export revenues, particularly for commodity-exporting nations. Strategic resource management and new trade agreements have also enhanced current account positions. As seen in the chart below, India, South Africa, Brazil, Indonesia, and Turkey now appear less fragile.

Political Analysis

The significance of politics in EM markets has increased. 2024 is a pivotal year, with recent elections in India, Mexico, and South Africa delivering varying surprises. This has triggered recent EM asset weakness, particularly the dramatic selloff in the MXN following Claudia Sheinbaum’s higher-than-expected victory margin in Mexico, raising concerns about aggressive leftist policies. For EM macro traders, understanding local politics is now crucial, adding complexity as traders must process both economic data and political shifts that influence market dynamics. While economic data can be efficiently condensed and analysed, following politics remains labour-intensive.

FX as a Limiting Factor for EM Central Bank Easing Cycles

The substantial Fed easing cycle priced out in Q1, coupled with ongoing EM central bank easing, has compressed rate differentials to pre-pandemic levels. This has left some EM central banks constrained by Fed policy. The challenging environment for holding EM assets makes EM central banks cautious about the impact of portfolio flows when setting policy. The deferral of the Fed’s easing cycle has caused many EM central banks to adjust their easing expectations. In some cases, central banks continued easing based on domestic factors, compressing spreads beyond market comfort levels, leading to significant currency underperformance, as seen in Chile and Czechia. In Brazil, FX weakness influenced market pricing away from easing altogether.

Currency Selection

Currency selection is driven by factors such as carry levels, vol-adjusted carry, ex-ante real rates, current account balance changes, growth, inflation, commodity terms of trade, and valuation. While these can be monitored, movements often rely on changes in expectations and narratives about these variables. A model monitoring these produces blended and disaggregated scores, with key variables highlighted below.

Ex-Ante Real Rates

Ex-ante real rates and their trajectory have been a good source of alpha recently, especially with Brazil’s recent rates selloff enhancing its appeal.

Valuation

For valuation, I default to the Real Effective Exchange Rate (REER) vs. its history. Although more sophisticated methods involving productivity adjustments or unit labour costs might offer improvements, simplified REER tracking remains useful. I do look at a range of BEER and FEER models produced by banks and research houses to give a blended impression, but I’m happy with historical REER for a single reference point.

Carry

One can look at simple carry, carry-to-vol ratios and the structure across multiple tenors. To include tail hedging costs, factoring in the skew, one can look at carry adjusted for 10delta USD (or EUR) call volatility.

IIF CEE trip

Lastly, I want to discuss a recent trip to Budapest, Warsaw, and Prague. For anyone who isn’t familiar with the IIF, they act as a link between the private sector and the official sector and produce excellent research for anyone focused on emerging markets, along with some capital flow data. I was lucky enough to join one of their regular investor trips to the CEE region, including the opportunity to speak on their panel at a regional central bank conference.

CEE FX has been a profitable vehicle for carry trading over the past year, and as a result none of the currencies of the countries I visited are cheap. All three countries have very challenging demographics that result in structurally tight labour markets. This is offset to varying degrees by immigration flows, but that leaves them vulnerable to swings in migration trends. From a political perspective, we have Poland moving on from a period of populism, Czechia potentially moving towards a period of populism, and Hungary likely to remain unchanged. The fiscal situation in all three is challenging with increasing energy transition costs and higher defence spending. Czechia seems to be the only one of the three where that challenge is met with caution – at least for now.

Poland has the most compelling flow picture and the most compelling growth dynamics. A new government will be deploying substantial EU funds over the coming years and these flows, both the RFF (post-COVID) and cohesion funds. These flows should support PLN and I have been keen to buy PLN on any position washouts.

HUF and CZK investing seems to also be a range trading exercise with both central banks dovish but cognizant of providing investors with enough real rates coverage to maintain currency stability. This naturally leads to mean reversion as policy drives FX then FX elicits policy tweaks.

I highly recommend the IIF and I look forward to future trips.

Signing off…

Thank you for your time and attention. Please feel free to reach out with any feedback. As mentioned earlier, these notes will be infrequent but I look forward to checking in periodically.

As always, if you’re trading, be disciplined and be lucky.

Stephen

Disclaimer

The contents of this note, including any analysis, opinions, and commentary, are purely for informational purposes and reflect solely the personal views of the author, Stephen Elgie, at the time of writing. They should not be construed as investment advice nor as an inducement, recommendation or solicitation to engage in any form of currency trading or other investment activities.

All information, data, and material presented in this note are believed to be accurate and reliable, yet they are not to be taken as a guarantee of future performance. The views expressed herein are subject to change without notice.

Readers are urged to exercise their own judgment and due diligence before making any investment decisions. The author and his employer, Argo Capital Management Limited accept no liability whatsoever for any loss or damage of any kind arising out of the use of all or any part of this material.

This note is not intended for distribution to or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.