Lombard Odier’s Salman Ahmed looks ahead to factors affecting EM assets, FX rates into 2014
Salman Ahmed, global fixed income and foreign exchange strategist at Lombard Odier Investment Managers, has provided an outlook on emerging market assets and FX into 2014.
As the dust continues to settle with signs of stabilization in emerging currency and bond markets, we take a stock of the situation and offer our forward looking views.
External financing Requirement has been the differentiating theme
Cutting through the mayhem of May and June, our analysis shows that current account dynamics have been the key differentiating theme in this latest episode of EM asset sell-off. Countries such as India, Turkey, Brazil and South Africa have been hardest hit and all have current account deficits in common.
Idiosyncratic factors have been important too, but the theme is best illustrated by CEEMEA countries, where Hungary has outperformed its peers given its better current account dynamics. As such, it appears that the re-pricing of US treasury yields tightened the global financing environment, which in turn led to pressure on current account deficit countries as fundamentals were exposed.
In terms of recent dynamics, we have seen a number of national central banks coming to the market in a bid to stem the pressure on their currencies. Indeed, the intervention theme is now beginning to converge, with countries such as Turkey and India readying themselves for rate hikes to relieve selling pressure as reserves fall.
Overall, the trajectory of US yields will remain key for short-term market sentiment as the Federal Reserve defines a new and a more nuanced policy regime, but based on cross-asset price-action, we sense a more fundamental shift in emerging markets is underway.
EM growth dynamics look vulnerable
More broadly, 2013 is not shaping to be a great year for EM growth. China is undergoing a visible slowdown, as evident in the latest trade data, and this is creating spill-overs for a number of China-exposed developing countries. In Europe, the sustained weakness of euro zone is also spilling over to CEEMEA countries that depend on the euro zone demand and bank financing for drivers of economic growth. Moreover, idiosyncratic factors, such as rise in political risks in Turkey, have also played a role in further weakening the fundamentals picture.
Looking ahead, China’s growth path remains key for the growth dynamics for a variety of EM countries. On this front, the long-term fundamental case for a number of EM countries appears have been damaged to a certain extent (for example, South Africa, Brazil and Chile).
But relative value opportunities have started to appear
As calm returns in EM markets, we are starting to see attractive valuations in a number of countries with strong fundamentals, such as the Philippines and Peru (where FX reserve cover is very strong having grown by 192% since 2007). Even in South Africa, there is a tactical bullish case on the front end as we see moves toward resolving the labour disputes, which should help take pressure off the foreign exchange.
In FX markets, we see scope for appreciation in the Mexican peso (MXN) and Peruvian sol (PEN) as the new government reform agendas start to yield positive results. Here, even the Indian rupee (INR) is looking interesting as the central bank fights back with higher rates coupled with a narrowing current account deficit on the back of recent policy moves.
However, at this juncture, we would note that given the policy regime shift taking place in the US, it is important to remain nimble and dynamic in risk management as fundamentals, positioning and policy changes come together.
In frontier markets, Pakistan is worth watching
One interesting frontier market where dynamics have shifted positively is Pakistan. Although, standard balance of payments and fiscal vulnerability analysis justifies the case for outsized yield premium, in Pakistan’s case, international and domestic politics are equally, if not more, important.
The May elections delivered the first civilian hand-over of power in the country’s history, which brought a pro-business party headed by former premier Nawaz Sharif into government. The initial policy moves announced have been positive with a practical plan to counter the extreme power shortages facing the country. In addition, the new government has reached out to the IMF for balance of payment support and has already taken some hard steps to increase the likelihood of a deal. Examples include a general sales tax and higher energy prices. Once completed, this support should take pressure off dwindling foreign reserves.
Moreover, as the 2014 withdrawal of US troops from Afghanistan comes closer, there is strong international support available to help the country improve its economic situation, which will in turn facilitate a smooth withdrawal.
All these positive factors are starting to be reflected in the hard currency bond market, with Pakistan 2036s now trading near a 2.5-year high of 83.7 cents. We believe Pakistan offers an attractive risk/reward profile, as given the factors mentioned above it is likely to enjoy a sustained period of outperformance among frontier markets. The key risks to this view are a bungled withdrawal of troops from Afghanistan, which would test the international support behind the country, or a failed IMF deal, which is unlikely in our view given the September timing of the potential announcement.