EM FX: Don’t get carried away – SocGen

Jason Daw, Research Analyst at Societe Generale, notes that for the past five years, emerging market currencies have generally weakened against the forwards.

Key Quotes

“However, over the coming year, weakness in spot rates will be broadly matched by positive carry. Risks are somewhat asymmetric through to mid-2017 – slightly greater probability of EM currencies doing worse than the forwards. There will be differentiation within EM - Asia is expected to underperform EMEA and LATAM, while by region, the best performers will likely be the RUB, INR, and BRL and the worst performers the ZAR, KRW, and CLP. Selective carry trades that are backed by country-specific fundamentals are appropriate, but a wholesale return of passive carry trade strategies is not in the cards.

Over the next few months, two-way risks for EM FX will be more balanced, especially if Fed tightening expectations are pushed back further (although a severe deterioration in US growth prospects could have a negative feedback to EM). During H2, there will be bouts of accelerated depreciation, periods of stabilization, and mini-rallies that will favour nimble tactical trading strategies. Oscillations in risk on/off trading should continue due to evolving expectations of Fed policy, Chinese, US, and EM growth prospects, and RMB depreciation.

Disorderly moves would require fresh factors coming into play (US recession, Chinese banking crisis, EM debt crisis, or broad-based deterioration in local politics) so the chances of a replay of 2015 price action have greatly diminished. We prefer to wait until fundamentals and sentiment show more clear signs of turning before considering shifting to a bullish assessment over the medium-to-long term. Tactical or structural short dollar positions will become more appropriate if positioning, technicals, and sentiment become stretched. However, these signals might be less powerful than in 2015.”