Emerging market currencies

Transcription

1 Emerging market currencies Positioning in a volatile market Chief Investment Office Americas, Wealth Management 16 November 2017 Jonas David, CFA, Analyst; Michael Bolliger, Analyst; Tilmann Kolb, Analyst; Teck Leng Tan, CFA, Analyst In recent weeks, emerging market (EM) currencies have remained under pressure due to less benign global conditions and, in some cases, additional domestic headwinds. Although further near-term setbacks cannot be ruled out, several factors support the outlook over our investment time horizon. Compared to the past, EM fundamentals have improved; there is better growth and stronger external balances. We see opportunities in markets with sound fundamentals and an attractive interest rate carry (BRL, INR, and RUB), as well as in selected relative value trades (long PLN / short HUF, short TWD / long KRW). Risks to our benign view are a faster-than-expected tightening of monetary conditions in advanced economies, weaker economic activity and a prolonged deterioration in investor sentiment. Our view EM currencies have remained under pressure in recent weeks following their strong performance in the first three quarters of the year. Less benign global conditions, including higher US Treasury yields and broad US dollar strength are ongoing headwinds. In some cases domestic issues have amplified the pressure. Further near-term setbacks cannot be ruled out, but we expect contained upward moves in global yields and a softer US dollar next year. In our view, gradually less accommodative monetary policy in advanced economies should not derail the EM outlook because fundamentals have improved. Compared to several years ago, economic activity is stronger, interest rates are higher, and external imbalances have declined. Still, country-specific factors matter in an investment context. Fig. 1: EM currency preferences Positioning over tactical investment horizon LatAm EMEA Asia BRL MXN CZK HUF PLN RUB TRY ZAR CNY IDR INR KRW MYR PHP SGD THB TWD USD EUR underweight new neutral overweight old Source: UBS, as of 16 November This chart shows our tactical positioning in EM currencies, usually over a six-month investment horizon. These are relative value positions meant for those seeking investment opportunities in EM currencies. The views take into account returns from interest rate differences. The length of the bars reflect risk-return considerations. This month we are tactically trimming some exposure in the Brazilian real (and adding exposure to Brazilian equities in our broader EM positioning), repositioning the overweight in the Indian rupee against the US dollar (SGD before), closing the overweight in the Indonesian rupiah and the underweight in the Singapore dollar, and closing the overweight in the Turkish lira against the South African rand. Moreover, we have opened an overweight in the Korean won against the Taiwanese dollar. In the EMEA region, we are keeping an overweight in the Russian ruble and still expect the Polish zloty to outperform the Hungarian forint. This report has been prepared by UBS AG and UBS Switzerland AG. Please see important disclaimers and disclosures at the end of the document.

2 Positioning in a volatile market Since mid-september higher US Treasury yields and broad US dollar strength have hindered several EM currencies, especially fundamentally weaker ones. The MXN, TRY and ZAR, where domestic factors amplified the pressure, initially began to falter, and weakness also arose in currencies with relatively better fundamentals. In this environment, we focus on those with sound fundamentals and an attractive interest rate carry (BRL, INR and RUB). Before taking outright exposure in the riskier markets, we want to see more signs of stabilizing global conditions and lower domestic uncertainties, especially politically. In the US, the market-implied probability of a Federal Reserve rate hike in December stands above 90% now, up from less than 25% in early September. Along with subdued inflationary pressure, some stabilization of market conditions looks likely. In our view, the monetary policy of major central banks remains accommodative, but is turning gradually less so. Next year we expect contained upward moves in global yields and a softer US dollar. Both should support emerging markets. But other important factors need to be monitored, including progress on US tax reform and other US administration policies like potential trade protectionism. Overall, we expect economic activity to remain sound next year and for the growth differential between emerging and advanced economies to rise. Historically, this has supported emerging markets. Moreover, interest rates are higher and external balances have improved. So gradually tightening monetary policy in advanced economies should not derail the EM outlook, in our view, though further temporary setbacks cannot be ruled out. In this context, EM political developments, including the ANC conference in South Africa (mid-december), presidential elections in Russia (mid-march) and general elections in Mexico (early July) and Brazil (October), will need to be monitored. Given their potential to lower investor sentiment, other factors to watch are commodity prices, China's economic outlook and geopolitical tensions (e.g. North Korea, Middle East). Fig. 2: EM currencies under pressure due to stronger US dollar Performance of US dollar against major world currencies and of EM currencies (indexed), as well as market-implied probability of US Fed rate hike in December (in %) % 80% 60% 40% 20% 96 0% Aug-17 Sep-17 Oct-17 Nov-17 Probability of December rate hike (rhs) US dollar index EM currencies Source: Bloomberg, JPM, UBS, as of 15 November 2017 Fig. 3: External balances have improved in recent years Regional current account balances (in % of GDP, ELMI+-weighted) Asia EMEA LatAm Fig. 4: Further weakness in the past month Performance of EM currencies in the last month (total returns measured in USD terms, in %), including FX and interest rate return KRW PHP MYR THB CZK IDR TWD INR PLN FX return Interest rate return Total return in USD CNY SGD MXN HUF BRL RUB TRY ZAR Recap Several EM currencies in the past month have weakened against the US dollar outside of those in Asia, which trended sideways to slightly stronger. The South African rand (ZAR) and Turkish lira (TRY) depreciated markedly due to high sensitivity to adverse global conditions and domestic issues. Although their fundamentals are stronger, the Russian ruble (RUB) and Brazilian real (BRL) also depreciated. Despite lingering risks, earlier pressure on the Mexican peso (MXN) has diminished. Chief Investment Office Americas, Wealth Management 16 November

3 Chief Investment Office Americas, Wealth Management 16 November

4 Investment views. Latin America: Short USD and EUR / long BRL (targets: USDBRL 3.00 / EURBRL 3.65) The Brazilian real (BRL) remains, relative to the US dollar and euro, one of our preferred currencies. Fundamentals have started to improve and make the risk-return outlook of a long BRL position attractive. Also, the real's interest rate carry enhances the total return outlook. Drivers Recent dollar strength following the repricing of the US fiscal and monetary outlook is only temporary, in our view. Risk sentiment should remain underpinned by the synchronized global recovery and stable-to-higher commodity prices. Brazil's economy has improved and forward-looking indicators point to expanding business activity. GDP growth next year is forecast to climb to 3% from 0.5% this year. Subdued inflation (2.7% y/y in October) leaves the door open to further monetary easing, although the end of the easing cycle is likely approaching soon. After the latest policy rate cut by 75bps to 7.5%, we expect just one more reduction to 7%. Despite a significant decline this year, Brazil's interest rate carry is still decent, in our view, both in nominal and real terms. Given the low yields in advanced economies, the real should keep attracting investors. On the external side, the country's trade surplus has reached USD 67.6bn in the past 12 months a record high which helped lower the current account deficit to 0.6% of GDP, though a recovery in domestic demand might lead to softer readings. Meanwhile, foreign direct investment remains robust. Politics may grab headlines again, but the situation has calmed of late. President Michel Temer's popularity is low, but he still has support in Congress and is expected to finish his term. Risks Further setbacks on reforms as well as deteriorating confidence and growth-inflation dynamics are possible; at the same time, the reform process could also surprise on the upside, e.g. we think progress on the pension reform remains within reach. Renewed political tensions/scandals in Brazil could destabilize the government and pressure the BRL. A swifter-than-expected normalization of global monetary policies is a key risk to EM currencies, including the BRL. Factors to watch Brazil: Growth and inflation data, central bank decisions (policy rate on 6 December, roll-over of FX swaps), external balance and politics. Global: Monetary policy decisions (US Fed on 13 December, ECB on 14 December), commodity prices and risk sentiment. Fig. 5: USDBRL exchange rate and target USDBRL Fig. 6: EURBRL exchange rate and target EURBRL Fig. 7: Trade surplus continues its rise Export and import growth (in % y/y), and trade balance (in USD bn) 40% 20% 0% -20% -40% Feb-16 Aug-16 Feb-17 Aug-17 Exports (% y/y) Imports (% y/y) Trade balance (USD bn), rhs Chief Investment Office Americas, Wealth Management 16 November

5 EMEA region: Short USD and EUR / long RUB (target: USDRUB 58.0 / EURRUB 69.5) The Russian ruble (RUB) is bolstered by improving fundamentals, an attractive interest rate carry and oil prices. It remains one of our preferred EM currencies relative to the US dollar and euro. Its spot appreciation potential looks limited, but its interest rate carry enhances its total return outlook. Drivers Stable oil prices and accommodative monetary policies in advanced economies should support the ruble, but temporary setbacks cannot be ruled out. The circa 7% interest rate makes the ruble attractive in an environment of low yields in advanced economies. The Russian central bank is pursuing prudent monetary policy, in our view. Recently, it cut the policy rate by 25bps to 8.25%. Assuming contained inflation and benign global conditions, we think further cuts to 6.5% by end-2018 are likely. Still, Russia's nominal and real interest rates should remain among EM's highest. Meanwhile, the Ministry of Finance's FX purchases will likely increase and limit the RUB's appreciation potential. Although weaker than expected, the latest GDP growth (3Q preliminary: 1.8% y/y; expected: 2.0%; prior: 2.5%) shows the economy is expanding a trend we expect to continue. At the same time, inflation is below the 4% target and is forecast to remain subdued. After some earlier deterioration, Russia's current account surplus is showing signs of improvement again, and seasonality should be favorable in the coming months. Risks Global setbacks (e.g. interest rate spikes, oil prices, US politics, geopolitical tensions or risk sentiment). Russia's banking sector facing increasing stress. Rising political tensions ahead of the presidential election scheduled for mid-march. Tougher-than-expected policy by the US toward Russia, including new sanctions. Factors to watch Russia: Growth-inflation dynamics and monetary policy (next central bank meeting: 15 December), current account balance, banking sector, geopolitics and presidential elections (first round on 18 March). Global: Oil prices, monetary policy decisions (US Fed on 13 December, ECB on 14 December), US politics and risk sentiment. Fig. 8: USDRUB exchange rate and target USDRUB Fig. 9: EURRUB exchange rate and target EURRUB Fig. 10: Prudent monetary policy amid declining inflation Policy rate (in %) and CPI inflation (in % y/y) Policy rate (in %) CPI inflation (in %y/y) Chief Investment Office Americas, Wealth Management 16 November

6 EMEA region: Long PLN / short HUF (target: 75.0) The Polish zloty (PLN) should continue to strengthen against the Hungarian forint (HUF), in our view. The very dovish stance of the National Bank of Hungary (MNB) should weigh on the forint, while the zloty is likely to appreciate once political tensions around legislative proposals calm down. Drivers Hungary: The MNB continues to signal its dovishness, and the recent weaker inflation readings play into its view. Its guidance is for an extended time frame for loose monetary policy, and additional measures to reduce longer-term rates are likely. We think the MNB will go on providing easy liquidity conditions in the coming quarters, while strong wage growth and tight labor markets should underpin inflation. In our view, the MNB will accept higher inflation rates to boost growth despite the risk they will overshoot the target and already deeply negative real yields. Poland: Political tensions linger due to proposed changes to the judiciary, and the dispute between EU institutions and the Polish government is set to escalate (please see spotlight below for further information). After discussions between President Andrzej Duda and the ruling PiS, two controversial bills reentered the legislative process. In light of worries about the rule of law, it remains to be seen how Polish civil society and the EU react to the outcome. Meanwhile, the zloty remains supported by a favorable growth outlook, and we think the National Bank of Poland will likely react earlier to inflationary pressure than its Hungarian peer. While rate hikes in Poland are likely some quarters off, the zloty may already benefit when the discussion shifts to the possible start date of a hiking cycle. Recent comments by members of the monetary policy committee indicate first cracks in the official dovish message, in our view. Finally, the zloty yields around 1.8% p.a. more than the forint, benefiting our position. Fig. 11: PLNHUF exchange rate and target PLNHUF Fig. 12: Wage pressure should feed into inflation Wage growth and core CPI (in % y/y) Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Hungary - core inflation (rhs) Hungary - wage growth Poland - core inflation (rhs) Poland - wage growth Risks Stronger-than expected European growth should help Hungary more than Poland, as Poland's economy is more closed than Hungary's. This could aid the forint. Hungary s current account surplus serves as a backstop against sizable HUF depreciation. An escalation of political tensions between the EU and Poland may weigh on investor sentiment toward Poland and the zloty. Factors to watch Hungary: Growth-inflation dynamics, next MNB meetings (21 November, 19 December), stock and maturity of swap instruments. Poland: Growth-inflation dynamics, tensions around legislative initiatives, next NBP meetings (5 December, 10 January). Chief Investment Office Americas, Wealth Management 16 November

7 Asia: Short USD / long INR (target: USDINR 64.0) The Indian rupee (INR) benefits from an improving Indian growth outlook and a reasonable yield carry and so remains one of our preferred currencies in Asia, relative to the US dollar. Its spot appreciation potential looks limited, but its interest rate carry enhances its total return outlook. Drivers Improving economic outlook. It should lure more foreign direct investment (FDI) and portfolio inflows, with GDP growth likely recovering to 7.4% next year from 6.6% this year, following last year's demonetization, July's GST reform and the bank recapitalization of a month ago. Indeed, industrial production and PMI have shown signs of recovery, after bottoming in June/July. Positive yield carry. The INR's is fairly attractive at 4% versus the USD. Given the broad USD weakness we see for next year, we think the INR is worth holding for its yield. The Reserve Bank of India's (RBI) vigilance on inflation. In October, five out of six board members (including Governor Urjit Patel) voted to keep rates unchanged, although one member voted for a 25bps rate cut. INR stability depends on stable inflation. The currency has remained in a range since mid-2015, as India's inflation has hovered between 3% and 5%. With the current USDINR 12-month forward trading slightly above 68, the entry level looks attractive. The current account deficit. It should remain manageable since crude oil prices should fall slightly, in our view. We expect Brent crude oil price to settle at USD 57/bbl in 12 months (from today's USD 61.6/bbl), which should keep India's current account deficit in the 1 2% range. Risks Risk of fiscal slippage in the run-up to the 2019 general elections (by May 2019). Should India s fiscal deficit deteriorate sharply, it could lead to a sell-off in Indian bond markets. Broad USD strength could hurt our trade. Notwithstanding a potential short-term USD rebound (triggered by progress on US tax reform), we expect the USD to drift lower next year, in view of the persistent US twin deficits and the lack of strong Fed tightening intentions. Fig. 13: USDINR exchange rate and target USDINR Fig. 14: Stabilizing inflation and current account dynamics should keep INR stable CPI (in %) and current account balance (% of GDP) (2) (4) (6) Oct-11 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 CPI India (%) India current account deficit (% GDP) Factors to watch India: Whether GDP growth rebounds as we expect and attracts FDI / portfolio inflows into India. US inflation: Whether it picks up and prompts markets to expect a faster pace of US monetary tightening. Chief Investment Office Americas, Wealth Management 16 November

8 Asia: Short TWD / long KRW (target: TWDKRW ) We are overweight the Korean won (KRW) against the Taiwanese dollar (TWD), due to stronger Korean growth and inflation dynamics vis-a-vis Taiwan. They should underpin a more hawkish bias by the Korean central bank, which in turn should welcome more KRW appreciation to curb rising price pressures. Drivers Stronger growth dynamics in Korea than Taiwan. Korea is running a larger output gap (3Q GDP of 3.6%, vs potential growth of 2.9%) than Taiwan (3Q GDP of 3.1% vs potential growth of 2.9%). We expect Korean GDP to rise 3% next year (the same as this year) and Taiwan's 2.3% (slightly down from 2.4% in 2017). Stronger inflation dynamics in Korea than Taiwan. Korea's inflation of 1.8% (vs inflation target of 2%) compares to Taiwan's deflation of 0.3% (vs implicit inflation target of 2%). Average CPI next year should come in at 2.2% for Korea (up from this year's 2.0%) and 1.0% for Taiwan (up from 0.6% in 2017). Growing divergence in monetary policy. The Bank of Korea is more hawkish than the neutral-to-dovish Taiwan Central Bank, which said in September that inflation pressures and the inflation outlook are currently very mild." By contrast, the Bank of Korea said in October that economic conditions appear ripe to reduce accommodation. (Moreover, a dissenting vote called for a rate hike.) Carry is slightly positive. Long KRW/TWD has a 1.3% p.a. carry (KRW -0.4%, TWD -1.7%). Risks Significant escalation of North Korean tensions, which will hurt the KWR more than the TWD. Risk aversion: KRW tends to see larger selloffs during general risk-off episodes, as evidenced by its higher implied volatility (8-9%) compared to the TWD (4-5%). Fig. 15: TWDKRW exchange rate and target TWDKRW Fig. 16: Korea's growth and inflation dynamics are superior to Taiwan's Data in % KR GDP growth (3Q 17) 3.1 TW GDP growth (3Q 17) 1.8 KR CPI (Oct 17) -0.3 TW CPI (Oct 17) Factors to watch Bank of Korea governorship. The current governor's term ends in March. North Korea: Ongoing developments on the Korean peninsula. Chief Investment Office Americas, Wealth Management 16 November

9 Further investment views and strategy updates Asia: Closing long IDR and short SGD We are closing our overweight Indonesian rupiah (IDR) position versus the Singapore dollar (SGD). In the coming year, we expect another round of USD weakness, which implies upside risk for the SGD. Given the Monetary Authority of Singapore (MAS) s tradeweighted exchange rate approach, the SGD is likely to be lifted by strength in its trading partners currencies versus the USD. In addition, the MAS has turned more confident about the global and domestic outlook, and has signaled that tightening is likely next year. As such, we expect the MAS to return to a policy of gradual SGD nominal effective exchange rate (NEER) appreciation in October 2018, and thus see the SGD being supported over the course of the year. For further details, please refer to "USDSGD: Further SGD strength in 2018" (8 November). Regarding the IDR, we still expect the USDIDR exchange rate to remain stable in an environment of broad USD weakness. But given Bank Indonesia s desire to rebuild FX reserves during periods of USD weakness, the return potential is limited to the yield carry. Since the yield carry takes time to accumulate while the SGD looks set to drift stronger, the investment case for staying overweight the IDR against the SGD has become less attractive. As such, we have closed this position and gone to the sidelines to wait for better opportunities. EMEA region: Closing long TRY / short ZAR We are taking profit on the overweight in the Turkish lira against the South African rand because the risk-reward of both sides has become less appealing. For further details, please refer to "USDTRY: Ongoing pressure" (8 November) and "USDZAR: Structural outlook at a crossroads" (14 November). In Turkey, we think a more decisive monetary policy response is needed to ease the lira's recent depreciation trend. Absent such measures, risks are skewed toward further weakness in the coming weeks. The interest rate in excess of 12% p.a. is high in nominal terms, and supports the total return outlook. In the current environment of global and domestic headwinds, however, investors are unlikely to increase exposure for now. A major obstacle remains the country's large current account deficit and its dependence on foreign capital inflows. In South Africa, upcoming event risks can trigger sharp moves in either direction. The upcoming ANC conference will be pivotal for the country's outlook, but the outcome of the leadership race is too close to call. In our view, the main scenarios are a victory by the status quo candidate Nkosazana Dlamini-Zuma, the reformist Cyril Ramaphosa or the "compromise" contender Zweli Mkhize. In the second and third scenario, markets are expected to react positively, which we see as more likely on the margin. In the first scenario, more weakness is probable given lower reform prospects. Meanwhile, another rating cut to non-investment grade would weigh on the rand as (passive) investors will likely reduce their bond holdings. The local-currency ratings of S&P (BBB-) and Moody's (Baa3) are currently just above the critical threshold with a negative outlook both agencies will announce their decisions on 24 November. If both issue downgrades, USDZAR could spike above 15.5, but we see this as a risk case. Chief Investment Office Americas, Wealth Management 16 November

10 Spotlight: Heightened tension between EU and Poland After the earlier veto of two controversial bills concerning the judiciary by President Andrzej Duda, discussions between him and the ruling PiS followed and the modified bills re-entered the legislative process. Meanwhile, in light of worries about the rule of law, the European Parliament recently took a first step in the Article 7 procedure, which may ultimately result in a suspension of Poland's voting rights in the European Council. However, we think the likelihood of this occurring is low, since unanimity is needed to determine the existence of a serious breach of common values and Hungary already signaled that it would not support such an assessment. The Polish zloty has not reacted meaningfully yet and continues to trade sideways around EURPLN While further news about the EU-Poland dispute may temporarily weigh on the zloty, we think it should strengthen against the euro once investors focus on the sound growth-inflation dynamics of the Polish economy. We reconfirm our forecasts of EURPLN 4.15, 4.10, 4.10 in three, six and 12 months, respectively. Fig. 17: EURPLN Exchange rate (incl. forward rates), CIO forecasts and volatility range Nov-16 May-17 Nov-17 May-18 Nov-18 EURPLN, incl. forward rates CIO Forecast Volatility range EM exchange rate forecasts Latin America Current 3-month 6-month 12-month Asia Current 3-month 6-month 12-month USDBRL USDCNY USDMXN USDIDR 13,534 13,500 13,500 13,500 USDINR EMEA USDKRW 1,112 1,100 1,080 1,060 EURPLN USDMYR EURHUF USDPHP EURCZK USDSGD USDTRY USDTHB USDZAR USDTWD USDRUB Source: Bloomberg, UBS, 15 November 2017 (please refer to our regular updates for latest views) Chief Investment Office Americas, Wealth Management 16 November

11 Appendix Emerging Market Investments Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. CIO Americas, WM generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law, CIO Americas, WM may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the CIO Americas, WM Education Notes, Emerging Market Bonds: Understanding Emerging Market Bonds, 12 August 2009 and Emerging Markets Bonds: Understanding Sovereign Risk, 17 December Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only. Disclaimer Research publications from Chief Investment Office Americas, Wealth Management, formerly known as CIO Wealth Management Research, are published by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG or an affiliate thereof (collectively, UBS). In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. 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