Our central view is that the growing resilience of emerging market (EM) currencies could extend into 2018 although some EM currencies may face a bumpier ride than in 2017.
EM currencies continue their tentative recovery
While we forecast monetary tightening to spread from the US to other developed market (DM) economies, moderate and gradually higher G10 yields are much less of a headwind for EM currencies when both external and domestic environments are supportive of economic growth in EM.
EM growth and currency performance are first and foremost functions of global growth. Global growth has strengthened and broadened in 2017 and the good times are set to roll, judging from higher prices across the commodity complex and with the recent round of manufacturing PMI pointing to continued manufacturing strength. EM economies also look well positioned to experience additional demand support from the passing of the US tax reform.
EM domestic fundamentals have also vastly improved since the ‘taper tantrum’ in 2013, creating a macro backdrop conducive to resilient and sustained growth: current account deficits have narrowed, inflation is well-behaved, and the pae of debt accumulation has slowed outside of China.
Among the potential risks that could derail EM FX resilience is sustained upside US inflation surprises fueling G10 yield surge. However, our forecast of slightly lower oil prices over the course of this year should make it harder for inflation to spring nasty surprises.
Other macro risks abound but seem manageable. First, China, just like every year, comes to mind. Policymakers are withdrawing support on multiple fronts, via credit, macro-prudential measures, and government spending. These shifts argue for slower growth but it seems the Chinese authorities will be able to engineer an orderly slowdown that should limit the scare for commodity-related EM currencies.
Second, the fact that the NAFTA renegotiations are going poorly is a reminder that trade protectionism remains a downside risk that could hit EM trade and investment. There are also the usual geopolitical risks, ranging from North Korea to the Middle East. But at this stage, these risks look contained in our view.
We don’t expect strong upside in EM FX in 2018. However, further USD weakening on a 2-3 year timeframe could augur well for EM currencies in the longer-term. Concerns over the aging US economic cycle and perceived poor political leadership could made it harder for the US to win the competition for capital and therefore does not augur well for USD’s longer-term outlook. By contrast, EM is characterised as early-to-mid cycle recovery and therefore could receive more relative capital inflows.
INR, BRL and RUB offer attractive real yields and supportive fundamentals
Earning carry in EM currencies in 2018 can still be rewarding. Earn carry with vigilance by buying dips rather than chasing rallies. Our preferred picks: BRL, INR and RUB.
Brazil’s improving external position is BRL-supportive. BRL’s real interest rate, supported by disinflationary pressures, is among the highest in EM. Market's apparent assumption that there is now little chance of any pension reform legislation being passed before October's elections may be too gloomy. Brazilians will choose a President, 27 State Governors, all Lower House Representatives, two-third of the Senate, as well as State Assembly lawmakers in October 2018.
India’s growth conditions are normalising on back of gradual re-monetisation and channel restocking post-GST. India's improving economic growth prospects, particularly following the bank recapitalisation programme, is supportive of the INR. The RBI has kept macro stability its priority, keeping high real rates and building up FX reserves to a record high. The risks for INR can come from significantly higher oil prices and any worse news on fiscal slippage. 2018 is also a pre-election year (general election due in April 2019) and a push for populist spending cannot be ruled out.
RUB has lagged the rally in oil price and could play catch-up. The Russian central bank eased by more than expected in December but RUB real yields are likely to remain one of the highest in EM given that the central bank is likely to revert back to a conservative easing mode. Despite presidential elections in March 2018, the authorities have committed to maintaining fiscal discipline in the 2018-2020 framework, pledging to bring the federal budget to primary balance by 2019. We assume no meaningful escalation of sanctions – the main risk we foresee for the RUB.
TRY’s yield at double-digit is eye-wateringly attractive. While core inflation remains sticky, headline inflation should drift lower in 1Q18 due to base effect, increasing the real rates in Turkey and could provide tactical opportunities to be long TRY. However, we still see a need for the Turkish central bank to hike more aggressively to stabilise the TRY in the medium-term.Disclaimer applicable to recommendation
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