There is room for a further “sell-off” of emerging market currencies, because countries with large external imbalances, such as Turkey (TRY), India (INR), Brazil (BRL), South Africa (ZAR) and Indonesia (IDR) remain vulnerable to rising US yields, says Macelo Assalin (pictured), lead portfolio manager, emerging market debt local currency strategies at ING Investment International…
Rising US rates pose a significant additional challenge for these countries when trying to attract the portfolio inflows needed to finance their external accounts, and can also face significant outflows should market conditions worsen. Therefore, a further sell-off cannot be ruled out. Despite this, we are of the opinion that the forthcoming reduction in the pace of bond purchases by the Fed is reasonably well anticipated in the marketplace and that US Treasury yields should rise more gradually going forward. In turn, some emerging market currencies that sold-off aggressively on the back of the recent spike in US yields should stabilize in the near term.
A ‘selling pressure’ in the US dollar has been witnessed in recent years due to the extremely low interest rates in the developed world which have underpinned massive flows into EM local markets. The increase in US yields since May 2013 has created the reverse effect. EM local markets have experienced significant outflows in this period and concerns around additional outflows have weighed on investor sentiment - resulting in increasing demand for hedging. This negative environment for EM currencies has certainly encouraged speculative bets against the most vulnerable currencies and ING IM believe that outflows should diminish as US yields stabilize in the near term.
In light of the very difficult market environment and extremely uncertain backdrop, we prefer to keep risk allocation in our portfolios to a minimum. We have very little directional exposure to EM currencies at this point, and prefer to express our views in that space through relative value trades (funding long positions with short positions within the EMFX space). We like the MXN, BRL, PEN, RUB, KRW, and PHP because we think that these countries are in a better fundamental position to withstand adverse market conditions (in the case of Brazil high levels of international reserves). We remain cautious on the TRY, INR, IDR, and ZAR because of their large current account deficits and low levels of international reserves.
In the long term, despite ING IM’s our more cautious short term stance, the investment house has a constructive long term outlook for EM countries and strongly believe that at some point investors will re-focus on attractive valuations and the asset class will start displaying strong performance numbers again. It ultimately suggests that this major correction will eventually translate into a great opportunity to re-position in the asset class. While the base case scenario anticipates a stabilization of US rates in the near future and therefore better price actions in the EMFX space, ING IM believe it is still premature to state that the sell-off has gone too far. This is because there is still a substantial amount of uncertainty surrounding the QE tapering process and given the importance of portfolio flows to many EM countries, EM currencies should continue to display high levels of correlation to US Treasury yields.
Despite the increased volatility and the general cautious outlook for emerging market currencies, we still note that many are looking attractive after the correction. We particularly like the BRL, CLP, MXN, PEN, RUB, KRW, and PHP. However, we also believe that currencies of countries displaying high levels of external imbalances will face stronger headwinds, with exception of the Brazilian real, given the high levels of international reserves accumulated there over the past years. We have moved the BRL to an overweight position after the Brazilian Central Bank announced the recent intervention program, and will certainly be keeping a keen eye on any developments.