We published a bullish view on Emerging Market FX today on Seeking Alpha. Below are some excerpts:
- The CEW WisdomTree Emerging Currency ETF is at its weakest level since 2000 in real terms.
- The EM FX basket has weakened despite a surge in real and nominal interest rate differentials suggesting that the risk premium is also at a record high.
- Superior external positions relative to the U.S. shoul dprovide EM currencies a degree of support in the event of a resurgence of dollar strength.
“Given the extent of the recent weakness it is important to understand to what extent, if any, it has been justified by its fundamental drivers. Our view is that the fundamental outlook has actually improved. The current 10-year interest rate swap differential between the CEW basket and the U.S. is 4.6 percentage points, its highest level on record. Meanwhile, the spread of inflation-linked bond yields for the countries where data is available (Korea, Chile, Mexico, South Africa, Brazil, and Turkey) relative to the U.S. is also at a record high 3.0pp.”
“This means that investors are pricing in real returns to be 3.5pp higher in emerging currencies relative to the U.S. dollar, reflecting ~2.5pp higher inflation and ~6pp higher interest rates. The collapse in liquidity has created an opportunity for EM currencies to benefit from the combination of bargain valuations and a record risk premium.”
“In order for the CEW index to decline in total return terms over the coming years we would need to see real interest rate differentials move roughly 3.5pp in favor of the U.S. or valuations decline even further from all-time lows. It is difficult to imagine the U.S. raising interest rates any time soon unless we see a sudden increase in inflation, and even then the Fed will likely err on the side of keeping real rates negative. This means that we would need to see real rates across emerging markets fall by 3.0pp in order for total returns to be negative.”
“As well as reflecting a risk premium, real interest rates in emerging markets are driven by real GDP growth for reasons explained here. This means that from a long-term perspective CEW appreciation will depend in part on whether EM economies can avoid a catastrophic decline in real GDP. While the near-term outlook is extremely poor, we do not expect to see zero long-growth across such a diversified basket of countries emerging market economies.”
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