- We remain bullish on the WisdomTree Emerging Currency ETF which we entered on April 2 owing to the elevated level of real and nominal yield spreads and cheap valuations.
- Even after a slight decline in EM real yield spreads, the average real yield in the CEW basket exceeds the U.S. by almost 5 percentage points.
- The two main risks come from the potential for another shift towards global risk aversion and/or the deterioration of U.S.-China trade relations and its possible impact on the yuan.
- We believe that the potential reward for the CEW over the coming years in terms of its high yield and capital gains outweighs the risks.
We remain bullish on the WisdomTree Emerging Currency ETF (CEW) which we entered on April 2 owing to the elevated level of real and nominal yield spreads and cheap valuations resulting from the global dollar liquidity crisis seen in March.
Even after a slight decline in EM real yield spreads, they are still significantly higher than the U.S. and are likely to remain that way, while EM currencies remain deeply undervalued. The two main risks come from the potential for a sharp fall in U.S. stocks to trigger another bout of EM risk aversion and the deterioration of U.S.-China trade relations and its possible impact on the yuan and other EM FX. However, we believe that the potential reward exceeds the risk.
The 4.5% gain in the CEW, made up of a roughly equal balance of the TWD, CLP, PLN, MYR, KRW, MXN, CNY, INR, BRL, TRY, and ZAR, since April 2 has been driven by a broad recovery in risk appetite, with currency gains corresponding with a move lower in CDS spreads across EM corporates and sovereigns. The Federal Reserve’s swap line extension in late-March helped to restore dollar liquidity which likely played a key role in boosting risk appetite, offsetting the decline in nominal yield spreads between EM FX and the U.S. dollar that has taken place over the past two months. The nominal 10-year bond yield differential between the CEW basket of currencies and the U.S. dollar moved roughly 100bps in the U.S. dollar’s favour over the past two months.
Real Yield Spread Still High And Likely To Remain That Way
Despite the decline, the real interest rate differential between the CEW basket of currencies remains at roughly 5 percentage points, as downside pressure on nominal yield spreads has been offset by a decline in emerging market inflation and inflation and inflation expectations. With the U.S. Treasury and Federal Reserve committed to keeping nominal yields depressed, we expect U.S. real yields to continue declining, keeping the EM real yield advantage in place. Furthermore, we expect valuations to gradually rise in line with faster real GDP growth and increased competitiveness, adding to CEW gains.
Repeat Of March Crisis Unlikely
Our view is that we have seen the worst of the dollar liquidity shortage and EM FX weakness. From a fundamental perspective, we believe we are past the worst in terms of global economic activity. With COVID-19 cases continuing to slow and lockdowns being gradually loosened, the global economy should begin to stabilize. Nonetheless, the U.S. equity market remains highly susceptible to a crash given their extreme valuations which could create renewed shocks for risk assets globally over the coming months.
However, with swap lines in place to prevent a freezing of the Eurodollar system, and the U.S. Treasury and Fed continuing to create record amounts of debt and money, we believe the transition from deflationary recession to inflationary stagnation has now begun. This suggests we are unlikely to see a repeat of the kind of panic we saw in March, particularly given the unique nature of the shock. It is also worth bearing in mind that even amid such a global shock, total swap line usage totalled no more than 4% of global central bank reserves.
China Risks Rising But No Existential Threat
Another risk to EM FX comes from the threat of large Chinese yuan weakness resulting from the rapid deterioration in U.S.-China ties. China faces a number of threats to its economy over the coming months and years as the backlash over its role in the COVID-19 outbreak rises. Larry Kudlow announced on May 26 that the U.S. would pay companies to bring supply chains home from China. This follows an announcement made by the Japanese government in early May that they will subsidize suppliers to move from China to South East Asia.
The risks to the yuan are rising, but we do not expect any large-scale weakness to undermine the CEW basket even if the yuan itself weakens sharply. Certain countries will greatly benefit from any shift in investment away from China. Meanwhile, the U.S. will suffer a rise in inflation and a decline in productivity as it subsidizes unproductive supply chain management shifts amid its high and rising government debt load.
Overall, we believe that the potential reward for the CEW over the coming years in terms of its high yield and capital gains outweighs the risks arising from another liquidity crisis or a China-led EM recession.