Emerging currencies hardest hit in the past few years are the most likely to benefit from a more positive context.
This includes the Mexican peso, South-African rand, Russian rouble and Brazilian real.
Stronger global trade, cheap valuations and attractive yields will help emerging market assets resist the gradual normalisation in US interest rates.
We believe that the emerging currencies hardest hit in the past few years are the most likely to benefit from this more positive environment.
Export-driven economies will be supported by the recent bounce in commodity prices and continued improvement in the eurozone and Japan. In addition, protectionism seems off the cards in the US.
As in the rest of the world, price pressure is muted in emerging countries. Imported inflation has been contained by more stable exchange rates and falling oil prices. Despite that, we expect emerging market central banks to remain cautious. We believe real interest rates will stay positive and even high in some countries such as Brazil or Russia. The yield differential will continue to attract foreign capital, especially as developed market central banks will be slow at normalising their monetary policies.
Some currencies have already bottomed out but the uptrend is not over yet as stronger growth will help correct the remaining undervaluation. We would avoid the Turkish lira given the political risks, persistently high inflation and the probability that the central bank will have to cut rates to boost growth – not a positive background for investors. However, we see four other currencies that should perform well against both the dollar and euro in coming months from a carry trade perspective.
Despite the 2018 elections and a tense relationship with the US, Mexico could see its cheap currency appreciate further. Inflation is on the rise since late 2016 but the central bank has already raised interest rates significantly, which could pave the way for a pullback in inflation.
In South Africa, economic policies are not always business-friendly, prompting negative market reactions. However, the rand remains cheap and could gain ground in 2018, supported by stronger growth and softer inflation.
Russia is experiencing stronger activity and lower inflation. High real yields and strong global trade are attracting investors to Russian bonds. The central bank may cut rates further but only gradually, preferring external stability to artificial growth. We see little room for appreciation in the rouble but the carry is compelling.
Brazil has been exiting recession quite slowly as political turmoil remains a drag. However, uncertainty has receded this summer with President Michel Temer now likely to stay in power until the end of his term in late 2018. Economic expansion resumed in Q1 2017 and inflation has fallen sharply giving the central bank little leeway to cut rates. Short-term real interest rates are among the highest in the world, well above 5%.
* The EM-8 Carry Trade Index measures the cumulative total return of a buy-and-hold carry trade position that is long on eight emerging market currencies (Brazilian real, Mexican peso, Indian rupee, Indonesian rupiah, South-African rand, Turkish lira, Hungarian forint & Polish zloty). The trade is fully funded with short positions on the US dollar.