EM assets have had an especially hard landing coming into 2016. Both EM currencies and equities are at their post-GFC lows. Over the past month, EM FX has fallen 3.3% versus the USD and 2.3% in TWI terms, following declines of 14% and 7% over 2015 respectively. The MSCI EM has fallen by a sharp 11% in the past two weeks and EM credit spreads (denoted by the EMBI index) have widened 60bp this year to reach a post-GFC high of 505bp. When compared to the standard deviations on rolling 2-week returns over the past two years, EM equity moves have been by far the largest, followed by EM FX and credit. Measured in these terms, EM rates have seen the smallest declines (Exhibit 1 plots raw asset moves).
These recent moves can be attributed to macro concerns surrounding the continued slide in oil prices and uncertainty regarding China’s 'bumpy deceleration'. Oil prices breached the $30/bbl mark earlier this month, stirring renewed concerns about exacerbated disinflationary shocks across EMs and causing an acute sell-off in risk. In the first trading session of the year, China A and H shares took a sharp hit of 5% and 4% respectively, followed by a significant RMB devaluation that unsettled markets across the globe. This not only dragged down global equity performance – particularly in the Asian regional markets, which have sold off 2.4% year to date – but also rekindled fears of a global slowdown. On top of this, USD TWI has continued to strengthen, putting further pressure on the oil price and exacerbating the pressure for the RMB to devalue. With the sudden increase in global risk aversion, DM rates have begun to rally. Signs of recovery in risk appetite, particularly after EMs calmly weathered the 'lift-off' storm, proved short-lived. As Exhibit 2 shows, EM rates have been selling off through much of 2015, decoupling with DM rates since 2H 2015, but also followed this recent rally with yields falling more than 10bp so far this year.
Oil price dynamics and China continue to dictate the broader direction of asset moves within the EM complex. With oil prices continuing to slide, negative spillovers from the China slowdown via the commodity markets continue to pose a serious problem for commodity producers, such as Russia, South Africa, Brazil and Mexico. These are also among the worst performers in the FX and credit space over the past month, and the benefit from external balance adjustments in places like Russia and Mexico will take a back seat until oil prices show some signs of stability.
Lower commodity prices provide tailwinds for commodity importers in Non-Japan Asia, such as China, Korea and India. However, many of these economies also face large headwinds from China’s growth deceleration and CNY weaknes.
We continue to see significant FX depreciation risks in places that are exposed to China's slowdown and currency shift (KRW, MYR), and commodity producers (such as ZAR, CLP). By contrast, we are relatively more constructive on currencies which are further ahead in their adjustment process and have the potential for stronger growth (INR, PHP,PLN). This group would also include currencies such as the MXN and RUB, which have been in the eye of the latest oil storm. Among the many cross-currents in the markets, our FX team believes the uncertainty over the scale of RMB devaluation is driving much of the FX moves, much as in August 2015.
While this means a stable or stronger RMB could therefore send markets higher, as it did last year, further RMB weakness may act as an additional pressure on EM FX beyond NJA currencies, which are geographically and fundamentally more exposed. Institutional fragilities in places like Brazil, South Africa, Turkey and Poland have exacerbated pressures on domestic assets, with currencies and credit feeling the most pain thus far. The prolonged environment of sluggish growth and Fed tightening creates scope for polarisation based on institutions’ ability to navigate the challenges. Changes in key policymakers in South Africa and Brazil have built up unexpected policy risk premia that have significant spillovers into credit, FX and rates markets. We forecast further depreciation in $/ZAR over a 12-month horizon. Similar concerns are present in Poland and Turkey, where the independence and effectiveness of key institutions have come into question.
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