BoAML| The emerging market rally of the past six months appears to have paused and needs another theme to resume: we think the exchange rates will be the key issue. Since end-January, emerging market assets have rallied on a compression of excessive cred it risk premiums that were created by the oil and China induced panic: EM credit spreads have by now returned to their 5-year average vs developed markets (DM), having reached a post-Lehman high at the end of January. On the other hand, EM currencies are still 30% below the post-Lehman high reached in 2011, or 10% including the carry.
Current accounts are crucial for long-term exchange rate trends, and they are at a promising juncture. After years of volatility, we forecast that the EM aggregate current account stabilizes during 2016 and remains quite stable in 2017 (Chart 1). The Asian surplus has increased since 2013 thanks to cheaper commodity imports and weaker exchange rates. But more important for EM currency stability is that EEMEA accounts have stabilizes after the oil collapse, and LatAm rebalances to a sustainable deficit.
EM and DM current accounts – as exchange rates – are two sides of the same coin, and the long-term cycle favoring DM may be nearing an end. Chart 1 shows that DM has substantially improved its collective current account since 2008 due to the recessions and lower commodity prices. Fiscal austerity has played an important role there too as DM has cut government spending by 5 percentage points of GDP since 2009, while EM has boosted spending by 3 percentage points of GDP over the same period.
Current accounts are also the key input of our long-term currency fair value model, “ FX Compass. ” Chart 2 underscores the high correlation between the change in the current account and real trade-weighted exchange rate since the 2013 “ taper tantrum ” . “ FX Compass ” looks at where the current account should be given commodity prices and the determinants of investment and saving in an economy and then shows how much the exchange rate has to move to get into that equilibrium. For example, South Africa and Turkey run current account deficits about 2% of GPD bigger than fundamentally justified (Chart 3), and thus their currencies are about 10% overvalued (Chart 4 ).
Overall, our “ Compass ” points north as EM trade-weighted real exchange rates are on average 2% undervalued. For comparison, at the peak of the QE-induced bubble in 2012, they were on average 4% overvalued. On the face of it this bodes well for EM assets in equities and fixed income, but there are at least two sizeable flies in the ointment: 1. All of the ten most undervalued currencies have a (latent) deflation problem, and thus central banks will be reluctant to allow exchange rate appreciation. 2. The high-beta currencies with attractively high interest rates are still overvalued. Most of these tend to be commodity exporters, with the exception of Turkey.
EM depends on DM
Higher commodity prices would ameliorate both these issues, and helpfully our team forecasts that Brent crude rises to $61/bbl next year. Higher commodity prices would support the commodity driven currencies and recycle USD liquidity back into the global economy as central banks pegging their currencies – such as in the Persian Gulf – won’ t continue to lose reserves at the present pace. Moreover, they would alleviate imported deflation in economies in Asia and Eastern Europe which leads headline inflation in many markets to deviate from strong performance of domestic inflation drivers such as credit growth or wages. This then should make central banks more comfortable with stronger currencies, and they may even have to raise interest rates.
Alternatively, strength in DM economies — due to say, stronger wage growth or looser fiscal policy — could support another round of EM strength. While weaker DM currencies would favor all of EM, the outperformers would not necessarily the fundamentally strong undervalued currencies but rather higher beta markets, for example Brazil and Russia where we remain positive on local currency assets.