Currency Outlook
The strong rally in EM currencies since March suggests that valuations are becoming less attractive and long positions are becoming crowded. Our in-house EM equity risk appetite indicator has already reached "euphoria" level, which suggests that EM equities are vulnerable to corrections (Figure 3). In addition, with inflation low and growth still weak, few EM countries currently have a policy incentive to let their currencies appreciate substantially above current levels. For example, in export-dependent Asia, central banks have a history of managing their currencies, reflecting a policy preference for exchange rate stability and the use of the currency as a nominal anchor for the economy. Other countries may also use this opportunity to build up their low reserves levels, such as South Africa, which has only USD 35 bn in reserves.
Speculation about a Latvian lats devaluation and possible contagion across Europe last week shows that investors should still assign a rather low weighting to Central and Eastern European (CEE) currencies in their portfolios, with very few exceptions. In particular, we view pegged CEE currencies (Baltic States and Bulgaria) and CEE currencies with weak fundamentals (e.g., Romania and Hungary) as being at risk. In the G10 space, the Swedish krona (SEK) could be affected via financial contagion, given that 20% of its cross-border lending goes to the Baltic States. While currencies of more solvent economies might suffer temporary setbacks due to contagion, we would view their correction as temporary and hence, potential buying opportunities. We would caution investors against chasing the market higher now and we would look for better entry opportunities in selected EM currencies that have solid economic fundamentals, access to sufficient liquidity and high yield. Our preference is to focus on selected Latin American, Asian and African currencies.
We believe high-yielding BITS currencies (Brazil, Indonesia, Turkey and South Africa) will benefit from a global economic recovery. With the worst of the global downturn likely behind us and major economies slashing rates towards 0%, investors are likely to seek currencies that can stay firm, are underpinned by solid economic fundamentals, and provide a significant positive carry (Figure 4). In our opinion, within the EM space, the BITS currencies (Brazil, Indonesia, Turkey and South Africa) offer the best return to risk ratio. In the upcoming section, we highlight our reasons for favoring these currencies. We expect an outperformance of the BITS currency basket in an environment where the global economy and risk appetite continue to recover (Figure 5).
