Box 10: Why is EM growth not benefitting from stronger US growth?

Figure 132: US real imports ex oil to GDP (pre-crisis)

-1% 0% 1% 2% 3% 4% 5% 6% 7%

Source: Haver, UBS

Figure 133: US real imports ex oil to GDP (post-crisis)

20% Non-oil imports (%,

y/y)

15%

y = 0.9891x + 0.0257 R² = 0.0698

10%

5%

0%

-5%

Domestic demand (%, y/y)

-10%

Source: Haver, UBS Note: Data is since 2011

In real (inflation adjusted) terms, the bond yield spread against G2 rates has increased, and sits at a comfortable level, precisely because EM inflation remains well contained and bond carry increased after local debt curves steepened in 2018 (Figure 134). However, an increase in real rates in Europe and higher domestic inflation, as pass-through from this year’s currency depreciation takes a toll on prices, could require a more forceful response from EM central banks.

Figure 134: In real terms EM (Ex Turkey) rates spread to G2 remains high

Source: Haver, Bloomberg, UBS estimates. Note: Real rate based on 36-month exponential headline Inflation.

…but in real terms the spread to G2 rates is back at the early 2018 level

We find few currencies to be cheap enough to withstand further pressure.

Our Fundamental Equilibrium Exchange Rate (FEER) valuation metric (Figure 135) shows a reasonable spread between undervalued and overvalued currencies. This suggests that at least some currencies have a degree of valuation cushion. However, we advise against resting too heavily on this assumption. Several of the most undervalued currencies have large current account surpluses because the currencies are deliberately kept cheap, e.g. SGD, TWD and KRW; yet all three of these currencies showed notable sensitivity to CNY weakness in the middle of 2018, indicating that cheapness did not provide much cover. Even though ARS depreciation in 2018 is set to halve the current account deficit in 2019, expectations of high inflation (around 40% in 2019) imply that in nominal terms the exchange rate will continue depreciating during the year just to impede unwanted real exchange rate appreciation.

Our biggest concern is that most EM currencies are fairly valued or rich. Therefore, in times of heightened stress, we believe valuation will provide limited, if any, protection. In addition, as DM central banks continue tightening monetary conditions, the recently observed levels of capital inflows into EM economies might overstate the sustainable current account balance. An increase in DM real rates would decrease the sustainable level of capital inflows, worsening the FEER metric towards less undervaluation.

Our FEER shows a majority of EM currencies as undervalued…

…but tighter DM financial conditions could imply lower capital inflows skewing FEER metrics to less undervaluation

Source: Haver, PIIE,

UBS estimates

The CNY will remain a source of volatility

Slower growth, policy easing and a deteriorating current account all point in the direction of more weakness in the CNY. We expect a further ~6% depreciation against the USD to 7.30. If 25% tariffs are imposed on ‘all’ Chinese exports to the US, the CNY will weaken more.

Assessing the sensitivity of USD/EMFX to USD/CNY while controlling for risk (using the MSCI World index) and oil prices, and using a smaller sample by including only periods in which USD/CNY trended higher for more than a 12-week period, we find that commodity exporters and deficit countries are the most exposed (Figure 136). Malaysia and Indonesia are the most exposed in Asia.

We expect the renminbi TWI to depreciate in 2019 as Chinese growth slows

Commodity exporters and deficit countries are the most exposed to CNY weakening

Main risks to our views

The biggest risk to our view is that even the small rise in US rates that we expect through 2019 continues to widen the cracks in EMFX, and the asset class is 1) weaker than we expect; and 2) high yielders do not outperform growth-sensitive currencies as a result. It will be a bigger challenge for EM if US rates rise more and/or for longer than we forecast.

ECB policy normalisation could be a double-edged sword for EM. Our baseline view is that as the ECB normalises, the EUR will erode its current undervaluation and, as it does, it will support EMFX vs the USD. In short, USD/EMFX has a high beta to EUR/USD, therefore if the EUR appreciates so will USD/EMFX, although likely with a lag. However, if the ECB does not hike confidently – for instance if growth disappoints or inflation is slow to pick up – the performance of EMFX would be at risk. In contrast, if the Eurozone recovery is stronger than expected, the ECB could normalises policy confidently, perhaps more quickly than we expect. This would put more upward pressure on Bund yields, driving lower EMFX if it causes European investors to curtail their appetite for EM assets.

A more positive risk for EMFX is a reduction in US-China trade tensions. Media headlines, at least, suggest that there is scope for a rapprochement around the Trump-Xi meeting scheduled to take place on the side-lines of the G20 meeting later this month. History tells us that it is foolish to try and predict what will happen next in the US-China trade spat, but some easing of pressures would be a positive for EMFX, as the recent price action around the trade headlines indicates.

Another positive risk is the possibility of more China stimulus, which is more likely if data remains broadly weak. However, more policy support to take away the tail risks to growth at least, would help EM assets, and indications of a pickup in growth, more so.

Our FX scorecard (Figure 138), which employs valuation, flows, carry and macro variables to rank EM currencies, screen high-carry and strong external balance currencies, RUB, MXN and BRL, as the most attractive among EMFX. Interestingly, ARS, which screens as undervalued and has high nominal carry, is weighed down in the scorecard by a weak macro backdrop. CNY, PHP and HUF screen as the least attractive currencies in the scorecard.

Higher US rates could still hit vulnerable EM currencies

Too timid or strong growth in Europe also poses a risk to EMFX

A decrease in US-China trade tensions would decrease EM expected growth deceleration

Forceful stimulus in China would boost EM asset prices