Emerging markets currencies outlook for Q2

Emerging markets currencies will be one of the most affected asset classes when the Federal Reserve starts to hike interest rates, but actually some of them stand to benefit.

This is according to Simon Quijano-Evans, head of emerging markets research at Commerzbank, who recently published his team’s outlook for emerging markets for the second quarter.

The outlook is tough for emerging markets currencies, but “this time around they are in good company, led by the euro, which has underperformed most of emerging market currencies versus the US dollar,” he said.

Emerging markets currencies and the dollar

Emerging markets currencies have weakened vs the dollar. Source: Commerzbank

Central banks in emerging markets will face a few major challenges in the second quarter. Reconciling rate cuts with pressure from the Federal Reserve’s raising rates will be a major challenge, as will be “second-guessing the direction of oil prices” and dealing with risks such as possible ratings downgrades for Brazil and South Africa.

Quijano-Evans acknowledges that “it is difficult to find a particular investment story” as the second quarter starts, but it is clear that many central banks in emerging markets will remain under pressure to cut rates in the coming months.

In Central and Eastern Europe, the currencies he calls “euro-based” such as the Polish zloty (PLN), the Czech crown (CZK), the Hungarian forint (HUF) and the Romanian leu (RON) will still be driven by deflation in the eurozone, as these countries’ economies move in step with the single currency area.

The European Central Bank’s quantitative easing will therefore ensure that these central banks will maintain an easy monetary policy.

The “US-based” emerging markets currencies such as the Turkish lira (TRY), the South African rand (ZAR), the Indonesian rupee (IDR) and the Chinese renminbi , or yuan (CNY) are also likely to remain in easy monetary policy mode.

This is because these currencies, despite the Fed’s hawkish stance, are driven by the global disinflation trend, accentuated by the sharp fall in energy prices, which has a beneficent impact on the respective economies.

However, emerging markets “have had plenty of time to prepare for a US rate hike, and a stronger US dollar should be beneficial for those countries in emerging markets that need to see a boost to domestic growth,” he noted.

Mexico is the best placed to benefit from a stronger US dollar, thanks to its close ties with the US economy and the relative openness of its economy compared to peers in Latin America.

Brazil, although struggling with a sluggish economy and its increased dependence on China, would also benefit from a stronger dollar – but the political risks are big, and the country’s assets could suffer a crisis of its own making.

Central and Eastern European countries are set to indirectly benefit from the stronger dollar because exports from the eurozone, and especially from Germany, will get a boost. Many subcomponents for Germany’s exports are produced in Hungary, the Czech Republic, or Romania.

In Asia, exporters in the Association of South-Eastern Asian Nations (ASEAN), and especially the “very open” Malaysia and Thailand, will benefit the most, Quijano-Evans predicted.

Looking at how he set up his trades for the second quarter, he cut Brazil to underweight from market weight because of “all the impending risks on the political and ratings front.”

He left Turkish local currency bonds on overweight because a lot of reaction to the Fed’s hiking has already taken place in foreign exchange and rates, plus there is “some possible ‘calming’ on the policy front.”

Russia is on overweight because its real interest rate has the potential to pick up versus that of its peers.

Finally, despite feeling comfortable with exposure to Central and Eastern Europe, Quijano-Evans recommended “a more cautious positioning” and cut Hungary to market weight while raising Poland to overweight in his outlook for emerging markets currencies for the second quarter.

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