Did Friday mark the end of 2019’s EM rally?

March 27, 2019

Friday saw Emerging Market currencies broadly sell-off after Eurozone and US data showed a significant slowdown in manufacturing sectors. The rout came after EM currencies began to claw back ground against the US dollar due to the dovish turn by the Fed and easing US-China relations.

Investors are now asking if Friday marked the end of the EM rally, or was it just a blip in the road to recovery? Developments in Turkey prior to Sunday’s local elections, LATAM’s potential rebound and Moody’s credit rating on Friday will set the tone for this week’s response.

USDZAR range bound ahead of Moody’s decision

The South African rand continues to trade in a tight range ahead of Moody’s credit rating decision on Friday. After Eskom increased its loss projection from R15bn to R20.2bn for 2018, problems with state owned enterprises in South Africa and the fragility of the South African economy after 2018’s recession were highlighted.

The government’s response of a R69bn bridging loan over the course of 3 years such that Eskom could meet its liabilities and restructuring costs, while also breaking the company up into 3 entities for transparency reasons, was initially deemed fiscally responsible by the market. But recent stage 4 load shedding by Eskom – which produced rolling blackouts in South Africa for the first time since 2008 – and risks of slowing growth has clouded Friday’s decision in uncertainty.

Should Moody’s follow Fitch and S&P’s guidance by downgrading South Africa to junk status, South African government debt would drop out of the Citi World Government Bond Index and would prompt investors to pull funds from the county’s fixed income instruments.

The likely consequence should Moody’s choose to downgrade their outlook is a fall in the rand, pushing USDZAR back towards the R15.00 level.

Investors’ fears of a deterioration in South African creditworthiness is evident in the recent spike in the cost of insuring default in South African debt over the 5-year horizon, which currently sits above that of Brazil whose credit rating is deemed junk by all 3 agencies. However, the aggressive pricing in fixed income markets could reduce the reaction in the rand if Moody’s chooses to downgrade rates.

However, the possibility of Moody’s downgrading South Africa’s status remains a tail risk on Friday; one that is likely to rear its head again later this year should growth continue to deteriorate and elections increase fiscal concerns.

The more viable option for now, as the effects of the Eskom crisis begin to take their toll, is a downgrade in Moody’s outlook. By changing their outlook from neutral to negative, Moody’s will acknowledge the current problems in South Africa while also taking into account the prudent response by Finance Minister Mboweni.

The move would also signal that a ratings downgrade in the next 12 months remains likely should the credit environment deteriorate, without pulling the ability for South Africa to finance itself at such a pivotal time for the economy.

 

Chart 1: The cost of insuring South African default over the 5-year horizon is greater than Brazil whose debt is currently rated junk status by all major ratings agencies.

Turkish lira remains tentative after investors flee

TRY remains affected by several domestic factors. By a range of indicators, both foreign investors and domestic users of foreign currency are extremely pessimistic about the currency. This sentiment has dragged on any rebound within the FX space from last week’s sell-off. Holdings of foreign currency within Turkey rose to an all-time high in March, while measures of investor risk aversion such as sovereign default protection remain extremely elevated.

The central bank is taking aggressive measures to tighten liquidity conditions without further hiking rates in order to support the currency, and responded to last week’s sharp 5% sell-off by suspending 1 week repo operations, with the apparent intent of making short term lira funding even more expensive.

FX reserves have also fallen by $6bn in recent weeks, suggesting direct intervention in currency markets.

Despite the fact that the lira has managed to pare back most of Friday’s selloff, the currency continues to look vulnerable. Politics remains a source of risk, with President Erdogan making characteristically bellicose threats about FX speculators, and authorities launching an inquiry into JPMorgan Chase for allegedly instigating last week’s rout with “misleading and manipulative” commentary.

If the probe leads to a wider clampdown on foreign financial sector involvement in the economy, investor appetite on Turkish assets, which is already at rock bottom judging by sovereign fixed income yields and default protection, is likely to sour further. However, the investigation could well amount to nothing, with the Financial Times reporting that a senior Turkish lawyer expressed doubts any charges would be made.

Politics remains another potential source of risk…

President Erdogan recently described the Trump administration’s acknowledgement of Israel’s occupation of the Golan Heights as a potential trigger for a new regional crisis, highlighting the risk of another diplomatic crisis between the US and Turkey.

Local body elections are set for this Sunday and may be a trigger for further domestic political tension.

Polls in the city of Ankara have showed the opposition candidate in the lead for Mayorship. The city has been governed by the ruling AKP party and its predecessors for the past 25 years, and an opposition victory here could be a bellwether for rising domestic unhappiness with the AKP’s recent government, possibly riddling the lira with greater downside risks.

 

Chart 2: 7-day repo rate cancelled forcing banks to flood the overnight funding window.

 

Rebound in LATAM

Friday’s EM rout saw BRL and MXN post some hefty losses, while the Argentine peso threatened an all-time low. Idiosyncratic risks in the shape of pension reforms in Brazil, falling growth in Mexico and inflation concerns in Argentina should dictate LATAMs prospects of recovery going forward .

BANXICO are set to remain on hold on Thursday’s meeting as inflation moderates back into the target range following a series of rate hikes in 2018. However, the Mexican central bank have recently change the balance of risks in the February meeting to match their current neutral stance.

It is our view that while the Fed remains on hold, risks to monetary policy remain to the downside due to a widening output gap and rising unemployment figures. However, Thursday’s meeting will prove too soon to tell for investors as BANXICO are highly likely to keep the status quo to consolidate the current dis-inflationary path.

 

Meanwhile, the Argentine peso continues to weaken as inflationary risks persist. These come despite Argentina’s monetary base shrinking following a series of extreme monetary policy measures after last year’s currency crisis. The peso continues to set the tone for LATAM sentiment and should ARS depreciate further, thus setting all-time lows, the green light may be shown for a further sell-off in LATAM currencies.

Investors will be keeping a close eye on Argentina’s January GDP release on Thursday to dictate terms for the peso.

For the real, however, questions over any recovery from Friday’s sell off are pinned on the progress of pension reforms to rebalance public finances. But, any such progress relies on tensions easing between President Bolsonaro and Rodrigo Maia, the head of the lower house of Congress.

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