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BNP PARIBAS MARKETS CALL: Emerging Markets – Bear Market Opportunities (04 JUL 2018)

Core Content Summary

BNP Paribas Markets Call provides a weekly cross-asset market view, focusing on emerging markets (EM) and their current bear market opportunities. The analysis highlights the impact of trade wars, currency depreciation, and the tightening of financial conditions on EM economies, as well as the potential for recovery and investment opportunities.

Main Points

• Trade Wars and Currency Wars: Trade wars are spreading to currency wars, with the RMB weakening despite official Chinese statements. The RMB has depreciated by 6.5% against the USD since April 2018, giving Chinese exports a price advantage over US tariffs, which are expected to be 10% on $50bn imports and potentially 200% on other Chinese goods.

• USD Tightening and EM Currencies: A stronger USD and higher USD Libor rates have tightened USD liquidity, affecting EM financial conditions. However, commodity-based EM currencies have depreciated by close to 10%, supporting their trade channels with China.

• US Economic Growth: US economic growth is outperforming the rest of the world, supporting the USD in the short term. US real rates remain below 80bp, which should continue to support EM and other risky assets.

• Flattening US 2s10s Yield Curve: The flattening bias on the US 2s10s yield curve is expected to continue due to market adjustments to the Fed dots indicating at least two more rate hikes. Long-end yields are likely to be weighed down by the potential drop in US fiscal impulse by 2020.

• Inflation and Investment Strategies: Higher oil prices are expected to push headline inflation higher, and investors may consider going long on inflation breakevens or swaps. EM earnings expectations have fallen, but forward P/E's are lower due to equity price declines, making EM equities attractive at current levels.

• EM Carry Trade Unwind: The unwind of the EM carry trade has led to a correlated sell-off in EM bonds. Going forward, EM bond performance is expected to diverge based on fundamentals, increasing dispersion.

• Trade of the Week: Investors who agree with the view may consider receiving rates in Brazil, where the official overnight rate is 6.50% and the central bank is not expected to hike this year.

Key Information

Currency Performance

• RMB Depreciation: The RMB has weakened significantly against the USD, but this depreciation has supported Chinese exports.
• EM FX Performance: EM currencies have underperformed, but only a few are significantly undervalued based on CLEERTM analysis. TRY, PLN, CZK, HUF, THB, and COP are the most likely to recover.

Market Outlook

• EM Financial Conditions: EM financial conditions have tightened due to wider credit spreads, rising volatility, and weaker FX. However, the long-term outlook suggests that USD may weaken as EM economic strength improves.

Investment Recommendations

• Inflation Instruments: Investors may consider going long on inflation breakevens or swaps due to rising inflation expectations.
• EM Equities: Despite weak performance, EM equities are attractive due to rising profitability and equity risk premiums.

Charts and Data

• Chart 1: Recent improvement in USD funding costs may provide respite for EM FX after a poor start in 2018.
• Chart 2: EM financial conditions have tightened, driven by higher CDS spreads and currency depreciation.
• Chart 3: EM equities underperformed due to the combined headwind of a stronger USD and weaker economic data.
• Table 1: Summary of medium-term fair-values for EM currencies shows most are slightly undervalued.

Economic Indicators

• Leading Indicators: There is a recovery in major EM areas, with the OECD, Brazil, and Asia showing improvement.
• Current Account Balance: Countries with current account deficits and commodity exposure are more vulnerable to global economic slowdowns.

Conclusion

The report suggests that while EM faces challenges due to a stronger USD and weaker economic data, there are still opportunities for investment, particularly in EM equities and inflation-linked instruments. The analysis highlights the importance of fundamentals and the potential for recovery in certain EM currencies. Investors are advised to consider the bear market opportunities and monitor the impact of USD movements on EM performance.