Focus on Fundamentals after the Fed

Kamakshya Trivedi -

A dovish FOMC may provide a reprieve, but EM FX weakness is not just about the Fed.

After the body blows of August, EM FX has experienced some relief over the past week on the back of stability in the CNY and the prospect of a dovish FOMC. In the near term, we expect Chinese policymakers to resist any large currency moves through a combination of FX intervention and recent measures that involve a modest administrative tightening of the capital account. And, given our view that the Fed is unlikely to hike rates into an environment of tightening financial conditions, both these sources of relief may well have a bit longer to run. However, any such reprieve is likely to prove short-lived, as was the case earlier in the year: in the medium term, risks are tilted in the direction of significant further weakness in the CNY as China’s debt build-up unwinds, and US rates will need to move higher as slack in the economy is eliminated gradually. Furthermore, as we have argued elsewhere, the recent bout of EM FX weakness has been driven by EM-specific influences (rather than broad USD direction). This includes the need to correct imbalances and absorb the ongoing commodity price shocks, and we continue to see room for EM FX weakness to extend in order to address these.

With oil prices lower for even longer, the headwind for commodity currencies (such as the COP and CLP) will persist. Our commodity team now expect the oversupply situation in the oil market to persist into 2016 on further OPEC production growth, resilient non-OPEC supply and slowing demand growth. Consequently, they now see WTI oil prices in 2016 at $45/bbl versus $57/bbl previously and forwards at around $50/bbl, and over the next 6 months they expect WTI oil to reach around $40/bbl, with risks skewed to the downside if the oil surplus exhausts logistical and storage capacity. Likewise, the team see nearly 15% further downside to copper prices, with a forecast of $4,500/t by end-2016. $/COP and $/CLP are the two crosses that are most vulnerable to these oil and copper price shifts, but whereas the current account in Chile has moved from a large deficit to a small surplus, in Colombia, the current account deficit is still large and further currency weakness is likely to be necessary to correct this (Exhibit 2). Accordingly, we are adjusting our forecasts for $/COP to 3,000, 3,150 and 3,300 in 3, 6 and 12 months. Our 12-month forecast of 3,300 (versus 2,800 previously) implies roughly a 10% move from current spot levels and is meaningfully above 12-month forwards of about 3,150. For $/CLP we adjust our forecasts to 680, 700 and 720 in 3, 6 and 12 months’ time. The path of the depreciation is more muted for $/CLP relative to $/COP, but with the balance of risks more skewed towards further depreciation if China concerns and copper downside materialise faster than our base case.

Exhibit 1: CZK, MXN and INR the only bright spots in a depressed EM activity picture
Manufacturing PMI data

Image1

Source: Haver Analytics, Goldman Sachs Global Investment Research

Weak EM activity is helping to correct current account deficits, but pain may spread to other assets. Stepping back from the now familiar monthly wait to see whether the Fed will hike or not, it is helpful to take stock of EM cyclical fundamentals. Exhibit 1 plots the manufacturing PMI data across a sample of 14 EM economies for August. Not only are most EM economies clocking PMI levels below the average of the past decade, but they are also operating below the weak levels recorded on average over the past year. A broader set of data also reflect this demand destruction taking place across parts of the EM complex: the recession in Russia has now lasted four quarters and counting; the contraction in Brazil is deepening, with sharp falls in industrial production and investment; growth in South Africa has stalled (GDP fell -1.3%qoq annualised in the second quarter driven by most major sectors); pro-cyclical rate hikes look likely in Chile and Colombia; and, last but by no means least, the August activity data in China managed to disappoint the already low expectations of the market. EM credits and equities are reflecting this weaker cyclical picture to an increasing degree, with Brazil at the ragged edge of this process. But for EM FX the implications are more ambiguous. On the one hand, the silver lining from an EM FX standpoint is that demand weakness is causing current accounts to adjust faster by inducing a contraction in imports, and to that extent it reduces the need for further currency weakness. On the other hand, if the cyclical weakness causes monetary policy to turn more accommodative than it would otherwise be, it erodes the carry support for EM currencies. The improvement in South Africa’s current account deficit alongside the economic contraction in Q2 is an example of this dynamic (Exhibit 2). But if a prolonged soft patch in growth causes the SARB to turn more accommodative, this would not be ZAR-supportive.

Exhibit 2: EM high-yielder current accounts finally adjusting on the back of currency weakness and slowing activity

Image2.jpg

Source: Haver Analytics, Goldman Sachs Global Investment Research

INR, MXN and CZK are the relative bright spots in an otherwise depressed EM cyclical picture. CZK, MXN and INR, with the outward spikes in Exhibit 1, are the only bright spots where the real business cycle is still operating at a solid pace. In Mexico, a gradually improving labour market, strong fixed investment and an expansion in non-oil exports all point to a relatively solid non-oil economy, but it will be hard for the MXN to reflect this without some stability in oil prices. Activity data have also been a bit better in India from disappointing levels, as Tushar Poddar has discussed: industrial production was better than expected and our current activity indicator improved in Q2 to 5.1%qoq sa annualised from the surprisingly weak 4.2% in Q1; and while legislation on GST reform has stalled, there has been important progress on banking reform. Lastly, despite the tick down in the latest PMI reading in Poland, the momentum of real GDP growth has been on an improving trajectory in Czech Republic and Poland, with output gaps closing on the coattails of the Euro area recovery. While other high-yielding currencies may bounce more in any short-term relief rally, INR, MXN, CZK (and PLN) are better medium-term stories given that they are also less directly affected by China concerns relative to other Asian and commodity currencies.

5. The slump in Korean exports bolsters the case for a weaker Won (KRW). As some of the external current account imbalances among high-yielders adjust with weaker activity, focus is likely to shift gradually to the need for currencies to weaken to facilitate internal balance. A move higher in $/KRW is among our highest conviction views (our 12-month forecast is 1,300), and the slump in export data for August serves to illustrate the severity of the challenge here (Exhibit 3). Headline exports declined nearly 15%yoy, the sharpest decline since 2009 and significantly below consensus estimates. And, no matter how the data are cut, they were soft: exports were weak sequentially on the month, they were weak excluding volatile items (such as ships) and oil and petrochemical products, and they declined to nearly all major destinations. Taiwanese exports were similarly weak in August. There is little question that demand weakness in China is playing a role here (and the sequential fall in Chinese imports is the flipside of this) and, as we discussed in our last EM FX Views, the open trading economies of Asean were most likely to feel the pressure; accordingly, our economists have cut their GDP growth forecasts for Korea again to 2.4% from 2.8% for 2015, and to 3.3% from 3.8% in 2016. This ongoing weakening in cyclical activity dynamics in Korea continues to argue for easier financial conditions, and we think that KRW weakness will be an important part of any easing package.

Exhibit 3: KRW strength a continued headwind for exports

Image3.jpg

Source: Haver Analytics, Goldman Sachs Global Investment Research

6. In the context of cyclical weakness, institutional fragilities can cause FX overshoots. Roughly a month ago, we argued that the BRL would need to weaken further to address the large accumulated macro imbalances in Brazil and the ongoing terms-of-trade shock from lower commodity prices (Brazil at crossroads – both roads involve BRL weakness, EM FX Views, August 11, 2015). Since then $/BRL has moved towards our 12-month forecast of 4.00, significantly more quickly than we anticipated. The speed of the move partially reflects the concern around a tail event where a deepening recession makes it hard to implement any sort of medium-term fiscal consolidation plan (the fiscal deficit is running at a worrying level of nearly 9% of GDP), a cycle of ratings downgrades ensues, and Brazil finds itself in a crisis of governability (potentially involving the departure of key policymakers). While this is only a tail scenario (rather than a central case), it is clearly clouding the outlook for all Brazilian assets even further. Similar worries are weighing on the TRY – a currency that should be benefiting from lower commodity prices and the fact that it is relatively less affected by China growth concerns. As Ahmet Akarlihas discussed, domestic political instability and the associated spillovers on the economic policy framework can result in an overshoot of the TRY exchange rate relative to its macro fundamental value. With limited reserves to control such an overshoot, we forecast $/TRY at 3.15 in 3 months and 3.70 in 12 months, before a gradual reversal at the end of 2016 and beyond. The November 1 (early) general elections will likely be a crucial turning point: the exact composition, leadership and economic policy choices of the new government will largely determine Turkey’s economic outlook in the coming few years, in particular its sovereign credit rating.


Kamakshya Trivedi – Chief Emerging Markets Macro Strategist – Goldman Sachs