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Looking to Brazil and commodities as EM bellwethers
admin | August 24, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The relatively large movements in emerging markets currencies this year are attracting significant attention. Of the universe of 31 expanded major currencies tracked by Bloomberg, nine of the weakest 10 are EM led by the 38.6% drop in the Argentine Peso and the 37.4% slump in the Turkish Lira. While it is too early to take these movements as signs of broader EM risk, developments in Brazil and the direction of commodity prices are good bellwethers.
Exhibit 1: Year-to-date performance of major currencies against the US dollar
Source: Bloomberg
This year has seen significant strength in the US dollar, with only three of the 31 currencies tracked posting gains against the dollar (Exhibit 1). Ironically, the Mexican Peso has performed well on hopes for an early adoption of a US-Mexico trade agreement to replace NAFTA. In an environment of diverging monetary policies, the steady policy normalization by the Fed has contributed to a steady dollar appreciation that appears to have further momentum in the months ahead.
What is not clear, however, is whether the general dollar appreciation and Fed tightening is creating conditions consistent with an EM crisis, a development that could interfere with US and global growth to a degree sufficient to limit further Fed tightening. To get a fairer assessment of that likelihood, it seems better to assess currency movements over a longer period. Indeed, there has been significant variation in dollar movements since the 2016 Presidential election, with initial, sharp dollar gains followed by steady declines in 2017. EM currency performance against the dollar since October 2016 offers a better benchmark.
Looked at over this longer period, the shifts in EM currencies still appear to be more country specific than generic. To be sure, the Turkish and Argentinian currencies remain, by far, the weakest, having fallen by almost 50% since the end of October 2016 (Exhibit 2). But there are also EM currencies such as the Czech Koruna and the Polish zloty at the top of the performance rankings with Asian currencies including the Taiwan New Dollar, Korean won and the Malaysian Ringgit among the top 10. That suggests EM currencies more broadly defined are not showing significant stress.
Exhibit 2: Year-to-date performance of smaller currencies against the US dollar
Source: Bloomberg
For now it appears that stress in EM currencies, a good reflection of market concern about their economies, is not sufficient to become a meaningful factor in Fed policy deliberations. However, there are at least two developments that bear close scrutiny during the months ahead.
In a recent interview with Bloomberg, Harvard professor Carmen Reinhart placed her focus squarely on Brazil, suggesting that additional turmoil in the currency and financial markets could be a bell-weather for broader risk in the emerging market world. With a Presidential election in October, the uncertainty in Brazil is likely to ramp up during the weeks ahead.
Then there are commodity prices. Two months ago, elevated level of commodity prices added some comfort with EM, with the broad-based CRB Commodity Spot Price Index –including foodstuff, energy, precious metal and industrial products—at a four-and-a half-year high (Exhibit 3). However, at least partly driven by the significant rebound in the US dollar, the CRB ALL-Commodity Spot Price Index has fallen by more than 8% from the mid-June highs, a setback that could reverberate through the economic fundamentals for many EM countries. For now, that setback in prices appears manageable, but clearly would bring broader risks if it persists during the months ahead. Rather than focusing on the attention-grabbing headlines on movements in currencies like the Turkish Lira and Argentine Peso, investors and Fed watchers would likely be better served to monitor developments in commodity prices and Brazil.
Exhibit 3: Commodity prices have dropped sharply since June
Source: Bloomberg, CRB
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