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EM FX: 4 green shoots

Fundamental signs to monitor for currency upside potential towards year-end and into 2020.

Positioning into rallying markets ahead of the herd is something active managers strive for to maximise their chances of alpha generation.

While the world of emerging market FX (EM FX) remains a challenging exposure for many investors, we are seeing early signs of green shoots that suggest the asset class could remain supported through to the end of 2019 and into early 2020.

While the shoots may be small, these are the four factors we’ll be watching closely for signs of development and upside potential.

1. FLOWS

We’re seeing early signs of inflows into ‘FX-sensitive’ emerging market funds – both equity and local currency bonds.

According to EPFR fund flow data, the final week of October 2019 marked the first week of inflows into EM equities since April. EM local currency funds also saw their largest inflows since April. This trend has been confirmed in the subsequent two weeks.

Most of the inflows into EM this year have been into hard currency funds, so a cyclical rotation into EM equities and EM local currency funds could be positive for EM FX, if the flows continue.

It is worth noting that EM FX has delivered +3% returns including carry this year, despite no inflows into equities/local funds, weak global growth data and broad US dollar strength. This suggests that if there is a notable turn in flows, this could provide a boost for the asset class.

2. TENTATIVE SIGNS OF GROWTH STABILISATION

We believe that there’s no imminent V-shaped recovery in the works, but there are signs of stabilisation and small improvements in global growth. These represent an important sentiment shift compared to the consensus of growth decline that we witnessed over the summer.

The percentage of countries where growth forecasts are being upgraded has increased (from a low base), while the percentage where growth forecasts are being downgraded significantly has gone to zero.

This suggests that the worst of the downward growth revisions are likely behind us.

 

Growth upgrades & downgrades

4 green shoots - chart 1

Chart source: JP Morgan, as at November 2019

 

Looking at EM specifically, equity earnings sentiment has improved sharply from the August lows. Earnings sentiment can be used as a leading indicator of EM economic activity.

IMF growth forecasts also support this green shoot, showing that the differential between EM and developed-market growth is set to widen significantly in 2020.

 

IMF 2019 and 2020 growth forecasts: EM pulls ahead

4 green shoots - chart 2

Source: IMF

 

3. REAL RATES REMAIN ANCHORED AT LOW LEVELS

US 10-year real rates are only 16 basis points – near 5-year lows – and we think it’s unlikely that real rates will rise meaningfully in the next six months or so.

 

US 10-year real rates

4 green shoots - chart 3

Source: Macrobond, as at 7 November 2019

 

In a ‘risk-on’, reflation environment, break-even inflation levels would have to rise before/along with an upward repricing in nominal rates, driven by expectations of Federal Reserve hikes. Therefore, real rates still shouldn’t rise by much. This has been the case since the October lows in US 10-year yields. Nominals have moved higher by 35 basis points but real rates have only increased by 15 basis points.

4. POSITIONING REMAINS LIGHT, VALUATIONS ATTRACTIVE

EM FX positioning remains close to the benchmark, and well below the historical average.

 

EMFX – room to return

4 green shoots - chart 4

Source: Morgan Stanley, as at November 2019

 

We believe there’s plenty of room for EMFX to catch up to its April highs.

 

JPMorgan EM Currency Index

4 green shoots - chart 5

Source: Macrobond