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EM FX value trade reliant on easing recession concerns

Investors wait on a positively sloped US yield curve while Trump creates more confusion with his latest tweet storm.

It was another challenging week in markets as a combination of trade headlines and Fed speak ultimately left equities down in the order of 1-2%. Most of the losses incurred late on Friday following a barrage of angry tweets from President Trump.

In his Jackson Hole speech, Chairman Powell struck the right notes as he laid the groundwork for a September easing, given the escalation in trade concerns since the Fed’s last meeting.

However, his good work was soon overshadowed by President Trump’s tweets upping tariffs by another 5%, demanding US companies cut ties with China and referring to Chairman Powell as an ‘enemy’.

At the weekend’s G7 meeting in Biarritz, President Trump then struck a more positive tone as he proclaimed that China wanted a deal “very badly” and that the Chinese had contacted his trade team to “get back to the table” in what he thought was a “very positive step”.

Needless to say, the market was left confused.

In emerging markets (EM), local markets remained under pressure via the FX channel given the concerns around the global growth outlook.
Credit markets held up better with high yield outperforming investment grade.

A (marginal) improvement in sentiment in Argentina towards the end of the week allowed for a rebound in other high yield credits that had been sold as investors reduced their high-yield risk, rather than because of fundamental concerns.

Market review

  • Argentine assets sold off again this week but at a much slower pace. The USD-denominated bond curve sold off around three points but the major action was in the local law curve, in particular, the Bonar curve, where bonds remain very weak, trading down nine points on fears that they may be converted from USD to ARS denomination.
  • The next major Argentine catalyst on the horizon is the USD1.6 billion Letes maturity on Friday, where the degree of private-sector rollover will be crucial to sentiment. As it stands, FX reserves are down USD8.8bn since the PASO and the upcoming maturity schedule in USD-denominated Letes is upwards of USD10bn until the end of November alone.
  • The short-term financing needs of Argentina makes the release of the next IMF disbursement all the more critical. Fernandez and his economic advisors met with the IMF this week with harsh rhetoric from Fernandez surprising investors after his more moderate tone last week. The IMF, for its part, called the meeting “a productive exchange of opinions”.
  • Ultimately, if Fernandez is elected, he needs the IMF on board to guard against a hard default and the huge cost to the economy that would entail. It is important, therefore, to view Fernandez’s comments in light of the fact he still has an election to win.
  • Lebanon’s sovereign debt rating was downgraded by Fitch to CCC from B- while S&P affirmed Lebanon at B- and maintained a negative outlook. The key concerns remain weaker deposit growth in the banking system and a large and persistent fiscal deficit, while upside catalysts largely remain around donor funding, which can only be accessed on the premise of a positive reform agenda. Bond prices have migrated to the high 60s in cash price in the long end of the curve.
  • In Egypt, the backdrop of sound foreign portfolio flows, an appreciating currency and a moderating inflation profile allowed the central bank to cut interest rates by 150bps, also catalysing a rally in the longer end of the local bond curve.

Market outlook

As we limp into the end of what has proven to be another August filled with poor liquidity and choppy market conditions, we see equities down between 3-7%, oil markets down 5-7% and spreads up to 100bps wider in high yield.

On the other hand, 10-year US Treasuries are over 50bps lower in yield and Bunds are 25bps lower with 30-year German rates firmly in negative territory. This dynamic of lower core bond yields remains the key support for equities as the dividend yield argument is increasingly powerful with core rates migrating towards zero and beyond.

It is hard to argue that earnings trends are likely to be particularly supportive though, given the continued uncertainty around trade and the knock-on implications that has for corporate capex levels.

On the trade war, the confusing messaging belies Trump’s difficult predicament where he is trying to pressure the Chinese into making a deal but he remains constrained given tariffs are now impacting the US consumer and the broader economy through the confidence channel.

The US yield curve (2s10s) ended the week on the point of inversion and has subsequently inverted at the start of this week, further evidencing the dangerous balancing act Trump is trying to perform.
The current shape of the curve suggests the Fed should be moving much more aggressively to avert a self-fulfilling recession, but the US data itself does not imply the need for such aggressive easing.

Herein lies the major dilemma for the Fed.

For EM, FX and high yield remain the trouble spots while the rally in core rates is keeping local rates and investment grade markets well supported.

The value trade remains in FX and higher yielding hard currency bonds, but for this trade to perform there needs to be less concern over recession.

In our view, this will most likely come with a positively sloped US yield curve.

The huge move in Argentine assets has sent a VAR shock through the market and exacerbated this divergence. We would expect some of this to mean revert over the coming weeks if Argentine assets can stabilise around current levels.