BAML Warns Of Trouble In Emerging Markets Currencies (Value Walk)

Bank of America Merrill Lynch analysts take a cautious view on currencies in emerging markets, and is particularly bearish on Asia FX after signs of China moving to a flexible exchange rate regime.

Alberto Ades and colleagues at BAML in their August 13, 2015 research note titled: “ Trouble in the East” anticipate further downward pressures on most Latin American currencies as commodity prices fall.

Further flattening in emerging markets interest rate curves

Ades and team note the U.S. July employment report was another stepping stone toward a September liftoff. The analysts point out that Treasury and Bund curves have flattened, but have not yet reached the levels observed before the selloff in 2Q. The BAML analysts note most EM curves have flattened too. BAML’s Scope90, a three-month-ahead local rates forecasting tool, signals further room for flattening, with the most upside in curves that have lagged the recent flattening such as South Africa, Turkey, Malaysia and Chile. The analysts anticipate tightening from these central banks during the next six months, except in Malaysia, to reinforce such flattening:

Flattening EM curves EMFX

Ades et al. reckon EM currencies have been weakening since 2011 and Compass FX, BAML’s long-term valuation model, points to the average EMFX (excluding CNY) slightly undervalued. The analysts note a scenario in which CNY weakens around 5-10% over the next 12 months appears justified by fundamentals, and more likely at the margin.

EMFX: CNY devaluation to put pressure on commodity prices

Highlighting how Asian business cycles are highly correlated with China, analysts point out that Asian growth cycles are increasingly synchronized to China. They argue Hong Kong, Indonesia, Malaysia, Korea and Australia are the top five countries most sensitive to China’s growth cycle. As can be deduced from the following graph, a 1% movement in USD/CNY would be accompanied by a 43-37bp move in MYR, PHP, TWD and KRW:

Correlation with China EMFX

Ades and colleagues argue that the recent CNY devaluation has added near-term risk for commodities, with the CNY devaluation impacting terms of trade for commodity exporters. They point out that BAML’s Asia economics team anticipates the CNY to devalue by around a further 7% and reach 6.9/USD by the end of 2016, while BAML’s Global commodity team forecasts that a 10% move in the CNY would translate into a 5-6% decline in USD commodity prices.

Elaborating on how EEMEA credits are under pressures, Ades and team point out that EEMEA credit and FX are under pressure, as the recent CNY devaluation has added near-term risk for commodities. The analysts’ estimated EEMEA sovereign credit spread sensitivities to oil, UST, SPX, and metal prices highlight that spreads for Russia, Kazakhstan, Nigeria, Ghana and Kenya are most sensitive to an oil price drop of 10% with sovereign spreads widening by up to 30-50bp:

EEMEA sensitivities EMFX

The following table captures BAML’s Global FX forecasts:

Global FX forecasts EMFX

Focusing on LDM, the BAML analysts favor duration in oil importers as low commodity prices should keep inflation on check. However, the analysts are cautious on EXD, as they believe risks in emerging markets are increasing with the sudden China devaluation and significant drop in commodity prices on top of concern over the upcoming Fed hike liftoff.

The post BAML Warns Of Trouble In Emerging Markets Currencies appeared first on ValueWalk.

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