Don’t disregard this emerging markets rally
Emerging markets are going through a liquidity rally, boosted by money-printing by the Fed and the ECB. But it may turn into a growth rally
I have now turned much more bullish on global emerging markets but I recognise that for now, the expected life expectancy of the emerging markets rally before us is going to be relatively short. My radar is set for six to eight weeks at best. It does not mean that EM investors should disregard this rally, as I still believe it may be a powerful one. I particularly like high-beta EM currencies, especially the Russian ruble (RUB), the Polish zloty (PLN) and the Mexican peso (MXN), but I am also bullish on EM fixed income, especially where the local curves are still pretty steep.
A quick look back at 2012
But before we can look ahead, I think it is useful to take a step back at how 2012 played out for emerging markets, as there has been some interesting asset rotation to consider. The year started with a spectacular rally in risky assets, with EM currencies fully participating in that move. For instance, the Hungarian forint at the time bounced aggressively back from 320 against the EUR to about 286. Likewise, the South African rand (ZAR) which in late 2011 was on a weaker trajectory rallied all the way to 7.44 against the dollar from 8.42 in mid-December. This was essentially an ECBs LTRO-driven rally. In that first quarter, while EM currencies performed strongly, EM rates somewhat lagged behind. By mid-March, the early-year rally had lost some of its steam, and we had to wait a few weeks to move on to the next major phase.
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By early May, it was indeed time for some asset rotation. The global growth outlook was then deteriorating sharply and EM central banks started sending powerful signals about some policy easing in the pipeline. That was good enough to trigger a spectacular rally in EM rates, which until now had lagged behind. And this time, it was the currencies turn to underperform. Fast-forward to the summer and then the major breakthrough occurred when Mario Draghi, the ECBs president, made a powerful statement in early August. That triggered a strong rally in central European currencies, but other currencies were still reluctant to participate in the move. Meanwhile, the EM rates rally was clearly losing some momentum. Now, September was really the game-changing month with two major policy signals from the most important central banks. The ECB announced its bond-purchasing programme, followed by the Fed which engaged in another round of quantitative easing.
A liquidity rally for now
So here we are, with a rally which I would qualify as a liquidity rally. A liquidity rally is a rally fuelled by official policy responses, and by the strong improvement in global risk appetite, and the associated search for yields. In this new state of the game in operation since mid-September, we need to price out contagion risks, and that is why I am going to be bullish on EMEA overall. I am also going to chase the lagging or undervalued currencies, as I want to position for some powerful catching-up process. I am going to favour EM currencies, especially in the high-beta space, as I believe that the market backdrop is propitious to upgrading the call on EM risky assets, and as we know, EM currencies are higher-betaby a large marginthan EM rates. This liquidity rally which has a few more good weeks to go has, in my view, the potential to be as juicy as what we saw in the first quarter. Lets take a few examples. The RUB can easily go to 34 against the dual basket. The MXN, which admittedly is already hugely popular among EM investors, may well go to 12.25 on account of its fundamental strength. As for the PLN, I can see it converge fast towards its medium-term fair value, which I estimate at around 3.80 against the EUR.
Now thinking like a real-money investor with a medium-term horizon, I would like to make it clear that now is the perfect time to buy long-end EM bonds, in my view. We like the long end of the bond curve in Mexico, Turkey, or Russia. In Central Europe, our favourite pick is Poland. I like EM bonds given this prevailing search for yields, but as I flagged above, in the majority of cases most of the gain is likely to come from the FX exposure rather than the pure rates play. There is of course some room for further yield compression in emerging markets as the easing cycle has not come to an end yet. In fact, in a number of countries such as Poland, it has not even started for now. But right now, the momentum is going to be on the currency side.
Soon enough this liquidity-driven rally is going to come to an end. There are two scenarios that come to my mind then. Either risk aversion returns after a bad accident occurs in global markets. Also there is still a fairly long list of tail risks to watch for, including a sovereign rating downgrade in the eurozone, some headline risks on Europe, or even the further deterioration in the news flow in China. The alternative is a much more positive outcome. It could well be that this liquidity rally gets upgraded to what I call a growth rally, meaning a rally that is supported by a tangible improvement in the global growth outlook. If that happens, investors are going to chase the successful growth stories in emerging markets. By early 21013, the Brazilian economy will haveat lastturned around, the Asian slowdown will no longer be a source of risk for global markets, and in EMEA, Turkey and Russia will be the major recipient of significant capital inflows. If we can manage to upgrade this rally from liquidity to growth, 2013 promises to be a great year for EM.
- The author is Benoit Anne, who joined Societe Generale in June 2010 to run the global EM strategy team. Previously, he was the head of EMEA and Latam FX and Debt Strategy at Bank of America-Merrill Lynch. Prior to joining Merrill Lynch in 2005, Benoit Anne spent eight years in Washington DC, working at the Institute of International Finance and the International Monetary Fund as an economist.