Emerging Market FX Looks Vulnerable As Commodity Plunge, Virus Worries, Idiosyncratic Risks Are Noxious Mix

I’m not going to spend a ton of time on this Friday, but it’s worth mentioning that the combination of plunging commodities, rate cuts and a negative macro catalyst with the potential to seriously undermine global growth is weighing heavily on emerging market FX.

As ever, it’s difficult to disentangle idiosyncratic, country-specific narratives in EM from the broader macro story, but a big picture take is simply that the coronavirus epidemic threatens to short-circuit the nascent global growth rebound and with it, Q4’s reflation trade. There is nothing positive about that for developing economies.

At the same time, many EMs are cutting rates. Russia joined in on Friday, delivering a sixth consecutive cut and signaling more to come amid persistently subdued inflation. Nabiullina described the probability of another cut at the next meeting as “relatively high”, and the central bank called the virus epidemic a source of “additional uncertainty”.

Policymakers across Southeast Asia leaned dovish this week and last month, Turkey delivered yet another cut, bringing the total under Murat Uysal to a cartoonish 1,275bp. Real rates in Turkey are now squarely negative.

Oil and copper have obviously been under siege, a clear negative for commodity-linked FX, while a resilient US economy points to dollar strength, even if the Fed continues to lean dovish.

Given all of the above, it’s no surprise that emerging market currencies are again beset, after a brief bit of respite to start February. JPMorgan’s gauge of EM FX is near a record low and MSCI’s widely-cited index fell.

As alluded to above, idiosyncratic stories are everywhere and always unfolding in EM. For example, reports that the US may sanction Russia’s Rosneft over support for the Maduro regime in Venezuela prompted shares of the country’s largest oil producer to tumble Friday. 

Although the stock would trim losses to around 3%, at one juncture it was down the most since April 2018, when Russian equities plunged in response to sanctions against dozens of oligarchs and companies.

The Rosneft story (originally reported by Bloomberg) conjured memories of Treasury’s decision to blacklist Rusal and En+, which set in motion the Oleg Deripaska drama that upended the global metals market.

Russia is, of course, in discussions with OPEC around a possible emergency cut to shore up crude prices. The Trump administration is reportedly concerned that tightening the screws on Rosneft would risk driving up oil, which actually wouldn’t be the worst thing in the world right now, given acute jitters about global demand destruction tied to the virus outbreak. But generally speaking, sanctions-driven commodity spikes aren’t the “good” kind of reflationary impulse.

In any event, the above is indicative of the kind of overlapping narratives that one is often confronted with when attempting to sort out the prospects for EM.

Meanwhile, the lira dove past 6.00 for the first time since May, as efforts by local banks to defend the level finally failed.

According to Bloomberg, state lenders blew through at least $4 billion this week trying to prop up the currency.

None of that is to suggest that things are on the brink of falling apart for emerging markets as they did during 2018’s mini-meltdown. But the last several weeks serve as a reminder of how quickly things can go awry in an environment where the outlook for global growth suddenly deteriorates.

“Despite reduced tail risks on trade wars and economic data appearing to stabilize, or in some cases improve… the good news is priced in and unless there is a sustained improvement in risk factors and economic data, EM currencies should be weaker going forward”, SocGen’s Jason Daw and Phoenix Kalen wrote, in a recent note, adding that “EM FX prospects will be hampered by a global and Chinese growth slowdown that could be headlined by a US recession, as well as by positioning constraints, and very low carry compensation”.

Hopefully, Jerome Powell learned an important lesson in 2018 about not overestimating developing economies’ resilience. Of course, the Fed was hiking during the 2018 EM mini-crisis, a far cry from where we are now when it comes to US monetary policy.

And yet, the US is still the “cleanest dirty shirt” economically (to employ a tired, old market adage), which means there’s scope for dollar strength which could eventually cause problems for EMs – especially if they’re forced to keep cutting rates.