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4 Jan 2016
Earn the ‘good’ carry; hedge the China (and CNY) risk – Goldman Sachs
FXStreet (Delhi) – Research Team at Goldman Sachs, suggests that FX carry opportunities in EMs that have adjusted imbalances (INR, RUB, MXN) but US steepening, oil downside and CNY devaluation are the main potholes to avoid.
Key Quotes
“Under our baseline global macro and market outlook, it is possible to envisage better performance for EM assets relative to the past few years. A modest pick-up in EM growth – even taking account of a deceleration in China, still broadly low inflation and a Fed that is only likely to move at a measured pace – should make for a macro backdrop where earning EM carry is less risky than in previous years, especially among the ‘good’ EM stories where imbalances have been corrected and valuations are supportive.”
“The INR remains top of that list, but the RUB also offers a good opportunity under our central forecast of limited further oil price downside. Among the lower yielders, the MXN should also offer stable carry in a world with flat oil prices, and we continue to see the PLN supported by the improving growth dynamic in Europe relative to Asia or the US. Funding these EM currency longs out of the EUR, where we continue to forecast further downside, still looks attractive. But, provided our baseline view plays out, stability versus the USD also looks within reach in 2016.”
“The challenge with such a strategy is that there are still at least three downside risks that can derail any constructive EM FX view. First, oil prices that undershoot towards a downside scenario of $20/bbl as storage capacity is exhausted are likely to put the entire EM complex under pressure. Second, it is easy to imagine how strong data can thwart the FOMC’s desire to deliver a ‘dovish hike’ in December. And, third, as China’s bumpy deceleration extends, the risks of a substantial (10%+) depreciation are likely to grow, posing a threat to the entire EM FX complex. Thus, even though we think EM FX will finally find a bottom in 2016, trading a constructive EM FX view is likely to prove a choppy and often frustrating endeavour, with a premium on avoiding these potholes.”
“We worry most, therefore, about the risks of a sharp CNY depreciation over the course of the next 12 months as the SDR decision fades into memory. This can be hedged directly through $/CNH upside, where the forwards currently price only a small depreciation over the next 12 months, reflecting in part the still strong trade balance and ample reserve cushion which should allow policymakers to move at a time and pace of their choosing. That said, capital outflows have been eroding the reserve cushion in recent months, and periodic official interventions through the forward book may actually provide attractive entry points for setting hedges.”
Key Quotes
“Under our baseline global macro and market outlook, it is possible to envisage better performance for EM assets relative to the past few years. A modest pick-up in EM growth – even taking account of a deceleration in China, still broadly low inflation and a Fed that is only likely to move at a measured pace – should make for a macro backdrop where earning EM carry is less risky than in previous years, especially among the ‘good’ EM stories where imbalances have been corrected and valuations are supportive.”
“The INR remains top of that list, but the RUB also offers a good opportunity under our central forecast of limited further oil price downside. Among the lower yielders, the MXN should also offer stable carry in a world with flat oil prices, and we continue to see the PLN supported by the improving growth dynamic in Europe relative to Asia or the US. Funding these EM currency longs out of the EUR, where we continue to forecast further downside, still looks attractive. But, provided our baseline view plays out, stability versus the USD also looks within reach in 2016.”
“The challenge with such a strategy is that there are still at least three downside risks that can derail any constructive EM FX view. First, oil prices that undershoot towards a downside scenario of $20/bbl as storage capacity is exhausted are likely to put the entire EM complex under pressure. Second, it is easy to imagine how strong data can thwart the FOMC’s desire to deliver a ‘dovish hike’ in December. And, third, as China’s bumpy deceleration extends, the risks of a substantial (10%+) depreciation are likely to grow, posing a threat to the entire EM FX complex. Thus, even though we think EM FX will finally find a bottom in 2016, trading a constructive EM FX view is likely to prove a choppy and often frustrating endeavour, with a premium on avoiding these potholes.”
“We worry most, therefore, about the risks of a sharp CNY depreciation over the course of the next 12 months as the SDR decision fades into memory. This can be hedged directly through $/CNH upside, where the forwards currently price only a small depreciation over the next 12 months, reflecting in part the still strong trade balance and ample reserve cushion which should allow policymakers to move at a time and pace of their choosing. That said, capital outflows have been eroding the reserve cushion in recent months, and periodic official interventions through the forward book may actually provide attractive entry points for setting hedges.”