A rally built on sand
For Emerging Markets, the coronavirus curve has not yet peaked, nor has the economic growth bottomed out, but EM currencies have been trading like the COVID-19 is yesterday’s news. The unprecedented liquidity injections by the major central banks have fuelled risk appetite and driven a V-shaped recovery in EM FX. However, EM countries are far from out of the woods. We see an increasing number of coronavirus cases, a murky growth outlook, elevated uncertainty and a market that can only be kept happy if the money-printing madness becomes bigger and wilder every time the central banks meet. This looks like the perfect recipe for a sharp correction, in our view, which we expect to take place in the coming months.
EM FX has gained traction since our last issue of EM View in mid-May
Most currencies have erased a large part of their COVID-19 losses against the USD, including the BRL, which had struggled to regain momentum up until then. The rally is driven by risk sentiment The optimism in the EM assets, triggered by a return of risk appetite, does not come from a stabilised global virus situation or a significantly improved growth outlook, but rather massive liquidity injections by the major central banks.
But uncertainty remains high Aside from the unprecedented policy easing, we do not see other persistent drivers supporting the V-shaped recovery in EM FX. The future looks as uncertain to us as it did at the beginning of the COVID-19 pandemic, if not more so.
The EM FX recovery is likely not sustainable
The past few months have proven that the mood of the markets can shift quickly. Without fundamental support, the EM recovery is fragile, and is susceptible to a number of factors that include a worsening of the pandemic, a slower recovery to a normal growth trajectory, and intensified conflict between the US and China.
EM FX faces considerable downside risks
Thus, we think there will yet be another leg down for EM FX in the coming months. The market, for EM as well as all risky assets, has priced in an outlook with business going back to normal. It will most likely be disappointed by the long-lasting effect of this crisis. That could trigger a correction of the current EM rally.
A broader sense of relief is observed in the advanced countries, as reopening has not so far led to more infections. But such comfort is nowhere to be found in EM, which have become the epicentre of the pandemic. After witnessing sharply rising infections, Brazil and Russia are now ranked second and third on the list of most confirmed cases. As a result, the global virus curve is still steepening and a second wave of infections cannot be ruled out.
EM and the global economy face large uncertainty
The still-evolving pandemic makes it practically impossible to assess its full impact on the economy. So far, most estimates have been lowered. The IMF has hinted that it will cut its forecasts from late April on 24 June. The World Bank just released a gloomy outlook for 2020 and warned that it could become even uglier.
Consumer spending is the most crucial factor to look for
Their caution is understandable. Despite improvement in the macro figures released by most countries, the level of activity remains far below normal. Consumer activity is the most crucial factor to keep an eye on, as it has direct consequences on business activity, global trade and thereby the financial markets.
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