A quick update to the post from a little under a month ago on the Troubled Three – Brazil, Turkey and South Africa (here).
At the time I argued that the fundamentals suggested a further weakening in these currencies, and that from a trading perspective, the momentum was supportive. Over the past month an equal-weighted basket of the BRL, TRY and ZAR weakened another 6.5%, with BRL the worst performer, followed by TRY and ZAR.
The further depreciation reflected events in each of these countries and beyond, and has provided further momentum to those looking to go short the currencies. Taking them in turn:
Brazil
- Inflation accelerated to 9.6% in July, up from 8.9% in June. The highest inflation print since 2003. COPOM do not appear to be making much of a dent, despite 14.25% Selic rate.
- Composite PMI fell to 40.8 in July, the lowest reading on record
- COPOM sort of hinted that the hiking cycle might be coming to an end (although their pronouncements are notoriously difficult to read).
- The latest estimate of the fiscal cost of lending subsidies to BNDES has ballooned to R$ 184bn over the coming decades, despite the cessation of new loans earlier this year.
- Moody’s downgrade Brazil to one notch above junk, although with a stable outlook (many feared it would be with a negative outlook).
- Political pressure has increased further on Dilma, with mass demonstrations and an abysmal approval rating of just 8%.
- The fallout from the corruption scandal rumbles on, with the big unknown being whether Dilma (who was Chair of Petrobras at the time) will be indicted.
Turkey
- Months have passed since the parliamentary elections and still no coalition govt has been formed. Talks collapsed last week and the acting PM has now called for fresh elections. New elections might deliver little change, forcing further coalition talks, or they might see the AKP gain a clear majority again. Neither prospect is good, with the former creating more uncertainty and the latter likely to see President Erdogan gain executive powers.
- Turkey’s military involvement in Syria (ISIL) and Iraq (PKK) has increased, with the latter particularly concerning for domestic stability.
- The CBRT left rates unchanged today (18th Aug), and published a rather bizarre document aimed at explaining how they plan to simplify the monetary policy framework going forward. It did not (see here).
- On the plus-side, inflation, the current account and IP all came out a bit better than expected this month.
South Africa
- Not so much in the way of negative domestic news, other than a far worse than expected trade balance in June. SARB hiked rates as expected and inflation was actually weaker than expected.
Global events
- Further declines in commodity prices have impacted sentiment around the EM commodity exporters, including Brazil and South Africa.
- The Yuan depreciation (my early take on it here) acted as a general risk-off catalyst for EM, the Troubled Three, and particularly Asia ex-Japan (eg MYR has fallen sharply, although domestic factors are at play there too).
- Increased confidence of Fed lift-off in September has added to fears of the impact on EM currencies.
There are no doubt more things I could have highlighted, but the list above supports the continued weakening in these currencies. They are yet to go parabolic, but there is a chance that some or all will. It’s worth having some skin in the game to try to catch it, even if the carry is painful.
Fundamental Macro 
Regarding your “troubled three” — what happens if the Fed doesn’t raise rates at all (this year)? Would this change your view, at least in the short-term? Do you have targets (to close out your position) — if the weakness of those currencies were to continue?
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Ivan – thanks for your question. My central expectation is that the Fed do hike this year (with slightly better than 50% chance of September). But I could be wrong about that, either because the Fed blink or because the growth/inflation outlook changes for some reason.
If the former, then it is likely to give the troubled three some more breathing room, just as in the post-taper tantrum period conditions relaxed. But I don’t think it gets them off the hook completely, unless they are seen to undertake some credible policy reforms in the mean time (like India did in 2013/14). At this point I struggle to see that coming in Brazil or Turkey, but maybe possible in South Africa. Moreover, I think they are all in a worse position now than they were two years ago.
If the Fed aren’t hiking because of some sort of external shock – such as a very sharp weakening in global growth (led by China) – then I don’t think that helps the troubled three at all. And so they remain just as vulnerable to an exchange rate correction.
In terms of targets, I would be looking currently at stops around BRL 3.35, TRY 2.78 and ZAR 12.50, and would want to trail those higher as the currencies weakened further over the next 3 months. Given the cost of carry, I would look to cut the trade if everything went sideways for 3 months. Lastly, I think it is really difficult to have a take-profit plan around these sort of trades, especially if things start to get away from the authorities and the currencies depreciate more rapidly. That said, I would look to take profit if BRL > 3.90, TRY > 3.20 and ZAR > 13.6
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Thank you for your response. Yes, the Fed could raise rates next month or later on this year — but should they? Inflation expectations are falling — even in the U.S. Oil doesn’t help, China exporting deflation (even with a small devaluation but potentially more to come?!) doesn’t help, and the general collapse in the industrial commodities complex (as a whole) certainly doesn’t bode well for world growth. All the other major central banks in the world are now in easing/competitive devaluation mode. Why should the Fed jump the gun, given the hugely uncertain outlook for world growth and the already strong USD which is starting to be a U.S. growth headwind? Clearly, the Fed might want to raise rates — just to get off the 0 bound and get the monkey off their back, so to speak — but I’d argue that the signalling effect here is quite important. Reminds me of what Trichet did in the summer of 2008. Sometimes being market savvy is more important that “being correct” from a macroeconomic, fundamental perspective. Assuming that Yellen et al. are (somewhat) market savvy, I am therefore less bearish on EM assets than you are, from this juncture onwards. I feel DM assets are much more expensive here, given the growth backdrop (even with QEs all over the place). Some might even argue that commodities and the EM world are the only places that have properly priced in a more sinister world growth outlook than what the soothsayers in the DM world are suggesting…
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Thanks Ivan. In terms of the Fed, I haven’t written a post for a little while, but you will get a flavour of my thinking if you follow the Federal Reserve link on the sidebar.
The factors that you cite as an argument for the Fed to wait a bit longer to start hiking are completely valid. Global growth does look to be slower than expected, with China and other EM countries slowing (that said, recent EZ growth has probably outperformed most people’s expectations). And along with a range of supply factors, that has seen commodity prices fall sharply, pulling down on the price of both consumables (ie energy) and inputs into production. Moreover, the USD has strengthened. But the key question for the Fed (and others, such as the BoE), is whether those deflationary effects are transitory. If you think that is right (it is the language used by the Fed/BoE), and you have already just about closed the output gap, then you really need to think about tightening policy.
One reason why you might not, even in those circumstances, is because of an asymmetry at the ZLB with inflation very low. It may be that transitory, headline inflation shocks impact negatively on medium-term inflation expectations. In which case you would look to keep policy looser for longer, or even ease (QE). But while market-based measures of inflation expectations have declined, survey-based measures have been pretty stable. So I think the asymmetry argument is a relatively weak one at this point.
The stronger USD does put somewhat of a dent in net trade. But against the majors at least, that reflects a relatively stronger domestic US economy (primarily consumption, but also non-energy investment) and hence rate differentials. So long as the domestic economy remains strong, you have to get a very big USD move to have a material policy impact, as the US is simply not a very open economy.
If the main concern is around global growth and commodity disinflation, then I think my view on Brazil and South Africa is supported. Both are major commodity exporters. But more importantly, each of the EM countries I have focused on have deep-seated domestic problems. I don’t expect the whole EM complex to be dragged down with them, and indeed, it may be better to look at some EM crosses as a better implementation.
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