Global Macro Strategy
EM Navigator: Quantifying Macro Risk - Healing or
Drifting?

How well has EM harnessed the fairwinds to heal itself?
Has EM benefitted from good fortune in propitious global circumstances or has it
become intrinsically more resilient? We detail our Macro Balance Sheet (MBS) risk
framework which measures EM's macro strength across the following dimensions -
leverage, external, fiscal and institutional risk. Despite an improvement in EM's external
risk profile, our overall MBS risk score is largely unchanged over the last two years as
leverage and fiscal risk have worsened. What the market is priced for would only make
sense if EM growth heads toward its long term median. We would position against
that.
Equities: Long Japan vs EM
Nearly half of year to date gains have been driven by the tech sector, which we believe
is now well priced. More broadly, the EM growth cycle has likely peaked, and while it
has come off only very slowly in Q2, the growth decline may speed up modestly as H2
wears on. It is unlikely that earnings growth will be revised up further. We have been
expecting EM gains to peak against DM in Q2, and thus far it is playing to script. After
tech's strong rally we suggest taking profits on our long Asia versus EMEA
recommendation. Given strong domestic reflation amidst still loose monetary policy in
Japan, we now recommend buying it against EM equities.
FX & rates: Can EM FX still win if the USD stops depreciating?
Despite a benign external environment, EM currencies have only appreciated 0.3% in
trade-weighted terms this year. The contribution of broad USD depreciation to EM
returns has been under-discussed, in our view. In H2, some weakening in Chinese
imports and in the tech cycle should drive a slowdown in EM trade growth, motivating
trade weighted depreciation. Despite a strong run we see greater value in EM local
rates, where prudent monetary and contained core inflation should keep beta to
modest FX depreciation muted. We favour short EUR/CZK, long 5y IGBs (short
AUDINR), long 7y OFZs (short CADRUB), and long USD/TWD and USD/THB. We are also
paid ZAR 1y1y IRS.
Credit: Where does commodity pain really kick in?
Our fair value estimate of EM sovereign credit is 35 bps wider to the market. It is likely
to drift wider still as weaker growth puts pressure on fiscal balances and slows
deleveraging. Lower commodity prices could refocus minds on deviations from fair
value. As we solve for it iteratively, we find that USD 38-40 per barrel on WTI is that
point of non-linearity that should evoke a big response from EM assets. We find
Malaysia, China and South Africa credit too tight, while Indonesia and LatAM quasi
sovereigns still offer value.