Commentary: Seeking Relative Value in EM and Commodity Space

This week EM turmoil has abated and even vulnerable markets like Turkey and South Africa have stabilized.  Turkey's Lira traded as low as 2.18 per dollar today, the lowest since Turkey's Central Bank hiked its key overnight rate by 400 basis points.  The South African Rand has been trading around the 11 handle after reaching as high as the 11.50 level earlier this year.  Other so called "risk" currencies among the industrialized nations have also outperformed this week, with AUD, NZD, and CAD all up this week.  Rates appear to be on hold for AUD and CAD, despite very low Canadian inflation.  Australian monetary authorities appear to be pleased with a lower AUD, with officials calling the .80-.85 a fair value for AUD/USD.  CAD has been up in this week as some analysts believe the Canada's terms of trades may improve as the Brent-West Canadian Crude spread narrows.  Meanwhile, New Zealand's economy appears to be picking up steam, with dairy exports surging with an accompanying pickup in domestic demand.  

On FX, the RBNZ most recent statement that "In this environment, there is a need to return interest rates to more-normal levels. The Bank expects to start this adjustment soon."  With CPI already at 1.6 percent, and the Bank keen to keep it below 2, most analysts expect rate increases by the end of Q2 this year.  I believe higher rates could be NZD supportive, though I am hestitant to buy NZD/USD in the face of Fed tapering as the US economy picks up.  Those seeking carry could consider buying NZD/JPY or NZD/CHF.  Personally, I am more inclined to sell AUD/NZD since these closely integrated countries appear to have divergent monetary policy.  A similar dynamic may be emerging between the UK and the Eurozone.  Indeed, short EUR/GBP (which already offers modest carry) trades are gaining popularity

Looking to EM space, I still believe that investors must continue to be highly selective.  MXN and KRW will continue to be outperformers.  Other regional LatAM currencies have been crushed, with USD/BRL and USD/ARS soaring in recent weeks.  Other countries with much stronger fundamentals have also been hit, with USD/CLP and USD/COP still up big on the EM sell off.  To be sure, both the central banks of both Chile and Colombia still have an easing bias.  Colombia's monetary authorities continue to fret over low inflation. On the other hand, the Bank of Mexico has very likely reached the end of its easing cycle.  Its quarterly report release earlier to today stressed vigilance on inflation and the need to tighten policy quicker than expected should the broader economic recovery produce inflationary pressures.  Inflation is gaining momentum in Mexico with core inflation reaching 3.21 percent, the highest since July 2013. Yesterday's IP report was more of the same, with manufacturing still humming along but construction continuing to contract. The last read on retail sales was stronger than expected, and unemployment is at the lowest level in five years. Consumers may be a position to do some heavy lifting this year.  Structural reforms, especially in the energy and financial sectors should also put the economy on firming footing and attract investment flows.  We'll get the first read on Q4 GDP next Tuesday.

In general, I expect ZAR, TRY, and ARS to remain under heavy pressure.  I am inclined to avoid these currencies altogether, but long BRL/ZAR or long TRY/ZAR may be an interesting play to capture some carry.  However, idiosyncratic weaknesses in many emerging market (labor unrest in South Africa, corruption in Turkey) may cause correlations between the "fragile five" to break down. Thus, great care is required.