Over the past week we took our fair share of jabs at SocGen EM FX analyst Benoit Anne (the one who said “Governor Basci, You Have Avoided A Domino Crisis In EM“… er, oops?) . They were all in good humor – after all when it comes to sheer contrarian cluelessness nobody, and we mean nobody in the known world, can even reach Tom Stolper’s toe nail, whose fades have resulted in over +12,000 pips on these pages alone over the past 5 years. Which is why we follow up the comedy with something more serious: now that the honeymoon is over, Anne has put together a solid compendium on how to trade the EM meltdown, with an emphasis on defensive strategies. Considering the tapering will continue for a long time, and as GaveKal explained yesterday, someone will have to lose (big) before EM normalcy returns, we urge anyone with EM exposure to read this.
From SocGen’s Benoit Anne:
How to trade the GEM meltdown
In the face of stress escalating in global emerging markets (GEM), we are currently focusing on implementing defensive strategies. In EM FX, we sell high-beta EM FX outright or favour defensive relative value crosses. In EM rates, we are looking at front-end rates payer strategies, combined with bear flatteners, especially in markets that are subject to policy pressure contagion of the kind that has been observed in Turkey and South Africa. Finally, in EM Credit, we favour low-beta countries with strong balance sheets (low external debt and high FX reserves) as well as Central European countries; we also favour short-dated papers as sovereign curves are likely to steepen further.
GEM stress escalating
We have witnessed a severe escalation of stress in recent days in global emerging markets (GEM). The stress has travelled across all regions and spread to all asset classes. In a few markets, the volatility has reached levels that had not been seen since the fall of Lehman Brothers. We are clearly in the middle of a severe Doom phase, with no signs for now that this will turn around. There is no denying that we had not anticipated that magnitude of the correction. In many ways, what we are witnessing is a proper market meltdown.
Ramping up defensive strategies
Against this backdrop, it makes sense to go fully defensive in all asset classes. On the FX side, the strategy should be centered on either selling EM FX outright or at least favouring defensive relative value FX. In Central Europe, we have just entered a long EUR/HUF position, with a target of 329. So far, Central Europe has been relatively resilient, but we believe that this resilience is only going to be temporary. We have already seen EURPLN coming under mounting pressure. Given its higher-beta status in the region, the PLN looks vulnerable, in our view. In relative value, we continue to like short PLN/RON which has now moved to about 1.06. In the dollar bloc, we believe that the ZAR and the TRY are to be played on the short side, but await better entry levels.
In EM rates, we are observing a radical shift as regards the curve move momentum. While the defensive positions would typically be curve steepeners recently, we now believe that the momentum has gone to curve flatteners simply because an increasing number of EM central banks are victim to policy pressure contagion. The hedge fund community has taken on some central banks, primarily the CBRT and the SARB, whose credibility has been badly shaken.
We believe that this market pressure will spread to other candidates, with the National Bank of Hungary, and perhaps even the Central Bank of Russia now in the potential line of fire. On this basis, we are now looking at rates payer strategies, together with curve flatteners. In Mexico, we just entered a 1y TIIE payer, simply because we believe that investors may try to push Banxico. It does not mean that we think Banxico will actually hike, but any move in policy pricing expectations will help the rates payer performance. One of the few markets where we would actually be comfortable with a steepener is Brazil.
Finally in EM credit, we continue to like Romania $2023 vs. Hungary $2023. We believe the credit profile of Romania has substantially improved is well poised to show better resilience than other EMEA countries, in particular Hungary which continue to trade rich in view of fundamentals, in our view. Generally speaking, and at this stage of the crisis, we favour lowbeta names with strong balance sheet (low external debt combined with high FX reserves).