FxWirePro: LATAM, EMEA EMFX valuations inch towards neutral, robust bond inflows and FX trade recommendations

The EM markets appear subject to local idiosyncratic factors (some common local themes include favorable current account/flow dynamics, FX valuations, and potential central bank tightening) and significant global risks. We see the two most pressing as China financial/macro stability concerns and a pricing in of more US rate hikes in 2018.

The fundamental case for EM currencies is clear but is very consensus – valuations, flows, slow place of DM policy normalization, global growth, commodities, real yields and external positions.

Valuations close to neutral: In aggregate, EM real effective exchange rates (REER) are just slightly below their long-term average. There are pockets of value in LATAM and EMEA, while Asia remains the most expensive region. US and Euro area data surprise indices have pushed substantially higher, which should support rates expectations, and US tax reform is likely to linger as an upside USD risk for some time in 2018.

Strong bond inflows: the Foreign appetite for EM bonds has been strong, with equity flows severely lagging. Even with the pressure on EM currencies between September-November, bond investments remained sticky, suggesting positions were FX-hedged.

Outflows have now commenced both from local bond funds, as well as equity funds and these could extend for some time. As such, we prefer to stay cautious.

Trade recommendations:

6m USDMXN digital put

6m USDBRL topside seagull

Short EURCZK

3m USDTRY put up-and-in.