Is the EM FX sell off overdone?

Emerging markets are in focus for another day. The South African rand made a fresh 2-year intraday low versus the USD and is now more than 4% lower since Monday. Contagion has taken hold, and emerging market FX is a sea of red today, this has also spread to the emerging market equity space, with the Chinese, South Korean, Czech, Brazilian, Chilean, Argentinian, and Indonesian equity indices a large band of notable decliners in the last 24 hours.

However, is this peak sell off for emerging market FX? Some people are worried that the “spread” to the equity market is a sign that another leg lower in emerging market assets is about to take place, however, that is not necessarily the case. Since FX is a major component of the returns for overseas investors in emerging market equities and bonds, when EM FX slides it is highly likely that equities and bonds will take a dip too, as overseas investors cut their exposure. But this broad-based decline in emerging market asset prices could actually mark the peak of the selling: if EM equities and bonds (which offer decent yields) become cheap then it will attract buyers, which could help the EM FX space to recover.  So don’t bank on this indiscriminate sell off continuing.

Is the sell off in the rand justified?

This is a contentious question, and one that will only likely appeal to the contrarian at this stage, but is South Africa really that worse off than elsewhere? Sure it has its political problems, but where doesn’t? Yes, it registered a second quarter of negative GDP, however, it was much improved from Q1’s sharp 2.6% decline, and Q2 was sometime ago now. Yes it has a current account deficit, but at 3.15% this is less than the UK’s, which stands at 3.91%.

Animal spirits will calm down

While it is natural for the FX market to react to these events individually, the EM sell off is becoming indiscriminate and animal spirits are starting to dominate. At some point reasoned investing will resume, so don’t expect the EM sell off to last indefinitely.

Why we can’t get positive on the pound, yet…

Elsewhere, the pound is the weakest currency in the G10 FX space today, which also seems somewhat unjustified since UK service sector PMI beat expectations and reversed some of July’s weakness. New car sales were also stronger than expected, although that was mostly down to car makers issuing heavy discounts ahead of new clean vehicle rules, which come into effect later this year.

Although the PMI data suggests that the UK is on a firm footing for a solid Q3 GDP expansion, the FX market is choosing not to listen and is instead focusing on the political problems and Brexit chaos. This is what worries us most about the pound’s long-term prospects: the political uncertainty is too big a force for the bulls to deal with. As we mentioned last week, it’s risky to trade on “positive” Brexit comments from the politicians as these sentiments can be reversed very quickly. Also, last week’s rally above $1.30 in GBP/USD is definitely not a sign that the market if fatigued with a weak pound. Although GBP/USD is finding some support at $1.28, this week should have taught us that there is further for the pound to fall if the politics of Brexit continue to descend into farce.