Earning the ‘good carry’ in EM, hedging the China (and CNY) risk – Goldman Sachs

Research Team at Goldman Sachs suggests to long an equally-weighted basket of BRL, RUB, INR, ZAR  versus short an equally-weighted basket of KRW and SGD, with an entry level of 100, total return target of 114 and stops at 93.

Key Quotes

“The expected return, including approximately 7% carry (on an annual basis) and 7% price return, is around 14%.”

“Our recommended Top Trade exploits the fact that there are a number of ‘good carry’ candidates in EM FX space: BRL, RUB, INR, ZAR – countries where external balances have strengthened materially, inflation is on a declining trajectory, the ‘carry’ in real terms is generous and there are prospects of stronger growth in the year ahead.”

“The ‘Trump tantrum’ has also seen meaningful pressure on many of these high-yielding currencies, providing more attractive entry points. In all four cases, our 12-month forecasts are meaningfully stronger than forward market pricing. Specifically, relative to spot, we have the most appreciation in $/ZAR (12month forecast of 13), reflecting that it has been one of the laggards to the global re-balancing story, but has now seen a clear narrowing in the current account deficit in recent quarters. There is more limited room for appreciation relative to spot levels in the other three currencies (our 12-month forecasts are 62 for $/RUB, 3.40 for $/BRL and 68.5 for $/INR). But all three should be more resilient to a modest further extension of the increase in US bond yields given the more compelling domestic disinflationary stories in each case.”

“The countries represented on the long side of our FX basket also have more limited exposure to US trade/demand risks if the protectionist rhetoric from President-elect Trump is transformed into action. Risks emanating from gyrations in crude oil should also be relatively well diversified, given that both India and South Africa are net oil importers, while Russia and Brazil are oil exporters.”

“On the short side of the trade, we recommend KRW and SGD – two low carry Asian currencies. While rate risk is front-and-centre of EM investor concerns at the current time and has affected high-yielders with heavy positioning, in the medium term the risks related to the unwinding of the Chinese debt build-up, and the depreciating CNY that goes alongside that, is probably the more systematic risk.”

“Korea has a high export similarity to China and is therefore exposed to the weakening trend in the CNY, which we expect to extend, as discussed above. There are also independent reasons for a weaker currency. Given the need to undertake difficult corporate restructurings in Korea against the backdrop of subdued global trade, a weaker Won is likely to be a key part of delivering easier financial conditions. And in the case of Singapore, the NEER basket has large weights in MYR, CNY and JPY – all of which we expect to weaken beyond forwards, and the low level of domestic inflation means that we continue to expect SGD to trade on the weak side of the band.”