Latin American markets came under significant pressure on Monday - with especially the Mexican and Brazilian markets suffering. The sell-off in the LATAM markets was primarily driven by USD weakness, which usually hits LATAM currencies hard. Furthermore, local political worries in Mexico and Brazil seem to be on the rise, and the election of leftist populist Correa as new president in Ecuador could have a (moderately) negative impact on sentiment in the LATAM markets. Note also that we have seen large falls in prices on US stock markets and a sharp rise in VIX volatility and in the EMBI spread, both of which are considered to be proxies of risk aversion.
Even though the weakness in the LATAM markets is not yet very dramatic, this is nonetheless the biggest correction in the LATAM equity markets since the beginning of October - a good reason to follow these developments closely. We could see the LATAM weakness spill over into the CEE/EMEA markets in the coming days - especially the Turkish markets, which are normally among the most sensitive to USD weakness and rising risk aversion. Furthermore, one should watch the news flow in relation to Turkish EU negotiations closely.
In our Emerging Markets (EM) Briefer from November 1, we argued that the EM markets would be "Waiting for the bandwagon" in November. It looks as if the bandwagon might have arrived, with continued USD weakness. Please note that the EM sell-off in May-June was preceded by a weakening of the USD from the start of April until mid-May. USD weakness does not necessarily mean that Emerging Markets will come under pressure, but normally EMs tend to underperform in periods of USD weakness. This might also be the case this time around. In April-June, especially countries with large current account deficits suffered. The same will probably happen this time around - and the situation looks especially troublesome for the TRY, ISK and HUF. We think, though, that the South African rand (ZAR) could hold up relatively better this time than in April-June, as it has not gained to the same extent as other EM currencies since the beginning of July. Furthermore, the ZAR tends to do relatively well in periods of USD weakness.
Recommendations:
We would recommend reducing exposure to the LATAM and other USD-sensitive markets like the Turkish markets. The Central and Eastern European (CEE) markets should do better than other EM, but with risk aversion on the rise, even the CEE markets could suffer relative to developed markets (especially in Europe). Obviously the Asian markets will also tend to under perform the European markets in periods of USD weakness, but the Asian markets - with strong external balances - should be more robust than the LATAM and Turkish markets. We would also point to the Israeli shekel as a fragile currency at the moment,given its traditionally high correlation with the USD and the fact that Israeli interest rates are now lower than US rates after the rate cut yesterday
Fixed income markets:
While EM FX markets have sold off over the last couple of weeks, fixed income markets have been holding up better. However, if the EM FX sell-off continues - as we believe it will- then it is likely to start pushing up EM yields and rates significantly as well. We could soon be back to speaking about rate hikes in countries like Turkey again.
