As volatility drops, investors will demand EM FX

FX markets quick to target CAD and MX after Trump’s action on Canadian wood

US President Donald Trump had been talking about placing tariffs on Canadian timber and dairy forever; however no announcement (if any) was expected until next week. But overnight Trump unexpectedly imposed a tariff of up to 24% on Canadian wood exports. This seems to be a response to Canada’s long-standing taxes on US daily imports, which the Trump administration views as unfair.

The trade dispute escalations highlight simmering discontent regarding NAFTA and it meant the FX markets were quick to target CAD and MXN. With Trump nearing his first 100 days with little of the “winning” promised, he will be quick to score cheap points with his core political base. Renewal of protectionist sentiment will likely upset upcoming NAFTA renegotiations, keeping NAFTA FX trades under selling pressure. In addition, the focus on dairy prices will highlight NZD issues.

Markets had been lulled into a false sense of security after Trump's retreating from harsh China rhetoric and broader legislative failures. However, this policy action is a clear illustration of the ease in which he can enact punitive trade policy. CAD came under significant selling pressure as news of the action hit the wires. We remain constructive on USDCAD, which has rallied above its falling trend line for December, targeting a range high at 1.3600.

As volatility drops, investors will demand EM FX

The most interesting result of the French election vote was the collapse of volatility indicators globally. The VIX index declined -19% from 15.30 while EURUSD one-month implied volatility fell to 8.20 from 13.45. The JP Morgan G7 volatility index fell to 8.03, a level not seen since November 2014. With volatility declining, a critical input in Emerging Markets investing is satisfied.

Looking forward to the next 2-3 months we are seeing clear sailing for EM investing. While developed markets are marginally rising, they remain significantly overvalued with corporate earning failing to warrant extended prices (INDU trailing 12-month PE at 20.81 and dividend yields 2.35 are both running well above historical averages). Given weak earnings, we doubt a mad rush from cash/EM in to European/US stocks, however there remains value in EM corporate. We concede that President Trump's renewed protectionism is concerning but given his lightening quick attention span, it is unlikely to remain a dominant policy objective (considering his healthcare and tax reform priorities).

We would avoid ZAR, TRY and MXN due to idiosyncratic risks but suspect yield chasers will migrate into high yielding EM. Finally, those that point to once historical accurate “sell in May” as a trading rationale, well there is not much to say there. Traders should watch today's US housing data, consumer confidence and manufacturing survey for the general direction of the US economy (and potential repricing for the Fed rate path).