Wells Fargo Research Team
Wells Fargo
Summary
Over the last few months, emerging market currencies have come under extreme pressure. A more hawkish Fed combined with deteriorating global growth prospects have been the root causes of the widespread selloff across the emerging currency complex. While we have a particularly pessimistic view on emerging market currencies, the depreciation has been more severe than we expected. In our view, this depreciation pressure is likely to continue; however, we have consistently been asked "how much more depreciation can EM currencies experience?"
To offer insight, we updated our emerging market currency vulnerability framework and use the results to gauge the extent of further depreciation. The results are compelling, and suggest that underlying economic fundamentals and local politics are consistent with additional weakness in most developing currencies. There are exceptions, however, and our framework suggests fundamentals are consistent with a modest rebound in the Chilean peso, while the politically driven Colombian peso depreciation has likely run its course.
Emerging market currencies have become more vulnerable
As economists, our responsibilities include proactively recognizing where economic fundamentals and local politics are trending in less or more positive directions. Early identification of these developments can help us make timely adjustments to our forecasts and recommend an appropriate course of action for clients exposed to these countries. Over the years, we have developed and refined tools to help us detect these developments. When we are analyzing emerging market currencies, especially when they have come under broad pressure the way they have this year, we tend to update and utilize our Emerging Markets FX Vulnerability framework quite often. Our vulnerability framework gives us a forward-looking view into how economies and politics are evolving, and supports our effort to be as early as possible in recognizing changing economic and political conditions. Our framework includes a rolling 1-year ahead current account balance forecast and a forward-looking measure of where inflation-adjusted interest rate differentials relative to the U.S. could be in 12 months time. In addition, we include foreign exchange reserve adequacy (import cover) and overlay these data with forward-looking judgment, as well as a political risk indicator which we also apply judgment to where necessary. We add up these variables to get an overall sense of where local conditions are evolving in each developing country we forecast. Currencies associated with eroding fundamentals and politics are typically more vulnerable and volatile, while currencies with stable politics and relatively strong underlying economics can be more protected in an environment where risk assets are performing particularly poorly.
In our view, markets are still in the risk-off environment that has permeated across the globe this year. This global risk off episode is also where our EM FX vulnerability framework works best. In that sense, we updated our vulnerability analysis for Q3-2022 in an effort to assess if and where conditions are evolving, and which currencies could be more or less sensitive. Our latest update reveals interesting conclusions. Our framework suggests that conditions in most countries are stable relative to Q2-2022; however, our analysis reveals that conditions in certain emerging market countries are evolving in a way where currencies are becoming more vulnerable to market shocks. To that point, the Russian ruble and South African rand have become "highly vulnerable" currencies, while conditions in Thailand have deteriorated to the point where the baht is now a "moderately vulnerable" currency (Figure 1). Including Russia and South Africa, conditions in seven countries have evolved in a way that is consistent with outsized depreciations in their respective currencies over the course of a global risk-off event. Including Thailand, ten currencies now fall into the moderately vulnerable segment, while only Israel and China have currencies our framework identify as having little vulnerability.
The ruble's downgrade comes from a lower real interest rate differential with the United States. Given the ruble's capital controls-driven rally and the downward trajectory of local inflation, the Central Bank of Russia (CBR) has started unwinding emergency policy rate hikes from earlier in the year. Over the last few months, the CBR has lowered its Key Rate 1,050 bps to 9.50%. This aggressive easing comes against higher policy rates in the United States, and has diminished the ruble's yield advantage over the U.S. dollar. While a diminished real interest rate differential is driving the ruble's move into the highly vulnerable segment, a reduced yield benefit of the ruble is combined with elevated political risk amid tensions with Western countries and the conflict in Ukraine. In addition, international sanctions restrict CBR access to a majority of its foreign exchange reserves as well as significantly limit the ability of Russia's sovereign wealth fund to transact and generate liquidity. Historically, more-than-adequate FX reserves and a large sovereign wealth fund have acted as pillars of support for the ruble; however, limited buffers has raised the country risk profile of Russia and contribute to the ruble now being a highly vulnerable currency. As of now, Russia's current account surplus prevents the ruble from being the most vulnerable emerging market currency; however, a negative real interest rate differential due to diverging paths for monetary policy between the CBR and the Fed, limited access to buffers and elevated political risk leave the ruble highly sensitive to a large depreciation in times of global market stress.
For the South African rand, we expect the current account surplus to flip into deficit, which is behind the currency's shift into the highly vulnerable segment. With the risk of global recession rising, demand for commodities is likely to ease over the medium term. In fact, we have seen these dynamics play out over the last few weeks as copper prices have plummeted and oil prices have dropped below $100 per barrel on recession risks. Given South Africa is a major commodity exporter, particularly of precious metals and agriculture products, lower demand should result in metals and agriculture prices softening over the medium term. As commodity prices come down, South Africa's current account balance should move out of surplus and into modest deficit. A current account deficit will likely be matched by persistent elevated political risk stemming from insufficient governance controls and little momentum behind implementing a much-needed reform agenda. In addition, the South African Reserve Bank (SARB) has inadequate FX reserves and may struggle to defend the value of the rand in times of extreme volatility. SARB is also likely to maintain only a slim positive real interest rate differential against the United States as policymakers have taken a more gradual approach to interest rate hikes relative to the Fed, while local inflation is likely to continue to trend higher. Altogether, fragile fundamentals and elevated political risks have resulted in the rand returning to a highly vulnerable currency susceptible to a large depreciation in a global risk off scenario.
And in Thailand, the baht's move to moderately vulnerable is driven by the currency now being associated with a negative real interest differential. Bank of Thailand (BOT) policymakers have been an outlier to the higher interest rate trend. Despite inflation trending toward levels last seen during the 2008-2009 Global Financial Crisis and the Asian Financial Crisis of the late 1990's, BOT policymakers have maintained a view that current inflation is only temporary. With a view that price pressures are transitory, the BOT has resisted raising interest rates or engaging in operations consistent with tighter monetary policy. With local inflation spiking, BOT policymakers on hold, and the Fed lifting policy rates quickly, real interest rate differentials have moved into negative territory and are now a source of potential stress on the baht. Aside from diverging paths for monetary policy between the BOT and Fed, underlying fundamentals in Thailand are actually quite strong. The country is likely to maintain a healthy current account surplus of around 1.5% of GDP in 2023, while BOT FX reserves are likely to remain adequate going forward. On the political side, local protests touched off over the last few years in response to COVID-related lockdowns; however, demonstrations did little to disrupt Thailand's political structure, policymaking abilities or governance controls. In that sense, we believe political risk in Thailand is low, and political stability should act as a source of support for the baht in times of global market stress. In aggregate, our framework identifies the economic and political mix in Thailand as consistent with a currency that can now come under more pressure than previously.
Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. Customers should be aware that market orders for these new public companies are executed at the current market price, not the initial offering price. Market orders are executed fully and promptly, without regard to price and in a fast market this may result in an execution significantly different from the current price quoted for that security. Using a limit order can limit your risk of receiving an unexpected execution price. Large Orders in Fast Markets Large orders are often filled in smaller blocks. An order for 10,000 shares will sometimes be executed in two blocks of 5,000 shares each. In a fast market, when you place an order for 10,000 shares and the real-time market quote indicates there are 15,000 shares at 5, you would expect your order to execute at 5. In a fast market, with a backlog of orders, a real-time quote may not reflect the state of the market at the time your order is received by the market maker or specialist. Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. Although this article may provide information relating to approaches to investing or types of securities and investments you might buy or sell, Wells Fargo and its affiliates are not providing investment recommendations, advice, or endorsements. Data have been obtained from what are considered to be reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Wells Fargo makes no warranties and bears no liability for your use of this information. The information made available to you is not intended, and should not be construed as legal, tax, or investment advice, or a legal opinion.
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