With recent volatility recalling memories of autumn 2008, the way forward is very unlikely to be either straightforward or smooth. However, while the present investment environment is difficult it offers potentially large gains. More than usually, timing is everything. Our investment strategy assumes no quick fix to the complex of interrelated economic, financial and political challenges facing especially (but not exclusively) the Euro-zone. The entire “food chain” of the debt crisis now lies in the open while markets (not unreasonably) doubt the capacity of policymakers to deliver solutions, with fiscal and monetary options all but exhausted. Crisis awareness is, however, increasing. Our main scenario assumes that satisfactory solution(s) will be engineered capable of preventing a renewed OECD recession. Risk appetite is therefore likely to stabilize during Q4 paving the way for a recovery in sentiment. By that time, we expect very attractive entry opportunities for medium- to long term investments in EM assets. However, investing now runs the risk of trying to catch falling knives. While we argue that the market’s retreat from EM assets over the past two weeks has left the space ripe for correction, policymakers are unlikely to devise satisfactory answers to present complex problems over the next month or so. We therefore expect dominant market drivers to be liquidity and position squeezing. When financial stress is high, as now, we believe the market is basically immune to both absolute and relative improvements in EM fundamentals.
Our qualified guess is that we should expect a correction in the very near term, high volatility with a clear risk-negative bias over the next 1-2 months, and gradually improving risk appetite during the coming 1-2 quarters. We are therefore shooting at moving targets. Given current uncertainty and volatility in financial markets we have shortened this report’s primary investment horizon from 3-6 to 1-3 months. From that perspective, we prefer developed (DM) vs. emerging markets (EM), and bonds vs. equities. We also recommend hedging EM currency risk despite the high costs involved. In the fixed income space we suggest selling highly vs. lowly indebted sovereigns such as Hungary vs. Lithuania. We reallocate defensively in our EM local debt portfolio and present an attractive curve play in Turkey. Within equities, we favour those markets with a large domestic economy, preferring India and Brazil while avoiding Mexico and South Africa. In the FX area we have taken profit on our long USD/BRL position initiated on August 8 but look to buy USD/CEE on dips. We prefer going long SGD/HUF as a less volatile relative play on differences in expected regional endurance and recommend selling USD/CNH 1Y fwd. Finally, we suggest a USD/MXN put spread as a general hedge in case markets should experience a sustained rally within the next months.
EM FI – HIGH VOLATILITY, LOWER CORRELATION
Recent volatility in financial markets has heavily impacted EM bonds. With EM bond movements unusually out of synch with equities, a trend of decoupling from riskier assets may be emerging. Volatility is however strong enough to urge caution.
EM EQ – PLAYING A WAITING GAME
At times of extreme financial stress investors tend to stay close to home. This is clearly the situation today with large outflows from EM equities following a switch from conviction selling to position selling. Though EM equities look cheap in both absolute and relative terms we fear it is still too early to aggressively buy and hold; better opportunities come later.
EM FX – IT’S ALL ABOUT CHANGING DRIVERS Solid fundamentals provide little shelter when liquidity and position squeezing drive the market. While a correction may be imminent cheap currencies are set to become cheaper. Progressively this autumn, the market will find other drivers much more favourable to EM FX.
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Skandinaviska Enskilda Banken AB