By Srinivasan Sivabalan
UBS recommends investors hedge against currency devaluation in emerging markets such as Brazil in the face of the impasse over the US debt ceiling, even if a deal is reached in time to avoid a technical default.
But if the fiscal disagreement between Democrats and Republicans in Washington drags on, developing country currencies will likely fall as much as 10% after a strong start to the year, the Swiss bank strategists warned.
With high carry trade costs – the strategy of taking money in low-interest markets and investing in others with higher rates – and new concerns about global trade, the risk reward of currencies is “far from attractive,” said the bank’s strategists, including Manik Narain and Rohit Arora.
Emerging market currencies tracked by an MSCI gauge recorded their best year-to-date performance since 2017, up about 7% from last October’s lows.
Volatility in the FX options market is near a 15-month low, and carry trades are headed for a third straight month of gains.
But that phase is about to end, UBS said.
“Our short-term models have shown that emerging market currencies are extraordinarily expensive relative to other asset classes,” the strategists wrote.
On the other hand, UBS said equities in emerging nations could outperform developed markets if the bank’s pessimistic bet on US equities comes to pass, the strategists wrote.
STRATEGISTS’ PREFERRED TRADE
In developing countries, UBS’s preferred asset class is local currency bonds, with strategies that include currency protection due to higher real interest rates.
UBS expects currencies to “enjoy only a modest, short-lived recovery if the US debt ceiling is raised in time.”
The Brazilian real, Indian rupee, Colombian peso, and Polish zloty will outperform.
However, the market will soon focus on the weakness of global trade and the limited risk premiums of currencies.
UBS recommends using the rally to build long dollar positions, especially against the yuan, Chilean peso, Mexican peso, and South African rand.
In case of a short delay in raising the US debt ceiling, volatility will increase, and currencies popular for the carry trade in Latin America and Eastern Europe will underperform.
If the impasse lasts a month, this phase could be “marked by a rapid onset of a recession in the US and a lack of timely fiscal stimulus,” strategists said.
Emerging market currencies could fall as much as 10%, while stocks could fall as much as 25%.
Even investment-grade bonds will underperform.
With information from Bloomberg
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