In recent years, economists have had a thing about easily pronounceable acronyms for groups of countries in similar situations. It started with the fast-growing emerging market BRICs—Brazil, Russia, India, China, and South Africa—and continued with the heavily indebted euro-area group known as PIIGS—Portugal, Italy, Ireland, Greece, and Spain. Last year, when investors began worrying about Brazil, India, Indonesia, Turkey, and South Africa, an apt acronym didn’t jump to mind. So they got a more prosaic appellation: “the Fragile Five.”
The five share an overreliance on foreign capital, a tendency that emerged as a potential problem when news of the U.S. Fed’s plan to reduce asset purchases began fueling capital outflows from emerging markets last May. Concerns grew in January and February of this year, when a combination of Fed tapering and slower growth in China sparked a selloff of emerging market currencies and stocks that had investors drawing parallels to the 1997 Asian financial crisis.
Fast-forward two months, however, and those countries’ currencies are looking anything but fragile. Bloomberg’s index of 20 developing-country currencies has fully regained its losses from earlier this year. By April 10, the Turkish lira had surged 10.2 percent from its 2014 low on January 24, the Brazilian real 9.8 percent from February 3, and the Indonesian Rupiah 7.2 percent from January 27. And the South Korean won is at its strongest level against the dollar in more than five years.
This reversal has helped fuel a comeback in the carry trade. According to Credit Suisse, the Fragile Five countries now boast five of the six most attractive emerging market carry-to-volatility ratios, an indicator that measures the attractiveness of a carry trade given its underlying risk. “The fragile five could transition into the formidable five,” analysts Ray Farris and Trang Thuy Le wrote in a recent report entitled “Carry Back in Fashion, But For How Long?”
Why the quick turnaround? Most importantly, the fundamentals look good. At the height of the emerging markets rout in February, we wrote that a full-blown crisis was unlikely because developing economies were stronger than in previous panics. This is still the case. Emerging markets have lower levels of external debt (25 percent of GDP compared to 40 percent in the 1990s), healthier trade balances, and higher levels of foreign exchange reserves (30 percent of GDP compared to 10 percent in the 1990s).
Another factor is that long-term U.S. yields have been more stable than markets appear to have been anticipating. Yields increased last month after Fed Chair Janet Yellen suggested policymakers could raise interest rates as early as the spring of 2015. But subsequent assurances by Yellen that the central bank intends to keep rates low for quite some time have eased concerns of a sooner-than-expected rate hike. At the same time, some emerging market central banks, such as South Africa and Turkey, have raised interest rates this year, making their currencies more attractive relative to near-zero U.S. rates. Finally, global business activity, as measured the Purchasing Managers’ Index, grew in the first quarter, helping emerging market sentiment.
If U.S. yields stay steady, Credit Suisse sees potential outperformance by the Russian ruble and Turkish lira among emerging market currencies in Europe and the Middle East. Russia’s fourth-quarter current account surplus was revised upwards while Turkey’s foreign trade deficit was narrower than the market expected, and both of their central banks have tightened significantly. Any signs of easing by policymakers would jeopardize that outlook, although that looks unlikely to occur in the coming weeks, according to Credit Suisse. Turkey’s trade deficit was narrower than expected in February
In Latin America, Credit Suisse is bullish on the currencies of both Mexico and Colombia. The Colombian peso is attractive in part because JPMorgan increased the country’s weight in two of its local-currency bond indices, a move that should fuel more demand for its bonds and thereby increase currency inflows. As for Mexico, the country’s strong credit standing makes its peso attractive. In Asia, the South Korean won seems likely to continue to shine. The Indian rupee, while currently attractive, is also more vulnerable to an eventual increase in U.S. yields.
Credit Suisse does offer a note of caution: there may not be much life left in the carry trade, as U.S. rates are still expected to start heading upward at some point in the coming months. The bank expects yields on 2-year notes to rise to 0.5 percent by summer (up from 0.36 percent on April 9), and 10-year yields to increase to 3.1 percent from 2.7 percent. “That suggests the need for caution in chasing the carry trade,” say Farris and Le. But not to eschew it entirely.
Above: As emerging market currencies have rebounded, the carry trade has come back in style.