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EM hit as Brazil bears brunt of investor unease

A new corruption scandal in Brazil sliced more than 7 per cent off the value of the real, as emerging market currencies suffered from investor unease over China as well as US economic prospects in relation to Donald Trump’s troubled presidency.

Investors have this year been rallying behind EM forex, but Thursday’s falls in the South Africa’s rand and Mexico’s peso of more than 2 per cent and 1.8 per cent in Turkey’s lira, as well as the real’s fall, underlined how quickly market sentiment could shift for the sector.

“EM FX is succumbing to the growing risk-off sentiment in the markets,” said Win Thin at Brown Brothers Harriman.

The real fell to R3.36 at the opening of São Paulo markets, coming under pressure after a report in a leading Brazilian newspaper embroiled president Michel Temer in bribery allegations, putting his reform agenda in jeopardy.

More broadly, EM forex was undermined by markets becoming unsettled by Washington ructions, which have been pulling the US dollar lower.

Dollar declines normally benefit EM currencies as investors seek out high-yielding assets, but Kamakshya Trivedi of Goldman Sachs said risky assets such as EM were coming under pressure from “a classic volatility shock”.

The latest Brazilian scandal was “a reminder of political risk that is a feature of EM investing”, Mr Trivedi added.

Political developments in Brazil were “adding fuel to the fire” in EM, said Mr Thin, while the peso’s fall suggested it was being used as a proxy for general market sentiment towards EM.

The peso’s fall came amid expectations that the US would send formal notification to Congress that it was negotiating the North American Free Trade Agreement, triggering the start of talks with Nafta partners Canada and Mexico.

Citigroup analysts trimmed their exposure to long EM forex positions. “As much as we believe the degree of panic in the market is exaggerated, there is now a clear crescendo in the amount of noise in the markets,” they wrote.

Market noise is rising around the reflation trade because of creeping doubts about growth in China and the US. Global growth was seen as “a good thing” for EM, said Jane Foley at Rabobank, even if that meant rising interest rates in the US that tend to drive EM forex lower.

“But if you’re hiking interest rates against the backdrop of more wobbly data, it’s more difficult to pass that off as a positive thing for emerging markets” Ms Foley said.

China was causing concern about the size and pace of debt, the lack of jobs growth in the private sector and slowing commodity purchases.

“China is the biggest consumer of commodities, so any sniff does feed back to the EM world quite quickly,” Ms Foley said.

Investors should remind themselves that current risk aversion did not alter improving macro fundamentals in EM, said Mr Trivedi.

“They are significantly better than they have been for a couple of years. Growth is recovering. “It is premature to conclude that this is the end of the EM rally,” Mr Trivedi said.

Bank of America Merrill Lynch said markets had taken up long positions in EM this year. While staying positive on EM because valuations remained cheap, BofA said investors should be selective because of the risk of a correction.