Strategist David Zervos Is Recommending Emerging Markets for the First Time Thanks to 'Currency War Truce'

Central bankers rescued the asset class.

You can count Jefferies Chief Market Strategist David Zervos among the investors who thinks this emerging market rally has legs.

A cautious Fed, a rebound in oil prices, strong inflows, and country-specific factors like Brazil's seeming move to stamp out corruption, helped the MSCI Emerging Markets Index outperform its all-world counterpart and the S&P 500 in the first quarter of 2016.

EM Winners
Source: Bloomberg

In a note to clients, Zervos announced that he was taking profits in his "Spoos and Blues" trade (long U.S. equity futures and Eurodollars) and deploying some of those proceeds in call options for the exchange-traded fund that tracks the MSCI Emerging Markets Index.

This marks a shift for the strategist, who has not recommended emerging market assets while at Jefferies, suggesting that the reflationary monetary policies pursued by the Federal Reserve, Bank of Japan, and European Central Bank would hamper growth in developing countries.

What changed his mind? A show of supposed coordination by these same central bankers in the first quarter—the BoJ and ECB seemingly prioritizing credit creation over currency depreciation, and the Fed's concern over the lofty greenback—that prompted some analysts, including Zervos, to conclude that some form of Plaza Accord 2.0 had been reached at the Group of 20 meeting in Shanghai.

"If the concept of a truce in the developed market currency war is for real (as I have been arguing since 19-Feb-2016), then the biggest beneficiary will be emerging markets," he explained. "The worst thing for emerging markets would be USDJPY at 140, EURUSD at 90 and the DXY at 120. The Europeans and Japanese would be stealing EM growth, and the US would be forcing all the USD liabilities in EM capital markets to rise in value — a toxic combination."

Instead, G3 central banks have brought returned stability to emerging markets and equity markets more broadly. In the process, implied equity volatility has also collapsed, which makes buying call options for the emerging markets and S&P 500 exchange-traded funds particularly attractive, according to Zervos.

"Both EEM and Spoos should be the largest direct beneficiaries of the currency war truce, while the Europeans and Japanese will need to get quite creative with central bank balance sheets in order for their capital markets to thrive in this brave new world," he concluded.

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