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Carry Phase in Emerging Markets Is Coming to an End, BofA Says

The "carry trade phase" that dominated this summer is winding down and it’s time to shift to a more conservative emerging markets strategy.

That’s Bank of America Merrill Lynch’s call as some emerging-market and currencies start to look stretched. Investors are "too complacent" about external risks from escalating tensions between the U.S. and North Korea and possibly China, even though the outlook for growth and inflation remains supportive, the bank’s strategists said in a note.

"Geopolitical risks should affect EM through higher risk premium," the strategists wrote, adding that markets continue to price in a modest pace of Fed tightening and a very low probability of a U.S. tax reform anytime soon. "Any surprise on that front also could trigger a correction in EM through higher real rates in the US."

On the positive side, emerging-market economic fundamentals remain supportive, with higher exports driven by recoveries in developed nations, faster growth in Latin America, and developing European nations benefiting from improved activity in the Eurozone. Asia is the only region seen moving in the opposite direction, as growth is expected to slow down through the end of the year amid tighter financial conditions.

To play this scenario, BofA recommends focusing on "idiosyncratic stories" and shifting to a more conservative strategy. Here are the highlights of their positioning:

  • In Asia, bond outlook through year-end remains supportive as inflation absent, recommends long bonds in Indonesia, Malaysia and India
  • In EEMEA, recommends paying 1-year rates in South Africa, long TRY/ZAR, selling GBP/TRY and PLN/HUF
  • In Latin America, recommends short MXN, long BRL, stay overweight on Argentina’s credit
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