Bank of America Merrill Lynch (BofAML) published today its Global Emerging Markets Weekly report, with insights on MENA countries from the bank’s EEMEA Cross Asset Strategist David Hauner.
BofAML ran a multi-dimensional stress test checking for exchange market pressure, external sustainability, exchange rate valuation and leverage.
It received positive results for Azerbaijan, Egypt, Kazakhstan, Nigeria and Ukraine, with negative results for Bahrain, Iraq, Lebanon, Oman, and Zambia.
Several GCC credits appear to be downgrade candidates: Bahrain, Oman and Saudi Arabia.
Many frontier currencies still overvalued
A more fundamental assessment shows that the majority of the EEMEA frontier markets still have overvalued exchange rates.
Bahrain, Iraq, Lebanon and Oman would need to adjust by ten per cent of GDP or more. Several credits would still require an adjustment of at least three per cent GDP: Angola, Egypt, Gabon, Ghana, Ivory Coast, Kenya, Saudi Arabia, Senegal and Zambia.
How does this translate into the FX misalignment? It is difficult to calculate the implied FX adjustment these economies with fixed exchange rates or other major rigidities.
However, based on the elasticities from BofAML’s Compass model for the more liquid EM currencies, a three per cent of GDP adjustment requires on average a real effective exchange rate devaluation by 15 per cent.
Only a few countries have an undervalued exchange rate according to this measure: Belarus, Kazakhstan, Kuwait, Nigeria, Tajikistan, Ukraine and the UAE.
However, note that a country that could borrow more from a sustainability point of view may still face depreciation pressure if investors are not willing to fund the current account deficit for other reasons. We thus also look directly at the valuation of the real exchange rate.
Ratings with downside risks
In this cycle, the average rating seems more likely to weaken than to improve. Russia is the major credit to stand out as under-rated, but the market already prices it as investment grade.
Otherwise, Belarus and Ukraine may have rating upside in line with our forecast. Angola and Nigeria are rated weaker than the macro fundamentals suggest.
In contrast, several GCC credits appear to be downgrade candidates: Bahrain, Oman and Saudi Arabia, where the bank believes there is risk of further rating downgrades.
Don’t be a frontier fashion victim
The EM bull market that the bank predicted for 2017 is well on the way and frontier markets are catching a bid. The experience from previous late-cycle episodes argues for going with the fashion to some extent but also for avoiding credits that are most vulnerable to an eventual downturn.