* After trending sideways for most of the year, emerging market (EM) currencies have come under pressure in May from the escalation in trade tensions between the US and China. The benchmark ELMI+ index is down 1.7% from a recent high in March.

* But the recent developments on trade are already reflected in EM currencies. Our base case is that a US–China deal will eventually be reached, so we think that select EM currency spot prices are attractive in an environment that offers the potential to harvest interest rate carry.

* Following the dovish pivot of central banks earlier this year, we expect accommodative monetary policy to become more entrenched globally in the coming months – i.e. the Federal Reserve to stay put and the European Central Bank and Bank of Japan to delay tightening plans. We also expect the Reserve Banks of Australia and New Zealand to cut interest rates further before the end of the year. This dynamic benefits EM currencies directly (by making their interest rate carry look more attractive in relative terms) and indirectly (lower global benchmark yields mean cheaper funding in hard currencies, reducing the pressure on public and corporate finances).

* Some EM currencies face idiosyncratic political and policy risks, so we recommend long exposure to selected currencies rather than a broad index. We think the outlook for the South African rand has improved given the potential for a renewed focus on structural reforms after the African National Congress won the general election in May. Pro-reform governments also retained power in elections in Indonesia (April) and India (May). We also like the domestic demand-oriented nature of the Indonesian and Indian economies, which insulate them somewhat from further global trade protectionism.

* In our view it is prudent to use funding currencies that are likely to mitigate sensitivity to risk-off events. We choose currencies that should react negatively to deteriorating global and China-related dynamics and also have a low interest rate carry. We believe the Taiwanese dollar is particularly vulnerable to further escalation in US–China trade tensions. The Australian and New Zealand dollars are cyclical currencies that tend to suffer during periods of risk aversion and are heavily exposed to shifts in Chinese growth and trade flows. Also, while they might depreciate in a risk-off scenario, they might not appreciate much in a risk-on scenario, given we expect the RBA and RBNZ to cut rates this year. This makes them good candidates for short exposure. We recommend holding a diversified position consisting of a long basket of select high-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) funded by a short basket of low-yielding, high-beta currencies (the Australian dollar, the New Zealand dollar and the Taiwanese dollar).