Professional Documents
Culture Documents
EM FI Enjoys macro support EM Equities Cheap could get cheaper EM FX Buy options now, spot later
4 JUNE 2012
Contents
General backdrop: Binary risks looming relief ................................................................................................................................... 4 Financial gains evaporated ................................................................................................................................................................. 4 Global economy set to avoid a recession.......................................................................................................................................... 4 Sharply lower inflation enables policy flexibility .............................................................................................................................. 6 Political risks.......................................................................................................................................................................................... 8 Eastern Europe vulnerable to deleveraging ...................................................................................................................................... 8 EM bond fund flows resilient............................................................................................................................................................... 9 The long-term case for EM......................................................................................................................................................................11 Fixed Income: Supportive macro .......................................................................................................................................................... 16 Lower inflation supports local bonds............................................................................................................................................... 16 Structural case intact ......................................................................................................................................................................... 16 Eurozone still a risk for EM ................................................................................................................................................................ 18 Inflation outlook revised down ......................................................................................................................................................... 19 Good environment for bonds in high-inflation economies .......................................................................................................... 19 Equities: Cheap to become even cheaper............................................................................................................................................ 23 EM equity flows................................................................................................................................................................................... 25 Valuation ranking model ................................................................................................................................................................... 27 EM vs. DM, P/E discount.................................................................................................................................................................... 27 Technical Analysis MSCI EM Index (USD).......................................................................................................................................28 Currencies: Potential for major recovery in Q3 ................................................................................................................................... 30 EM FX look cheap in trade weighted terms..................................................................................................................................... 30 EM FX drivers ahead........................................................................................................................................................................... 32 External financing vulnerability ........................................................................................................................................................ 33 SEB EM FX forecasts........................................................................................................................................................................... 35 Investment strategy ........................................................................................................................................................................... 35 Cautious near term trade it through options............................................................................................................................... 35 Still a bumpy road ahead ................................................................................................................................................................... 36 How to trade it .................................................................................................................................................................................... 36 Cut-off date: 1 June, 2012
Editors: Mats Lind Mats Olausson Contributors: Julius Duksta Dag Mller Jurgis Rosickas Anders Sderberg The long-term case for EM: Kristina Styf SEB X-assets Research Contacts: see page 43.
320 300 260 240 220 200 MSCI EM GBI-EM 180 160 140 120 GBI-EM Div. Global (Local Bonds) 280
currencies that we often refer to is down by 2.1% vs. USD YTD after having lost a massive 6% during May.
1400 1300 MSCI-EM (Equities) 1200 1100 1000 900 800 700 600 500
Source: Bloomberg
320 300 260 240 220 200 MSCI EM GBI-EM 180 160 140 120 GBI-EM Div. Global (Local Bonds) 280
With the benefit of hindsight, we overestimated the positive impact of the ECBs two LTROs and underestimated the risks posed by Greece at the time of our last EMXA report. Spains (probable) journey towards a bail-out package is, however, consistent with our long held expectation.
others too, current high indebtedness implies relatively restricted room for manoeuvre. Further, the EUs new Fiscal Compact will also set clear boundaries.
Home prices, S&P Case-Shiller (LHS) Household debts as a percentage of income (RHS)
Source: Standard & Poor's, Federal Reserve
Going forward, we expect global growth to fall below a bit below trend this year and to rise just above next with our forecasts at 3.4% and 4.0% respectively in purchasing power parity (PPP) terms. The improvement in the US economy last autumn appeared to be spreading to other countries at the end of last year and the beginning of this. This perception obviously invigorated the market rally in January. However, it failed to follow through in March and especially April. Our own SEB EM Surprise Indicator, for example, shows a sharp drop.
SEB economic surprise indicator, Emerging markets
1.0 0.5 0.0 -0.5 -1.0 -1.5
3-month average
30 25 20 15 10 5
ECB
Bank of England
Federal Reserve
Source: ECB, Fed, Bank of England
05
06
07
08
09
10
11
12
Overall, the global economy is weak. Further economic policy stimuli will dampen the effects of continued deleveraging. We still believe the global economy can avoid recession. Worldwide growth increasing from just below to just above trend appears reasonable based on positives such as the fact that many EM and Northern European economies are fundamentally sound and that many companies enjoy very strong balance sheets.
with China at 8.1% and India at a nine-year low of 5.3%. Further, Q2 PMIs generally declined, particularly in China.
followed by sequentially improving momentum from August through the end of the year. Significantly however, this still comfortably qualifies as a soft landing with EM growth of 7.3% in 2010 partially reflecting base effects from the very weak performance in 2009 and 6.2% growth reported in 2011 still benefiting from overall lax policy prescriptions.
SEB GDP forecasts
2010 China Indonesia India EM Russia Mexico World (PPP) South Korea Poland South Africa Turkey Brazil Ukraine Singapore Lithuania Latvia Iceland OECD Estonia Romania Czech Rep. Hungary 10.4 6.2 10.6 7.3 4.0 5.5 5.3 6.3 3.9 2.8 9.2 7.5 4.2 14.8 1.4 -0.3 -4.0 3.1 2.3 -1.7 2.7 1.3 2011 9.3 6.5 7.2 6.2 4.3 3.9 3.9 3.6 4.3 3.1 8.5 2.7 5.2 4.9 5.9 5.5 3.0 1.7 7.6 2.5 1.7 1.7 2012 8.1 6.0 6.0 5.2 3.8 3.5 3.4 3.5 3.1 3.0 3.0 2.9 2.9 2.7 3.0 2.5 2.5 1.6 1.5 0.5 -0.2 -1.0 2013 8.4 6.5 6.6 5.7 4.1 4.0 4.0 4.0 3.6 4.0 4.5 4.3 4.0 3.9 3.5 4.0 3.1 2.1 2.5 2.5 2.0 1.5
The stabilisation/bottoming out that we expected during Q1 now looks more likely to occur in Q2. We have therefore downwardly revised our respective full year 2012 and 2013 growth forecasts for China (to 8.1% from 8.5%; 8.4% from 8.7%) and India (to 6.0% from 7.0%; 6.6% from 7.3%). We have also slightly lowered our Brazilian GDP estimates due to weaker than expected data at the beginning of the year. We now expect growth to increase only slightly from 2.7% in 2011 to 2.9% (previously: 3.5%) this year with recent major stimulus measures impacting in 2013 when growth will accelerate to 4.3% (same as before). Our forecasts for many other countries remain unchanged. This is the case for Russia but we have downgraded our growth forecasts for Ukraine.
BRICS PMI manufacturing, SA
70 65 60 55 50 45 40 35 Jan Mar May Jul 11 Sep Nov Jan Mar 12 70 65 60 55 50 45 40 35
India 50
Brazil China,Official
Source: Reuters EcoWin
Our expectation that growth momentum will improve from H2 2012 is based on the belief that more stimulative policies in countries such as China and Brazil are progressively implemented. Overall, EM growth appears more likely to bottom out in Q2 rather than Q1 2012, which is more consistent with the implications of our Global Leading Economic Indicator, GLEI, developed by Mattias Sundbom. The GLEI points to continued weakness in the very near term to be
policies arise. Furthermore, the supply situation is benign going forward. For foodstuffs, most La Nina effects have according to forecasters dissipated while inventories have greatly improved. As regards crude oil, the Iranian situation still represents a risk.
SEB forecasts of policy rates until Q1 2013, %
May, 2012 EMEA Poland Czech Hungary Turkey 1W Turkey O/N S. Africa Romania Russia LatAm Brazil Mexico Asia China China RRR Korea India Indonesia 8.50 4.50 8.00 4.50 7.50 4.50 7.50 4.50 7.50 4.50 7.50 4.50 4.75 0.75 7.00 5.75 11.50 5.50 5.25 5.25 4.75 0.75 7.00 5.75 11.50 5.50 5.25 5.25 4.75 0.25 7.00 5.75 11.00 5.50 5.25 5.25 4.75 0.25 6.50 5.75 10.25 5.50 5.25 5.25 4.75 0.25 6.00 6.25 9.50 5.50 5.25 5.50 4.75 0.25 6.00 6.50 9.00 5.50 5.25 5.75 Q2, 2012 Q3, 2011 Q4, 2012 Q1, 2013 Q2, 2013
Consequently, EM assets generally look cheap. However, this does not in any way rule out the possibility that they may become even cheaper. Certainly, the near term outlook is very likely to be governed by developments in Athens, Madrid, Brussels and Frankfurt. In particular, the Greek election on June 17 has the potential to trigger significant positive or negative changes in EM asset valuations. Victory by parties that reject the bail-out package could trigger an uncontrolled break-up of the Eurozone creating a flight to liquidity reminiscent of the post-Lehman period. EM assets would suffer considerably in such a scenario.
Positively however, Saudi efforts to increase oil supply to maximise the effect of sanctions against Iran have been successful supported by Libyan and Iraqi developments. According to our main scenario, crude oil prices will increase only slowly going forward, while food prices will continue to fall.
but our main scenario is EM bullish over the next 3-6 months
Given current market pricing, a victory for Greeces previous pro-austerity coalition parties ((New Democracy and PASOK) should pave the way for a substantial relief rally. Towards the end of June and no later than Q3 we expect four factors to provide further momentum to such a recovery: Additional support for peripheral Europe US QE3 Accommodative Chinese economic policies A turnaround in leading indicators, however shallow, in August (SEB proprietary GLEI-indicator).
Regarding support for Europe, we expect Spain to receive EUR 150bn intended to bolster its banking system. Cyprus is also expected to apply for and receive financial support from the EU and IMF while Portugal and Ireland are likely to receive somewhat leaner repayment conditions. Meanwhile, we do not expect the new French president to rock the boat by implementing any destabilising reforms. His emphasis on shifting policies from austerity to growth will, however, be recognised by strengthening European Investment Bank resources with a further EUR 50bn, to be leveraged up to EUR 300bn, at least in our opinion.
In the US, a third round of quantitative easing this fall looks likely as Operation Twist ends, inflation risks remain remote, and the labour market recovery loses traction (see Nordic Outlook from 8 May). A policy shift is due in China with recent developments arguing for a shift from fighting inflation to supporting growth. We expect authorities to implement wide ranging monetary and fiscal policies although less so than in 2008/09. It will, however, suffice to engineer a soft landing, evidence of which we expect to see in Q3 (see our Strategy Focus EM from 24 May). Finally, leading indicators have been bearish to mixed following signs of improvement late last year and during Q1 in many EM. Our leading indicator on the OECDs own leading indicator (GLEI) has still pointed to a turnaround, however shallow, in August. However, it will be insufficiently strong to cause the indicator to show expansion before the end of this year. In other words, we should expect a slowdown tending to bottom out but not before the end of the forecast horizon.
could be interpreted as an increased threat to extend its nuclear program beyond its civilian capabilities. In part at least, it is reassuring that the position has so far been contained. Sanctions against the country have effectively hindered their efforts. Still, the situation will remain fragile going forward. The political window for military action against Iranian sites will not be closed before the end of the summer. Thereafter, the US election campaign enters its final stages making a strike less opportune. Crude prices have declined despite the embargo against Iranian oil having been put in place.
Political risks
Political risks have moved further up the agenda in China with the purge of influential Chongqing major Bo Xilai from the countrys political scene. Rather than being a part of a popular unrest indicating or driving potentially adverse economic outcomes, this should be seen more as an intrigue within the highest echelons of the Party. As such, its economic consequences should be limited. It nonetheless stands by its mandate to deliver continuous strong growth, a task to which it will remain strongly committed. From a general perspective, the risk of widespread instability in EM has decreased as food prices have fallen. Ongoing normalization of crops should continue according to our forecasts, representing a key positive for the region. Nevertheless, countries such as Romania and Serbia are experiencing a combination of economic pressure and post election political tensions. Meanwhile, recent opinion polls in the run-up to the Mexican presidential election have shown that the PRDs candidate narrowed the gap to the PRIs Pea Nieto, a development badly received by markets. Nevertheless, we still believe Pea Nieto will win the election on July 1. In Russia, Vladimir Putin has been reinstalled as President. While we expect the status quo to be largely maintained concerning both economic and political reforms, risks are probably biased to the downside. In conclusion, the key risks to EM in coming quarters are as follows: Eurozone crisis escalates Middle East tensions trigger an oil price hike Food prices turn around and rise substantially, depriving EM central banks of room for maneuver Political risks
economies heavily dependent on foreign banks at a time when they are seeking to improve financial ratios. The results of targeted de-leveraging could have highly adverse consequences. Also, borrowing may become more difficult in the event of a disorderly Greek exit from the Eurozone. IMF calculations based on official leverage targets from European banks produced fairly bearish conclusions reported in its Global Financial Stability Report (April). According to the IMF, the most vulnerable countries are Hungary, Poland and Turkey. If capital inflows to EM economies were to reverse as they did post-Lehman, the IMF estimates that their currencies might depreciate vs. USD by 15% per annum. A slightly more positive message was issued concerning EM funding by the banking industry organisation, the IIF. According to its EM Loan Survey in Q1, an EM counterpart to the Federal Reserves Senior Loan Officer Survey in the US, banks are now more willing to lend. However, loan demand from clients has declined, according to the survey, a worrisome development indicating that the impact of stimulative monetary policies is weakening. To help the economy, fiscal policies must fill this void, substituting private demand for funds and investments. However, fiscal room for manoeuvre is limited in several of the worst hit economies. In EM giant China, however, we expect continued cuts in reserve requirement ratios for banks and a rate reduction in Q3 to be complemented by a more accommodative fiscal policy.
Regionally, outflows have been reported by EMEA bond funds so far this year while Latin America and Asia have continued to attract high levels of investment. Furthermore, in recent weeks, flows have increasingly switched from EM Asia bond funds to their Latin American counterparts.
% AUM
60 50 40 30 20 10 0 19/01/2011 30/03/2011 08/06/2011 17/08/2011 26/10/2011 04/01/2012 -10 -20 -30 Source: EPFR 14/03/2012 23/05/2012
09/05/2012
However, during the week ended May 30, EM bond funds posted their third biggest weekly outflow YTD. Absent decisive action by European policymakers, fund investors have continued to reduce their exposure to higher risk asset classes, while downgrading their expectations and looking ahead to Greeces new elections on June 17. Flows into bond funds, which usually remain more resilient to market turmoil, lost momentum as safe haven demand drove US and German debt prices even higher and investors reduced exposure to several riskier fixed income asset classes.
USD bn 6.00 5.00 4.00 3.00 2.00 1.00 0.00 15/02/2012 25/01/2012 28/03/2012 07/03/2012 -1.00 -2.00 -3.00 30/05/2012 18/04/2012 04/01/2012 EM Equities EM Bonds
Source: EPFR
18 15 12 9 6 3
Source: EPFR
During the week before, high yield bond funds reported their biggest outflow in more than nine months at over USD 3bn, becoming the worst performing asset in the Bond Fund category. At the same time, EPFR-tracked EM bond funds posted a total outflow of USD 0.48bn while EM equity funds suffered a loss of USD 1.55bn. EM bond fund redemptions were evenly divided between local and hard currency mandated funds.
bn USD
Asset allocation next 3-6 months and key message each asset class
For EM asseets in general we see large downside risks. At the same time, there are good fundamental value in many markets and a good medium term return potential. Our recommendations imply a low allocation to riskier assets for now, while at the same time maintaining a readiness to expand exposures if the risk picture would improve. Looking at the least risky assets in our universe, the currency-hedged local bond yields, we maintain a constructive veiw. Going into FX, we are more cautious even though we look to buy downbeaten currencies. Option strategies to hedge against adverse scenarios are our first recommendations there. In equities, we warn against getting trapped into strong values that soon might find themselves even stronger; again our recommendations are on a look to buy basis. While being cautious on Europe for all asset classes, we favour Asia in equities. Brazil and Indonesia look attractive both from a yield and currency perspective, while we look positively on Chinese equities. So, while repercussions from the Eurozone debt crises periodically triggers substantial outflows from EM funds and EM countries in general, we firmly maintain our long term bullish view on this part of the world. In the following section we present the findings of a recent study by our colleagues at SEB X-assets Research looking at The long term case for EM with implications for asset allocation in EM.
12
EM Bonds
8 4 0
30/04/2011 30/06/2011 31/08/2011 28/02/2011
EM Equities
31/10/2011
31/12/2011
Source: EPFR
Superficially, the current situation may appear similar to the sell-off that occurred last August and September when EM equity funds suffered severe outflows and even bond funds faced losses. However, current withdrawals are far smaller with last years mass exit impacted by investors reacting to the recent US sovereign debt downgrade, persistently high oil prices, the aftermath of the Japanese earthquake and tsunami, and of course the Eurozones escalating debt problems.
USD bn
Source: EPFR
30/03/2011
08/06/2011
17/08/2011
26/10/2011
04/01/2012
14/03/2012
-2.0
Since our last EMXA in February, hard currency bond funds have been in high demand, attracting flows of around USD 3bn, compared with USD 0.2bn and USD 0.4bn by local and blend currency funds, respectively, with a few interim weeks posting net outflows. Hard currency funds are likely to continue to attract higher flows for some time yet provided investors maintain their preference for liquidity over carry. With EMEA remaining at greatest risk of contagion from the European credit crunch we retain our cautious view on the region. However, as Spanish problems are increasing, Latin Americas relative attractiveness may also be hurt. We expect Asian bond funds to continue to attract inflows, particularly given the regions relatively greater resistance to slowing global growth, and its geographical distance from the epicentre of the highly problematic Eurozone debt crisis.
23/05/2012
30/04/2012
29/02/2012
10
Upside
Carry countries have relatively weak fundamentals, but also substantially higher yields to compensate for the risks, G7 currency war losers countries have the same kind of weak fundamentals as the Carry group, but without the high yield. Upside countries have strong fundamentals accompanied by lower yields. These countries have significant appreciation potential the day the rebalancing process begins in the G7 countries. Transition countries are in between the two other groups, but their problem is too little carry and not enough upside.
2011 10Y yields & 1996-2011 inflation
35% 30% 25%
1996-2011 inflation
Turkey
20%
Russia
Meanwhile, creditor countries now feel the side effects of holding exchange rates and interest rates too low for too long: high inflation, property bubbles, debt crises and misallocation of capital. This will eventually force them to let G7 currencies go if the G7 central banks keep printing money. The end result is likely to be a currency crisis, but we dont know when: economists have called the imbalance unsustainable for years. Until G7 currencies have been devalued, zero rates will increase the attraction of higher rates in currencies with weak fundamentals. For now, both arguments work but they work in different ways.
8%
10%
12%
Three groups
Not all emerging market countries are equally exposed to both types of return potential. In order to get building blocks to structure we group the universe into three emerging market groups: those with carry, those with upside potential and those in between. Fundamentals and pricing of risk underpin ranking countries in terms of global currency and bond market. The chart below shows accumulated current account and budget balance for the past 11 years and bond yields at the end of 2011. Based on shared characteristics we can group the countries into three broad types of exposure.
The difference between the groups is also evident in inflation history. In the past, many emerging market countries have experienced currency crises followed by high inflation and bond yields. Since then, structural reforms and more sound fiscal management have over time contributed to a more stable economic outlook. Current low bond yields for Upside countries are a result of a long period of low inflation and strong internal and external balances, and entering this group will thus take a long time.
11
We include Nordic currencies as a reference as they are the developed market equivalent to the Upside group.
Money market risk and return, real USD, 2000-2011
10% 8% 6% Real return
Carry: India, Brazil, Turkey, South Africa, Russia Transition: Mexico, Poland, Chile, Indonesia Upside: China, Singapore, South Korea, Taiwan, Thailand, Malaysia
Carry
-5%
Average 2000
-10%
Average 2011
Upside ex China
Sin
2000
2011
The question going forward is whether the current low interest rate environment will offer a risk premium. With most countries reducing their interest rates over the last couple of years investors might expect carry to have come down. Comparing carry in 2000 with carry in 2011 it is evident that the risk premium was actually lower in 2000 with most countries paying higher carry in 2011. With current US interest rates close to 0%, carry can virtually only be positive. It is not possible to reflect appreciation potential with negative carry in this kind of environment.
2000 and 2011 10Y yield spreads relative to US
14% 12% 10% 8% 6% 4% 2% 0% -2% -4%
Average 2000 Average 2011
0%
2%
4%
6% Standard deviation
8%
10%
12%
Over the last 10 years investing in money markets outside US has involved higher risk, but also higher returns. Both return and risk increases as we move from Upside to Carry and the differences are significant: Carrys risk is almost twice as high, but the annual return is 7% higher. Nordic currencies have in fact been more volatile in USD terms than all EM groups, with a return in the low end of the range. An investor afraid of a G7 debt crisis should thus consider if capital protection from Upside will add risk at low returns for longer than he or she is prepared to wait: the longer it takes, the more attractive the direct returns from Carry look. But the historical data obviously fail to capture the missing carry argument: if currencies are likely to rise over time, even a carry of zero would suggest a long-term return well above the historical one. And with US rates at zero, there carry must be at least zero.
Ch in Sin a* ga So por ut e h Ko re a Ta iw an Th ail an d M ala ys ia M ex ico * Po lan d Ch In i do le ne sia * In di a Br az Tu il r So key ut * h Af ric a Ru ss ia*
2000
*From: China: 2002, Mexico: 2001; Indonesia: 2004, Turkey: 2005, Russia: 2003
2011
Source: Ecowin , GFD and SEB X-asset
Another consequence of more stable economic outlooks are lower bond yields. As with carry, the bond yield risk premium is a relative game and with very low US bond yields the risk premium in bond spreads still exists. Average yield spreads at the end of 2011 were at the same level as in 2000.
12
20%
10%
0%
excess return is small. Carry has experienced close to equity like risks, but also a return close to normal equity market returns and far above the realised US equity return. Of course, the same argument applies here as in money markets when it comes to the long-term return potential of the Upside group.
Emerging market risk and return, real USD, 2000-2011
-10%
15%
-20% Early recession US T-bills Transition Late recession Upside Carry Early expansion Late expansion Upside ex China Nordic money market
Carry Transition Carry
10%
Carry
Transition Nordics
Real return
Early recession is the worst phase from an investment perspective, with elevated volatility and large losses from risky assets. A cyclical safe haven, like US, has its losses distributed to other phases than early recession. Emerging market money markets have their largest losses concentrated to early recession and are obviously not safe haven investments from a cyclical point of view. Decomposing money market returns into the underlying components we find that emerging market exchange rates are cyclical which shines trough in the stratgic money market results.
Tactical money market returns, real USD2000-2011
25% 20% 15% 10% 5% 0% -5% -10% Early downturn US T-bills Transition Late downturn Upside Carry Early upswing Late upswing Upside ex China Nordic money market
Source: Ecowin, GFD and SEB X-asset
5%
Nordics
0%
USA USA
-5% 0% 5% Money market 10% 15% Standard deviation Bonds 20% 25% Equities
Source: Ecowin , GFD and SEB X-asset
30%
Emerging market equities have had much higher risk than bonds and also far above US equities. All groups have outperformed US equities over the last decade with significantly higher risk-adjusted returns, but there is not a clear-cut risk/reward pattern as we found for both the money market and bonds. In spite of the much higher risk, the historical return from EM equities has only been modestly higher than the return on EM bonds.
The tactical inventory cycle is also broken down into four phases, depending on whether short-term leading indicators are rising or falling and whether the change is accelerating or decelerating. Over the past 40 years, each phase has lasted on average 4-6 months. Early downturn is the most critical phase with elevated volatility and large losses. Tactical money market returns have showed less distinctive cyclicality than the strategic cycle. Upside has had its largest losses in early downturn while both Transition and Carry show defensive characteristics. Underlying exchange rates have been less cyclical in the tactical cycle, lowering the risk of losses in early downturn.
Turning to the strategic investment cycle we find that local bonds have defensive characteristics and have had their highest return during early recessions. Open FX exposure increases cyclicality for all emerging market groups, but only the Upside has delivered positive returns in early recession while both Transition and Carry have experienced losses: the fundamental strength of Upside economies makes their local currency returns behave more like thoese in the US, which also decline in recessions. Carry bonds have had losses close to 15% in early recession, significantly higher than the other groups. Nordic bonds are also cyclical, but less than both Transition and Carry.
13
20%
Tactical equity results are relatively similar to strategic, the main difference being the close to flat returns in the late part of the downturn phase. Equity returns have recovered in early upswing with extra ordinary high returns.
10%
0%
-10%
Tactical bond cyclicality is less pronounced than strategic. Local as well as emerging market bonds have had positive returns in early downturn over the last decade, mainly due to less cyclical exchange rates characteristcs.
80% 70% 60% 50% 40% 30% 20% 10% 0% 6.5% 8.5% 10.5% 12.5% 14.5% Standard deviation Transition MM Transition bonds Transition equities 16.5% 18.5% Carry MM Carry bonds Carry equities
Source: Ecowin , GFD and SEB X-asset
20.5%
In order to illustrate how an investor can allocate within and between the three emerging market assets we have optimised portfolios based on Upside, Transition and Carry. The optimisation is based on historical data over the last decade and uses resampling in order to avoid some of the well known problems with traditional Markowitz optimisation. The results should be used as indications.
Optimal portfolio at 10% standard deviation
1% 5%
Source: Ecowin, GFD and SEB X-asset
1% 19% Upside MM Transition MM Carry MM Upside bonds Transition bonds Carry bonds Upside equities Transition equities Carry equities 42%
10%
Local equities are cyclical and systematically underperform in the worst part of the strategic cycle with historical losses around 30% in early recession. Equity returns in USD show cyclical characteristics, but the inverse relationship between appreciating currency and equity returns leads to somewhat dampened losses. Nordic equities have been as cyclical as Carry equities, with losses around 45%. Equity returns have recovered in the late recession phase and stayed positive throughout the expansion phases.
Tactical equity returns, real USD, 2000-2011
100% 80% 60% 40% 20% 0% -20% -40% Early downturn US equities Upside Late downturn Upside ex China Early upswing Transition Carry Late upswing Nordic equities
Source: Ecowin, GFD and SEB X-asset
4%
8%
10%
The pie chart shows the optimal historical long-term allocation at 10% risk, giving an annual real return of 7.7% over the last 10 years. The portfolio is relatively balanced with 60% allocated to bonds and the rest split between money market and equities. Within the asset classes Carry dominates the money market exposure, Upside bonds and Transition equities. On an aggregated level close to half the portfolio is allocated to Upsidemaking the portfolio more robust and better prepared if there is a debt crisis.
14
with equal weights we end up in our current overlay recommendation, illustrated in the matrix. Our main scenarios in both the strategic and tactical cycles are reflected in overweights to both Upside and Transition money market and bonds, at the cost of mainly Carry. Active views should be seen as ballpark qualitative indicators of direction rather than specific detailed portfolio recommendations.
30%
The long-term portfolio can be adjusted to fit the specific strategic regimes. Money market and bonds are preferred at lower risk levels while the end of the efficient frontiers are tilted towards equities and Carry but 10% standard deviation means you can not go far out on the curves in all climates.
Tactical efficient frontiers, 2000-2011
70% 60% 50% Real return 40% 30% 20% 10% 0% 0% 5% Early downturn 10% 15% 20% Late upswing
Source: Ecowin, GFD and SEB X-asset
On the tactical level money market and bonds are overweighted in downturns, with a tilt towards Upside. Equities regain strength in, mainly allocated to Upside.
MM Bonds Equities
Upside 1% 8% 2%
Transition 4% 1% -7%
Based on the phase specific benchmark deviations above and our currenct views on where we are in the strategic and tacitcal cycles we calculate two overlays reflecting our current medium- and short-term benchmark deviations. Combining the two overlays
15
Hard currency index gains have also been eroded, although the EMBI has still reported a 3.4% return since the end of 2011. Gains in hard currency bonds earlier this year mirrored (albeit subject to a lag) the stronger performances of other risky assets in January, largely as we predicted in our last EMXA.
GBI-EM local bond Indices Index = 100 on Jan 2003 320 310 300 290 280 270 260 250 240 230 220 Jan-10 180
Unhedged
150 Dec-10 Dec-11 Sep-11 Mar-12 Apr-10 Apr-11 Oct-10 Jun-12 Jul-10 Jul-11
International investors that have been able to overcome their home bias and diversify away local risks have secured very attractive risk-adjusted returns. So far these profits
Hedged
16
have mainly stemmed from low prices. Going forward; capital gains from bond prices increasing toward equilibrium levels could further add to strong returns. But so far, how much is still left of the return generating price discount on EM bonds? Comparing EM inflation with an index of EM local yields, as we do in the diagram below, we see that markets hardly at all have priced-up EM bonds to reward the so far successful inflation targeting in EM economies.
Picture: Hyperinflation in a still not Emerging Market Bond yields remain well above current inflation rates, indicating that markets still offer a solid premium return to those willing to bear EM inflation risk. Returns connected to inflation risk-premia are even more apparent at the country level, as discussed in the February 2011 EMXA report.
rate/yield, % p.a.
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Regarding the historical relationship between VIX fluctuations and variations in the hard currency spread, the reaction affecting the latter appears slightly exaggerated.
17
hard currency space, which is further supported by our macro view on the region.
spread, bps
Mar-12
Jan-10
Dec-10
Regional differences
Significantly, we note differences in regional fundamentals. As we and others have observed several times, CEE countries are especially vulnerable to the ongoing crisis in the Eurozone. It should come as no surprise if CEE hard currency spreads were most severely hit if problems intensify. Still, mitigating factors may apply. Hungary has progressed toward initiating formal negotiations with the IMF. Production data for Polish products potentially part of supplychains possibly leading to Asia via Germany have remained resilient. Nevertheless, financial vulnerabilities pose regional risks justifying the widened Hungarian spreads.
Regional Hard Currency Spreads 550 500 450 400 350 300 250 200 150 100 Dec-10 Sep-10
Dec-11
Sep-11
Jun-12
Jul-10
Apr-10
Apr-11
Oct-10
Jul-11
bps p.a.
Jun-11
Mar-11
For less impaired regions such as Latin America and Asia, fundamentals look stronger. During the winter, hard currency spreads outside Europe did not increase as much as they did in Europe; according to local EMBI indices (see nearby diagram). This spring, regional spreads have moved in tandem, with those in Europe not increasing more than elsewhere. In fact, so far this year, the European hard currency index has narrowed while its Latin American counterpart has increased. This, together with the lack of improvement in the European situation, leads us to favour Latin America in
Dec-11
Sep-11
Mar-12
Jun-12
18
7 6 5 4 3 2 1
slowly and with a lagged effect, as shown in diagrams nearby showing both local EM yields and their spreads above Treasuries relative to the inflation path. To complete the pattern, it is time for EM yields to begin significantly decreasing, adding capital gains to positive carry where yield curves slope upwards. Bonds gaining most from this development include those in high-inflation countries with large premiums due to recently high inflation rates. Of course, other factors usually present risks, particularly a potential risk-off driven slump in lower grade bonds. Note on inflation measure: Our CPI measure for EM comprises a weighted average for China, Brazil, South Korea, Taiwan, Russia and Poland. These countries have been selected based on their relative importance and data availability. Weights are based on the MSCI Equity index.
Current inflation, target and forecast, %
April CPI, CB target Av. inflation Av. inflation SEB f-cast, SEB f-cast, y/y 2012 2010 2011 av. 2012 av. 2013 EMEA Poland Czech Hungary Turkey S. Africa Romania Russia Estonia 4.0 3.5 5.7 11.1 6.1 1.8 3.6 4.0 2.8 3.2 0.6 2.5 2.0 3.0 5.0 4.5 3.0 5.5 2.7 1.4 4.9 8.6 4.3 6.1 6.9 2.7 -1.2 1.2 9.4 4.3 1.8 3.9 6.5 5.0 5.8 8.5 5.1 4.2 4.1 8.0 3.8 3.2 5.5 9.5 6.1 3.0 4.5 4.0 2.5 2.5 3.6 2.8 1.8 3.5 6.5 5.5 4.2 5.5 5.0 2.1 3.0 7.0
Latvia Lithuania Ukraine LatAm Brazil Mexico Asia China Korea India* Indonesia Singapore
4.3** 3.4
4.5 3.0
5.0 4.2
6.6 3.4
5.2 3.6
5.2 3.5
*Wholesale prices
19
appetite. These reforms are driven by the need to improve finances by a government committed to its promise to implement a costly flat-tax reform and to hold property-taxes at zero.
base where long positions are concentrated. Downside risks tend to follow from such situations.
Picture: Irina Ivaschenko, IMFs representative in Budapest More positively, export sectors are strong, generating revenues which enable the country to continue to pay down its external debt. In this context, softening external demand is also a risk. The possibility of a stand-by credit facility from the IMF being established has an important stabilizing effect on Hungarian markets. The chances of the country successfully negotiating such an arrangement have increased after the EU recently dropped its political pre-conditions for formal IMF negotiations to start. Another EU positive is its more optimistic view on the possibilities of Hungary improving its fiscal position. Negatively though, formal negotiations have yet to start. The IMF is also concerned about the structural growth impact stemming from the unpredictability of Hungarian fiscal policy. As we write, the question of whether or not the Hungarian central bank is independent has almost, but not entirely, been resolved.
400
EURHUF
3 Feb-12
3 May-12
15
Hungary 5yr yield
13 11 9 7 5
South Africa, Indonesia and Brazil to benefit from low inflation environment
To secure a geographically diversified exposure to the improved inflation environment, we consider bonds in South Africa, Indonesia and Brazil.
2008
2009
2010
2011
From a portfolio perspective, the premium offered to compensate for carrying Hungarys own unique risks is attractive due to diversification benefits. However, the countrys heavy dependence on the Eurozone still ensures it remains a leveraged bet on risk sentiment in global markets. Overall, we recommend near term caution due to the countrys non-diversified investor
20
16 14 12 10 yield, % p.a. 8 6 4 2 0
inflation
03 04 05 06 07 08 09 10 11 12
inflation developments have remained benign while growth has decreased. The currency war is going in reverse with authorities recently buying their own FX on the open market at just over USD/BRL 2.0 to prevent excessive weakness. While domestic capacity appears limited, demand seems to have softened while inflation rates are down, supported by international developments. We believe a couple of more short rate cuts remain likely, with authorities now considering the consequences of potentially easing IOF taxes to strengthen the currency and stimulate investment. It all appears a very conducive environment for lower yields.
40 35 30 25 yield, % p.a. 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Brazil 2yr yield inflation
The focal point for political risks in South Africa is Mr. Malema, the former leader of the governing ANC party youth league (ANCYL). After being removed from his post by the government who accused him of acting contrary to the national interest by threatening to nationalize the mining industry, his popular base has so far not revolted, as feared by many analysts. In this respect, risks are in the process of being unwound, with some way left to go. While lower food prices could help, at present inflation rates have not yet begun to decrease. As in the case of Hungary, local political risks weigh on asset prices. Consequently, to a diversified global portfolio South African bonds offer an additional return at little extra total risk. Inflation in Indonesia have proved very benign despite increasing to 4.5% over the past couple of months; as late as 2008 prices were rising at doubledigit rates. Recent action to support the depreciating rupee focuses on this issue. With a low GDP per capita, reduced food prices have an important effect on household economy. Domestic demand may thus support growth when external demand softens. Bond yields have been trending steadily lower with more likely to come.
20 18 16 14 12 10 8 6 4 2 0 2003 2004
Investment conclusions
With European risks continuing to increase, most strongly fuelled by Greek parliamentary uncertainty, and the negative outlook for banking and macroeconomic stability in Spain, recommending specific securities is difficult. We do however highlight our previous recommendation to buy Latvian bonds vs. Lithuanian. For the hard currency space, we see value in Latin American sovereign credits following recent spread developments. Despite ongoing concerns regarding the Eurozone, Latin American credits have underperformed vs. CEE securities, leaving spreads relatively attractive.
Bond basket
Over the past couple of years, we have used a table which has included a selection of our favourite bonds to express our fixed income recommendations, concentrating on unhedged local currency positions, and comprising those most easily investable by ourselves and our clients. In addition, we offer to wrap these baskets (or indeed any combination of EM bonds) in SEB certificates. Having already positioned our basket on the basis of an expected improvement in the global inflation environment in our last EMXA, we largely reiterate our earlier call to benefit from a continuation of this trend. Reflecting our previously issued (see below) recommendation to take profits on the Lithuanian hard currency bond, we switch
2009 2010 2011
yield, % p.a.
Brazil has continued to switch from monetary to fiscal policy constraints. The monetary stance has softened significantly, on the fiscal front; at least official numbers show some tightening. Nevertheless,
21
out of it in favour of a corresponding Latvian bond consistent with our favourite trade (also below).
SEB EM Bond Portfolio February 13 2012 to January 1 2012
SEB weight Poland Hungary Lithuania S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average 5% 7.5% 10% 15% 5% 10% 15% 10% 15% 7.5% Rating S&P (LT-FC) ABB+ BBB BBB+ BB A BB+ ABBB BBB Yield 13-Feb 5.1% 8.5% 4.3% 6.6% 9.3% 3.6% 4.5% 3.2% 11.0% 5.0% 6.2% m~==cJNP= Yield 01-Jun `= i~=K rpa=K JNMKTB OKOB JUKTB 4.9% 8.9% JNMKPB MKVB JVKRB 4.0% MKMB OKOB OKOB 6.4% JNMKOB OKSB JTKVB 9.3% JRKMB OKVB JOKPB 3.4% JQKUB NKVB JPKMB 5.6% JQKMB JPKMB JSKVB 3.2% JRKPB MKTB JQKSB JNRKVB TKSB JVKQB 9.8% 4.9% JNNKNB NKVB JVKQB 6.1% JTKVB OKMB JSKNB
Favourite trade
We made a substantial profit from our favoured trade to buy Lithuania in USD with a European corporate CDS index as a hedge, as recommended in our previous EMXA. We thought EM hard-currency bonds should eventually catchup after the risk-rally in January, during which they did not participate. And they did. Our exit recommendation was published on April 4 in our publication EM Fixed Income Market Views. Entry and exit points are marked in the EMBI and VIX diagram earlier in this section. Currently, our favourite trade is based on our macroeconomic analysis of the Baltic region and was previously published as part of our Baltic Fixed Income research. Despite S&P having recognised the improvements achieved in Latvia, the market has still not responded by tightening the countrys spread vs. neighbours, especially the more internationally exposed Lithuania. From a 3-6 month perspective, we believe markets will eventually discover the relative value of Latvian credits and the problems Lithuania faces due to its economys heavy export dependence.
100% BBB
Our bond-basket this time outperformed the GBI-EM both on a currency hedged and fully exposed basis. Since the stop-date for the last EMXA on January 13, our basket has gained 2.0% currency hedged, and 6.1% fully exposed in USD. The corresponding number for the GBI-EM Global Diversified is -0.3% and -7.5% respectively. Our decision to avoid CEE assets but to invest in Lithuania in USD has been helpful, while our overweight in Brazil has been costly due to the softness of the real. We hope to recoup those losses as the Central Bank now has stepped in to defend its currency. Our position on high-inflation countries was gainful on a currency-hedged basis, but weighed down our returns when currency returns are included. Also, as an effect of our positive view on Latin American economies, we increase our exposure to Mexican bonds. This we finance by decreasing our Hungarian holdings. We already have enough of exposure to Eurozone developments indirectly as it will affect all and every risky asset, including those in our portfolio. Above that, we remain uncertain regarding the lack of heterogeneity of owners of Hungarian bonds.
New SEB EM Bond Basket June 1
SEB weight Poland Hungary Latvia S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average 5% 5% 7.5% 15% 7.5% 10% 15% 10% 15% 10% Rating S&P (LT-FC) ABB+ BBBBBB+ BB A BB+ ABBB BBB Yield 01-Jun 4.9% 8.9% 5.4% 6.4% 9.3% 3.4% 5.6% 3.2% 9.8% 4.9% 6.2% Duration years 4.0 4.6 4.2 2.7 3.1 4.0 4.2 3.9 3.6 3.1 3.7
100% BBB
22
The MSCI EM Index performed spectacularly well in Q1. However, very much in line with our view as expressed in the previous edition of our EMXA report, EM equities failed to maintain their gains, being sold off in Q2. Currently, the MSCI EM index is almost unchanged YTD. Since the start of 2011, EM equities have underperformed DM as shown in the following chart, mainly due to an increased risk premium and general flight to safety. However, periods in which EM tend to underperform are often followed by significant outperformance.
EM Equities relative to the world
110 105 100 95 90 85 80 75 70
Ju n11 Au g11 Ap r-1 1 -1 2 Oc t-1 1 ar -1 2 b11 c11 De De Fe Ja n M ay -1 2 M c10
Source: Bloomberg
110
105 100 95 90 85
80 75 70
Regionally, Latin America has performed worst so far this year, losing 5.8%, mainly due to the 10.4% decrease in MSCI Brazil (in USD terms). Fully consistent with consensus expectations, EMEA equity performance has been weak. Its long and safe distance from Europe and superior growth prospects have caused investors to favour Asian markets, which remain higher (+1.6% in USD terms) compared to the end of last year.
23
Source: Bloomberg
We still believe there is a good chance that Asia will outperform other regions going forward. Despite reduced growth forecasts in several countries including China, earnings per share in EM Asia should still increase faster than in other EM. In our view this situation is also likely to be reflected in equity prices. In effect, Latin America stands between Asia and EMEA. Although market expectations concerning earnings growth have decreased, equities are more expensive based on either P/E or P/B ratios. Arguably, Latin American markets have already sold off aggressively with most of the negative news already discounted. However, recent regional underperformance is largely explained by negative currency contributions due to the simultaneously strong USD as local currency-based equity indices fell much less. As regards EMEA, we believe it will be very difficult for the region to outperform given very weak Eurozone growth. On the other hand, strong, short rallies are not unlikely if temporary relief measures to ease the Eurozone debt crisis are implemented. Although, while we believe the region is already underweighted by investors, we do not expect it to benefit from major regional rotation during the next 36 months.
MSCI AC World selected markets (local currency)
MSCI Germany MSCI Mexico MSCI Taiwan MSCI Malaysia MSCI Hong Kong MSCI Ireland MSCI China MSCI Chile MSCI Australia MSCI Sweden MSCI Japan MSCI Switzerland MSCI Poland MSCI Brazil MSCI France MSCI Hungary MSCI United Kingdom MSCI Czech Republic MSCI Indonesia MSCI Russia MSCI Morocco MSCI Portugal MSCI Greece MSCI Spain
3.2 3.1 2.7 2.0 1.5 0.8 0.8 0.1 0.0 -0.6 -1.1 -1.5 -2.1 -2.8 -3.6 -4.2 -4.4 -5.5 -5.8 -6.6 -8.6 -20.1 -22.2 -29.2
-16.4 9.4 -18.1 -0.6 -18.3 11.4 -22.8 -11.3 -14.2 -16.7 -15.5 -11.3 -27.6 -11.4 -23.6 -34.0 -11.1 -19.8 -5.6 -22.7 -22.3 -39.4 -67.4 -42.4
3.2 3.1 2.7 2.0 1.5 0.8 0.8 0.1 0.0 -0.6 -1.1 -1.5 -2.1 -2.8 -3.6 -4.2 -4.4 -5.5 -5.8 -6.6 -8.6 -20.1 -22.2 -29.2
Source: FactSet
-1 2
-1 2
b12
ar -1 2
r-1 2
Ja n
Ja n
Ap
Fe
ay -1 2
From an MSCI AC World Index perspective, Spain and Greece have performed worst so far this year for several good reasons. The recovery in Egypt which began at the start of this year helped the market recoup most losses incurred in the sell-off that followed the Arab Spring. Asian markets particularly the Philippines and Thailand have also performed reasonably well. In addition, Indian equities posted solid gains at the beginning of the year, although the INR has been one of the worst EM FX performers since December 2011, with the result that foreign investors are receiving much lower unhedged returns than those included in the table above. Another market worth mentioning is Russia where equities increased almost 20% during the first quarter. However, the sell-off which occurred in Q2 produced negative YTD returns, making it one of the worst performing markets since the end of last year. On a GICS sector level performance between the various industry groups has varied widely. The difference between the best and worst performing sectors was 16 percentage points. Best performers have included the IT and Healthcare segments while Materials and Energy fell furthest. Outperformance by the Health Care industry may be explained by investors positioning themselves in defensive sectors less sensitive to demand shocks caused, for example, by a rapidly slowing economy or an unexpectedly negative outcome to the European debt crisis. Underperformance by the Energy and Materials sectors was caused by sharply lower oil and commodity prices. On the other hand, it is fairly difficult to explain the especially poor performance by Utilities, a sector so far regarded as safe. From a valuation perspective, it appears
Market MSCI AC World MSCI Egypt MSCI Philippines MSCI Thailand MSCI Colombia MSCI New Zealand MSCI India MSCI Singapore MSCI Peru MSCI Turkey MSCI USA MSCI South Africa MSCI Korea
YTD % 0.9 31.9 16.9 9.9 9.4 7.7 6.3 5.4 5.4 5.1 4.3 4.2 3.9
Feb EMXA 1 year, % cut- off, % -10.2 -6.3 -11.3 18.6 3.3 2.2 -1.4 -13.3 -13.7 -1.6 -12.3 -2.8 5.5 -11.7 31.9 16.9 9.9 9.4 7.7 6.3 5.4 5.4 5.1 4.3 4.2 3.9
24
attractive with a P/B ratio of 1.0x. Meanwhile, Healthcare and Consumer Staples have remained the most expensive in our EM universe.
Sector Performance and 12m fwd expectations
MSCI EM GICS Sectors YTD, % IT Health Care Industrials Consumer Staples Financials Consumer Discret. Utilities Telecom. Services Materials Energy 8.5 7.3 2.5 1.7 0.4 -0.8 -3.2 -3.5 -6.4 -9.7
1 year. P/E % -10.6 11.3 -15.5 17.5 -27.4 11.1 -2.0 18.9 -24.5 8.2 -19.1 9.6 -21.0 11.3 -12.5 11.6 -34.1 9.0 -31.2 6.1
P/B EPS, % 1.8 2.6 1.3 3.1 1.2 1.7 1.0 1.9 1.2 0.8 34.8 17.8 19.4 18.3 12.1 16.7 16.8 9.5 2.9 -0.1
Source: FactSet
EM equity flows At the beginning of this year, EM equity funds experienced large inflows of new money. Investors rushed to catch up with rapidly rising markets. Consequently, by the end of the first quarter, cumulative flows to EM equity funds totaled USD 22.6bn or 3.5% of AUM. However, the trend reversed immediately in Q2. Investors changed their minds and began withdrawing money from EM equity funds, with outflows totaling USD 7.8bn or one third of total cash received in Q1. Investors decided to favour global EM funds at the expense of regional counterparts. Latin America was worst hit by the outflow. According to EPFR data, it lost 4.2% of AUM YTD followed by EMEA with almost 1.5%. Wholly consistent with the consensus view that Asian markets are most resilient to slowing global growth and Eurozone debt problems, Asian funds have reported the smallest outflows so far this year.
Cumulative EM equity fund flows, 2012 YTD
7 Global EM Asia 5 EMEA Latam 3
1.5bn or 8.3% of AUM so far this year. Huge outflows have depressed equity prices producing much better local equity valuations. The downward revision of growth has also impacted returns negatively. Policy makers are doing what they can for the economy to regain momentum by lowering the SELIC interest rate by 400bps in less than a year and supporting the export sector by intervening in the currency market. With the Brazilian real having depreciated 8.4% against the US dollar since the beginning of the year, we think the market will become attractive over the coming months. Also, significantly, investor sentiment increasingly favours Chinese funds. Local equity funds have posted the second highest peer-relative inflows so far this year totaling USD 700mn, a major change compared to last year when investors withdrew USD 3.2bn. Apparently, money is being put back to work in Chinese equities despite recent warnings concerning the countrys slowing GDP growth.
Equity fund flows
4wk ma Brazil -171 Chile -15 China -125 Colombia 9 Czech 0 Egypt 0 India -59 Indonesia 1 Korea -42 Malaysia -1 Mexico -25 Peru -15 Philippines 3 Poland -1 Russia -86 Singapore -3 South Africa -15 Taiwan 76 Thailand 11 Turkey -24
YTD, USD YTD cum, 2011, USD M % AUM M -1552 -8.3 -2,167 64 7.6 -239 706 2.0 -3,235 67 6.1 39 0 0.3 -19 -44 -36.3 53 -205 -1.0 -3,841 274 13.4 -199 -1304 -10.6 -318 -64 -5.0 -267 -35 -1.8 -422 -68 -13.9 20 61 51.3 78 -6 -3.7 56 962 6.6 -166 -11 -0.5 -804 24 4.6 -255 -810 -9.1 1,726 273 19.3 -383 -23 -1.5 -547
Source: EPFR
r-1 2
-3
-5
Concerning individual country flows it is easy to conclude that Brazil is to blame for outflows from Latin America. They began as early as 2011 but accelerated only recently. Brazilian funds have already lost USD
r-1 2 M ay -1 2 M ay -1 2
Fe b
Fe b
Fe b
Ja n
Ja n
ar -1 2
ar -1 2
-1
Source: EPFR
Also reporting strong inflows is Russia at USD 970mn, equivalent to 7% of AUM. The recent fall in oil price and subsequent Russian fund redemptions have driven equity prices much lower with valuations once again back at attractive levels. Overall, flow data shows a mixed picture. Clearly, investors generally favour global EM funds at the expense of their regional or national counterparts, a phenomenon likely to continue at least in the near-term. On a country basis current flow data support markets such as China and Russia, ranked first and fourth respectively in our EM equity markets assessment discussed in more detail in the following section.
-1 2
-1 2
-12
-12
-12
Ap
Ap
25
break up and signs that the growth is losing momentum in both the US and Asia. Although EPS growth estimates have been revised lower in most EM markets during the last three months, equity prices declined much more, producing a substantial improvement in valuation measures. Currently market consensus forecasts 11.3% growth in MSCI EM Index EPS, compared with 11.5% expected in February this year. Significantly, the same market consensus expects higher MSCI World Index EPS growth (+11.5%) than for EM. With EPS recently increasing faster in EM and GDP forecasts tending to be higher for EM countries, DM earnings are unlikely to outstrip those in EM, at least in the longer term. Latin America remains the most expensive region in P/E, P/B and PEG terms. On the one hand, this is attributable to the inclusion of very expensive markets such as Mexico, Peru and Chile. However, Mexicos high P/E ratio is justified by strong EPS growth expectations. On the other hand, while Brazilian equities may appear cheap based on a P/E ratio of 9.0x compared with a 5 year average of 10.7x, its EPS growth expectations have been slashed more than any other EM country over the past three months. Currently, analysts expect EPS 14.8% lower than three months ago. Regionally, EM Europe remains cheapest in our EM universe. Certainly, it appears very inexpensive at a P/E ratio of 5.3x compared to 6.4x in our last EMXA and a 5 year average of 9.2x. Of course, there are two reasons for the low regional valuation. Firstly, most analysts agree that EM Europe is most vulnerable to Eurozone problems. Secondly, the Russian equity market is cheap. Russia has always been one of the least expensive EM with a P/E ratio rarely exceeding 7.0x. We do not expect this situation to change fundamentally in the foreseeable future such that P/E ratio to rise sharply in Russia However, while markets suggest a difficult outlook with valuations implying significantly slower earnings, we regard a P/E ratio of around 4.0x as attractive for longterm investors. Further, Hungary also appears cheap. Its equities recently lost all YTD gains as investors decided to flee local assets including currency, bonds and equities on concerns that its promised IMF deal would not materialize anytime soon. With a P/E ratio of 7.3x and PEG of 0.4x, Hungary is one of the cheapest markets in our EM universe. Obviously, if the Hungarian government is able to secure a stand-by agreement with the IMF in the near future the market is likely to outperform its peers even if the European debt crisis remains unresolved.
Market P/E MSCI EM 9.4 MSCI World 11.0 MSCI EM Asia 9.8 MSCI EM Europe 5.3 MSCI EM Latam 10.6 MSCI Brazil MSCI China MSCI Korea MSCI Russia MSCI Taiwan MSCI S Africa MSCI India MSCI Mexico MSCI Poland MSCI Turkey MSCI Malaysia MSCI Indonesia MSCI Chile MSCI Thailand MSCI Colombia MSCI Peru MSCI Egypt MSCI Philippines MSCI Hungary MSCI Czech R. MSCI Morocco
ROE Yield% P/B 14.4 3.4 1.3 13.3 3.2 1.5 14.4 2.9 1.4 13.8 4.6 0.7 13.8 3.8 1.5 13.3 15.7 13.2 14.1 11.9 17.7 16.0 16.0 11.1 15.2 14.0 23.2 13.8 18.5 13.1 24.8 14.3 15.9 10.4 15.7 30.7 4.6 3.8 1.4 4.2 4.0 4.3 1.8 2.0 5.8 3.7 3.4 3.3 3.0 4.2 3.1 3.4 4.4 2.5 5.0 7.3 5.4 1.2 1.3 1.1 0.6 1.6 1.9 2.0 2.5 1.0 1.3 1.9 2.8 2.1 1.9 1.9 2.6 1.2 2.5 0.7 1.6 3.6
PEG 0.8 1.0 0.6 -1.4 1.3 1.8 0.7 0.4 -1.1 0.6 0.6 0.9 0.7 -0.6 0.8 1.1 1.0 1.3 0.6 1.2 1.0 0.4 1.4 0.4 1.8 1.5
9.0 5.1 8.4 11.3 8.2 21.7 4.6 -4.2 13.4 22.2 10.6 16.9 12.5 14.0 15.5 22.2 9.3 -14.4 8.4 10.2 13.9 12.8 12.2 12.8 14.9 11.3 10.2 17.3 14.6 12.0 10.2 9.8 8.4 20.8 16.0 11.7 7.3 20.7 10.0 5.7 11.7 8.0
Source: FactSet
Despite increasing 32% YTD, the Egyptian stock market remains cheap based on key valuation metrics. Following last years sell-off due to the Arab Spring and overthrow of President Hosni Mubarak, Egypt has recovered strongly since the year end. With an elected parliament installed, presidential elections are scheduled to take place at the beginning of June. If political tensions continue to ease and the country decides to adopt even a limited form of democracy, equities will enjoy further upside potential. Currently, Egyptian equities trade approximately 25% cheaper than they were immediately prior to last years political upheaval. Furthermore, Asian markets are now also cheaper. While the effects on Asian economies of a possible blowout in Europe should be limited, markets have begun to discount slowing growth in the worlds second largest economy China. While EPS forecasts have been reduced slightly, lower PMI figures, slowing exports and weaker GDP projections have caused a sell-off, sending the MSCI China index down sharply to levels last seen at the beginning of this year. Currently, the market trades at a 2012 P/E ratio of 9.8x, equivalent to a 26% discount to its 5 year historic average. Similarly, the P/B ratio is now 21% below its 5 year average. Arguably of course, these metrics may be justified by expected significantly slower GDP growth. Overall, based on P/E and P/B ratios China and South Korea are currently Asias two cheapest markets. Conversely, the Philippines remains the regions most expensive market. Further, with local equity market prices having increased so far this year, it has become even more
26
so since the end of last year. All valuation metrics for the Philippines are well above their respective 5 year historic averages. Valuation ranking model Using most of the metrics in the table on the previous page, we have created a ranking model for the 21 countries included in the MSCI EM Index. We use fundamental valuation metrics on an index level to rank markets from cheapest to most expensive. We have taken into account ratios such as expected P/E, P/B, dividend yield and ROE, and compared them to their 5 year averages. To capture earnings momentum, we also include expected EPS growth for the next 12 months and incorporate EPS revisions made by analysts over the past three months. When ranking markets we attach different weights to our inputs. In our model we weight the difference between the current value of the metric and its 5 year average, and also EPS momentum data more heavily. Using fundamental valuation ratios and EPS momentum indicators allows us to divide the total score into two parts: valuation, which shows the score based on valuation ratios; and EPS momentum which shows the score attributable to the expected change in EPS and EPS revisions.
Index Ranking MSCI China MSCI Korea MSCI Egypt MSCI Russia MSCI Thailand MSCI Morocco MSCI Taiwan MSCI Hungary MSCI Peru MSCI Turkey MSCI India MSCI Colombia MSCI Malaysia -EM MSCI Poland MSCI Brazil MSCI Czech Republic MSCI Indonesia MSCI South Africa MSCI Chile MSCI Philippines MSCI Mexico Tot. Score 274 254 251 250 230 226 221 211 210 199 190 185 182 177 169 169 166 158 156 145 135 Value EPS mom. 196 78 138 116 135 116 216 34 132 98 180 46 107 114 169 42 120 90 127 72 154 36 71 114 96 86 167 10 161 8 149 20 104 62 118 40 112 44 65 80 55 80
Data Source: FactSet
materialises and the Chinese economy slows as some predict, EPS forecasts will be slashed going forward justifying the markets present cheap valuation. Moreover, while Russia posted the highest score in the last edition of our EMXA, its cheap valuation and relatively high EPS momentum did not help the market to outperform. As we discussed earlier, Russia is even cheaper today than it was at the beginning of the year. While EPS momentum is low, a very high score attributable to the value component has helped the country achieve its fourth ranking. While a leading recommendation in our previous edition of EMXA South Africa - has outperformed all other EM, currently the market score is among the lowest. We do not expect it to continue to outperform. Concerning the weakest scores, Chile and the Philippines are currently joined by Mexico. According to our model Mexicos value component is extremely low, despite the market enjoying sufficiently strong EPS momentum to indicate attractive growth going forward. EM vs. DM, P/E discount To better understand how EM equities are valued compared to their DM counterparts we usually compare MSCI EM and MSCI World P/E ratios. For a long time we have argued that a P/E discount of between 5-15% should be regard as normal. However, during periods of market stress and flight to quality investors tend to favour DM far more. Consequently, the P/E discount decreases below the aforementioned band. However, at least recently, investors have tended to overreact with price action unjustified by subsequent changes in earnings. Currently, the EM universe trades at a 15% P/E discount, equal to the lower band of the interval. In our opinion, while this does not immediately imply a strong overweight EM recommendation, investors should be looking to add EM to their portfolios if they become even cheaper in the shortterm.
Relative EM valuation and relative performance
1.3 1.2 1.1 1.00 1 0.9 0.8 0.7
7 t-0 Oc y-0 Ma 8 8 c-0 De 9 l-0 Ju 10 bFe 10 pSe 1 r-1 Ap v-1 No 1 12 nJu
1.20 1.10
5%
0.90
15%
0.80 0.70
According to our model the cheapest market currently is China. Obviously, this can be explained by increasing concerns regarding its slowing economy. However, EPS expectations remain high and analysts have not rushed to downgrade earnings forecasts sharply. Of course, if the worst case scenario
27
C A
USD 1,100
1,000
900
1,000
100.0% 835
B
800
100.0% 700
700
2009 2010 2011 2012
500
2000 2010
600 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2009
2010
2011
2012
All eyes remain focused at the B-wave low at 874, as a break will also confirm passing the 2011 low point, 824, setting the next likely target at the negatively sloped neckline, currently running in the 800-area (a secondary ideal wave target will however be found closer to the 700 handle). To ease downside pressure the market needs to recover above 1,005.
MSCI EM/MSCI World ratio
With only small upward corrections on a declining path, the big picture still clearly supports an imminent test (and breach) of the 2011 low point. As previously, the violation of the B-wave low has confirmed that the 2011 low point will be passed (minimum target = 1,200) and that a medium term ideal target is around 835.
Brazil Bovespa (BRL)
Price BRL 50,000
1
0.95
0.9 0.85
2006
2008
2010
2012
2014
161.8% 0.8232
0.8 0.75
2000
2010
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2008
2009
2010
2011
2012
As previously, we believe the market will plunge through the Aug 2011 low point, 47,793, taking aim at long-term trend lines. In the short-term we may nevertheless see some further congestion in a probable bear triangle. Strategically, we would sell up tics to the 56,000-area.
Mexico IPC (MXN)
Price MXN 36,000 32,000
The break down from the recent bear flag and the successful passing of the 2011 support line clearly indicates further underperformance to come. The next potential target is the low 0.91s, the point at which the decrease roughly equals the two preceding declining phases (seen from the peak). Our advice is to further reduce emerging market exposure generally in the near term.
28,000
24,000
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2010
2011
2012
The market has properly corrected, erasing the oversold position occurring around the 233d moving average. Consequently, we seek a new short from the current area
28
and an upcoming test and break of the 233d ma. The next target remains 31-33.000.
Indonesia JKSE (IDR)
Monthly graph Price IDR
3,500
3,000
2000
2010
After having printed a new record high in early May the market subsequently collapsed, falling below the April low point to create a key month reversal, a very bearish price pattern emerging from a new all-time high. This implies further weakness going forward and a probable first hand target around the 2011 low point. We expect upside reactions to be capped by the 4,000 resistance.
29
In retrospect, this comes as no surprise given the markets focus this spring on the vulnerability of Spanish banks and their substantial involvement in Latin America both through direct bank ownership and funding. The best performers since the beginning of the year are COP, TRY, TWD and PHP. Three are well removed from the epicentre of the Eurozone crisis, while in the case of the Turkish lira its strong performance more reflects last years severe depreciation and its central banks sharp, effective, hike in interest rates.
30
Furthermore, external deficits in some EM indicate that the currencies of these countries may be over-, rather than undervalued, at least in the near term, unless their respective deficits are the result of ongoing, heavy, investments in export oriented industries. Countries with external deficits that clearly become a liability for their currencies during periods of risk aversion include; Poland, Romania, South Africa, Turkey and Ukraine (all in Europe) and India and Vietnam in Emerging Asia. In Latin America, the Brazilian current account deficit is most in focus. While almost fully financed by FDI inflows, with external debt low and FX reserves substantially increased, the wider external deficit is a key factor behind the governments desire to prevent the real from excessive appreciation.
The institutional framework, incentives structure and predictability in decision making must all meet minimum standards for economic development to occur. Progress made in absolute and relative terms (i.e. vs. mature economies) have in some cases led to complacency among EM policymakers regarding the need to maintain momentum in the structural reform process. There has also been an element of reform fatigue among large parts of the electorate in these often young democracies. With much attention rightfully devoted to crisis management (especially in developed countries) in recent years, there is a slowly increasing need to drive the reform agenda forward. While unorthodox experiments in policymaking in some EM may deserve criticism, the general sense is, nonetheless, that the process is moving in the right rather than the wrong, direction.
REER, % change vs. 10Y avg.
BRL RUB CNY SGD CZK LVL IDR CLP THB LTL TRY MYR ZAR RON INR HUF PLN EUR TWD MXN USD KRW ISK
-40
-20
20
Source: BIS
40
31
Measuring the most recent reading of the REER relative to its 10 year historical average shows that the most expensive EM currencies are the BRL, RUB, CNY and SGD. Overall, those characterised by a growth strategy involving a greater reliance on domestic demand are high on this list. In some countries, this also reflects the demographic situation. A young population is good for growth and pension system viability though young people typically save less. In aggregate terms, this results in low savings and a high current account deficit. Provided productive investments account for a reasonable share of domestic demand, and financing of the external deficit is stable, this is economically rational. In some countries, such as Turkey, Romania and Brazil, this has not been entirely the case with high external deficits therefore raising questions concerning the viability of maintaining a strong currency. As regards China and Singapore, it is hard to argue that their currencies would be overvalued given their very strong external balances, i.e. this proxy for capturing valuation mis-matches has some limitations. With relative productivity gains being a dynamic process through which we believe EM will retain superiority for many years, we see scope for EM REER to appreciate modestly without creating vulnerability. Indeed, many EM currencies should possess a current REER exceeding their respective 10-year averages. Consequently, as shown in the previous table, in our opinion, most EM currencies are also relatively cheap from an REER perspective, particularly KRW, MXN and TWD. From a fundamental point of view and taking the ongoing expansion of central bank balance sheets in major economies into account, one can argue that increasing exposure to EM currencies is a hedge against a potentially significant erosion of currency value in much of the G7 countries. For more on this and how to allocate within EM, see the special study by SEBs X-assets team on p. 1115.
If carry will become a progressively more important driver moving into Q3, EM currencies are likely to become major beneficiaries. TRY, BRL, INR and HUF should be well positioned, having the highest effective policy rates. Indeed, based on carry actually received by investors, they are ranked high although current NDF pricing pushes INR to the top with TRY in second place followed by IDR, RUB and BRL. However, in some countries with a high policy rate conditions in the non-deliverable foreword (NDF) market imply that actual carry earned is significantly smaller. As shown in the following chart, China (through CNY NDFs) offers only low carry, although at least it is not negative for once.
Carry %, 3m vs USD, Annualized
10 9 8 7 Carry %
EM FX drivers ahead
To use a well-known quote: Prediction is very hard, especially about the future Yogi Berra This is certainly true today. In our General section we have tried to describe the most likely scenario given the assumptions we make as well as the biggest risks and their potential impact on EM macroeconomies and markets.
6 5 4 3 2 1 0 ZAR AUD KRW MXN RUB CNY TRY BRL HUF CLP INR IDR PLN
Flight to liquidity
Regarding the likely FX market drivers going forward, we conclude from this analysis that flight to liquidity will continue to dominate the market in the very near term as risk appetite continues falling and carry positions, for instance, fall further.
Also, taking into account uncertainty in carry positions resulting from spot market volatility, we derive a risk adjusted carry measure. Doing so shows that IDR ranks highest followed by INR and TRY, all of which offer Sharpe ratios close to or exceeding one based on the developments during the last three months. In turn, they are followed by RUB, CLP, BRL, ZAR and
32
CNY (surprise!). All EM currencies we have considered for the purposes of this study except PLN, provide a better risk adjusted carry than the prime (and only) carry alternative among G10 currencies, the AUD.
Risk adjusted 3m carry
2.0 1.8 1.6 Sharp ratio 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 ZAR CNY TRY KRW RUB AUD BRL HUF CLP IDR INR MXN PLN
This time again we rank Emerging economies by calculating the so called liquidity ratios, that indicate how big or small
33
external financing needs over the coming 12 months are in comparison to the FX reserves. Let us the reader remind that this measure shows the total amount of hard currency a country needs, which is the sum of C/A and FDI plus short term external debt and amortizations on long term external debt, in relation to available hard currency in the FX reserves. Compared to our previous update, few changes are notable in our ranking. Turkey remains on top of the list with the large short term debt burden and C/A deficit as well as relatively small FX reserves, thus being most vulnerable to a freeze in financial markets. Other economies in the not so favourable position from this standpoint are Ukraine, Romania and Poland, with the ratio exceeding 100%. China, Russia, Brazil, Thailand and Mexico are the safest ones with the aforementioned ratio being below 50%. Hungarys position has improved due to lowering amortizations to be paid, improved C/A balance and slightly higher FX reserves. Chile stands stronger as its international FX reserves soared during the last year. Ukraines position, on the other hand, deteriorated due to increased short term debt and amortizations paid on the long term debt.
Given such a negative environment, USD/HUF emerges a winner with a likelihood of imminently breaking 2009 & 2011 tops at 252/253 and extending towards 285/300 or even 311/>319. The first target is derived from the 2008/09 rally and an equality point measured from the 2010 low. The second objective is measured by the base of a previously violated contracting range and the 2000 high. A move back below the yearly low of 213 is needed to justify thinking otherwise from this broad perspective.
USD/BRL
USD/BRL (1mt NDF) has rallied sharply into a medium-term stretch and in the process filled previous objectives and possibly completed a full medium-term 5-wave impulse. Still, this does not in itself promote shorts as the 5-wave sequence is part of a much larger picture most likely comprising A in a bigger A-B-C correction. Therefore, following a period of correction or consolidation (to neutralize the stretch), we expect another 5-wave sequence higher. Previous highs (resistance) at 1.97 & 1.93 probably act as a firm support zone going forward. A bearish move back under the rapidly rising 26week (year) average, now at 1.86, is needed to blunt a mediumterm bullish outlook for USD/BRL.
USD/KRW
USD/KRW (1mt NDF) has also been pushed into a shortterm impulse which so far is incomplete (i.e. arguing for fresh highs) and therefore runs an increased risk of further distancing itself from the already violated high of 1183 from December 2011. An upper parallel suggests 1205, while a
34
medium-term 261.8% Fibo projection holds 1219 possible (not far from the 2011 high). Medium-term support at 1160/1150 needs to be taken out to reassess the bullish approach in this laggard USD/EM cross.
SEB EM FX forecasts
The analysis above boils down to the following forecasts for the EM currencies where we have our primary focus:
SEB EM FX forecasts for eop 01-Jun-12 2Q12 3Q12 4.20 3.33 295 234 25.0 4.40 220 40.1 35.5 31.8 8.03 1.78 8.20 1.95 13.50 490 6.28 6.26 1140 54.0 9200 1.26 1.26 82.0 4Q12 4.10 3.28 290 232 24.6 4.30 210 38.8 34.5 31.0 8.03 1.75 7.95 1.88 13.00 480 6.20 6.20 1100 52.0 9000 1.24 1.25 84.0 1Q13 4.05 3.27 290 234 24.4 4.25 200 38.1 34.0 30.7 8.03 1.73 7.80 1.85 12.80 475 6.16 6.16 1075 51.0 8800 1.22 1.24 87.0 2Q13 4.05 3.27 290 234 24.2 4.25 195 38.1 34.0 30.7 8.03 1.73 7.80 1.85 12.80 475 6.12 6.12 1065 51.0 8600 1.20 1.24 90.0
Vs. EUR
PLN USDPLN HUF USDHUF CZK RON
ISK offshore
RUB
RUB/BASKET
4.40 3.55 305 246 25.7 4.46 240 41.8 37.3 33.7 8.08 1.86 8.58 2.03 14.38 518 6.37 6.37 1178 55.6 9380 1.29 1.2402 78.2
4.50 3.66 315 256 26.0 4.52 240 42.3 38.0 34.4 8.15 1.90 8.80 2.07 14.60 525 6.38 6.38 1200 57.0 9500 1.30 1.23 80.0
Vs. USD
RUB UAH TRY ZAR BRL MXN CLP CNY CNH KRW INR IDR SGD EUR/USD USD/JPY
Our first forecast point is usually 1M which on this occasion coincides with end-Q2 (based on a cut-off date for this report of 1 June). As we have already discussed, we expect the factors that drove the sell-off in May to continue to destabilize markets in the nearterm. If the Greek election is market positive and a support package for Spain is made very likely already by mid-June, then, obviously, the relief rally would not wait until July 1. Instead, we would move along the chain of market drivers as described above. Conversely, if developments in Greece and Spain do not proceed as we expect, the sell-off of EM currencies will certainly not stop in line with our Q2 forecasts. An additional 5-10% upside in the USD/EM crosses would certainly be possible, implying a return to the March 2009 fire-sale rates.
We therefore recommend positioning for near term developments through options and by buying a 6 month butterfly in EUR/MXN for the down side and by buying a 1 month USD/HUF call spread.
Investment strategy
Our investment strategy is characterised by three stages. Firstly, in the very near-term, we recommend caution ahead of the Greek election on June 17, the G7 meeting on June 18 and EU summit at the end of the month. Once these are over and Spain has received a support package, FX drivers will become far more conducive for EM currencies. Consequently, a longer-
35
EM currencies after the Lehman shock and is over 10% weaker than its 10 years average in REER) Strong fundamentals (prudent policies, low indebtedness) Reasonable carry Positioning now positive (speculators are short MXN, for once) More economically dependent on US than EU.
For these factors to start supporting the MXN, market drivers must move away from flight-to-liquidity. While this situation may include some relief for the EUR, we still regard the single currency as one of the weakest of the G10, also due to substantial event risk (see Currency Strategy, 23 May). Consequently, we prefer to express our bullish views on the MXN vs. EUR. However, while we regard MXN as currently cheap, near term risks favor further weakness. We do not therefore recommend buying spot just yet. At present, the technical outlook also indicates EUR/MXN upside risks. Indeed, in our opinion, it would require a move below 17.31 from currently 17.80 to alter the technical position, see box below. From a short- to medium-term perspective the EUR/MXN chart looks like a bearish 5-wave impulse followed by a "Double Zigzag" (correctional pattern). Currently the cross is in a near-term bullish drive and at the time of writing not confirmed as having passed its high.
How to trade it
Given the strategy discussed above, we regard the most appealing trading opportunities from a risk reward perspective to be as follows:
But a move back below 17.31, followed by confirmation below 16.93 would substantially increase the odds in favour of a later violation under the yearly low of 16.38 which would be our minimum objective. If the current high is the peak a better target could then be sought at 15.95 or even as low as 15.33.
36
Our preferred strategy is to trade this via a put butterfly where we buy the wings at 17.25 and 15.25 and sell the double amount in the belly at 16.25. The cost of this structure is 1.0% of the nominal amount with a maximum net profit of 5.2% if spot trades at 16.25 in six months: 16.25 just happens to be our endQ4 forecast.
Consistent with these arguments, we recommend buying a 1 month USD/HUF call spread with strikes at 250 and 275. This costs 2.1% and has a maximum net profit of almost 8%. The current strongly positive skew in the market also benefits our strategy of selling the lower delta call option. Below we present the skewness for the 1 month 10 delta risk reversal showing a positive call skew of 8.35% for the 10 delta USD call HUF put strike, also revealing the markets view on risk:
USD/HUF 1 month 10 delta skew
14 12 10 8 6 4 2 0 30/12/10 28/02/11 30/04/11 30/06/11 30/08/11 30/10/11 30/12/11 29/02/12 30/04/12 30/06/12
37
disappointing Q1 GDP data, up just 0.8% y/y, we expect a further 100 bps in rate cuts. Consequently, the BRL no longer occupies the prime position in our rank of EM currencies based on carry. Still, it does remain respectable in most comparisons.
Inflation and policy rate
14 13 12 11 10 9 8 7 6 5 4 08 09 10 11 12
CPI (IPCA), % change y/y Policy rate (SELIC), %
14 13 12 11 10 9 8 7 6 5 4
During periods of high uncertainty, we have often used EM currency baskets to secure exposure with slightly less potential but with expected greater resistance to market volatility. An EM currency basket will provide several diversification benefits as currencies included are from different regions, and because their respective advantages and disadvantages are differently distributed along the lines of the drivers we expect will influence the market going forward. This effect should not however be exaggerated as the correlation during the last 2-3 quarters has been high, and because we do not expect any major changes in the near term. The use of several funding currencies probably provides more diversification benefits including reducing risk, while it also limits upside potential. This is preferable when positioning with a slightly longer term investment horizon. Based on the insights derived from our investigation of risk and return from investing in different groups of EM currencies over the last decade (see p. 11-15), we suggest two EM baskets; one offensive with Carry currencies and one defensive with fundamentally stronger Upside countries. In the carry basket we include currencies with strong potential according to our forecasts, together with high risk adjusted carry and reasonable event risk. We look to buy a basket comprising IDR, INR, TRY, RUB, ZAR and BRL equally weighted. On average, we expect these currencies to strengthen by over 9% vs. USD by the middle of next year. Consistent with this rationale, we diversify the funding leg and sell USD, EUR, JPY and CHF also equally weighted.
However, the central bank is gambling with its hard earned credibility as inflation, despite decreasing from 7.3% last September to 5.1% in April this year, remains above the mid point of the 2.5-6.5% target. Rapid BRL depreciation in May therefore forced the central bank to switch sides concerning its intervention policy; it began offering USD to the market at around 2.09, shortly after having been on the other side buying USD up to around 1.90.
To us, this latest action is a credible message that the BCB wants to see USD/BRL below current levels and that it is prepared to act to achieve its objective. And indeed, if risk appetite was to improve, old correlations provide room for a rather solid BRL come back. As outline above, however, we are not prepared to act due to fear of catching a falling knife. We would rather await clarification regarding the Eurozones near-term challenges while standing ready to jump onboard the train once it has started rolling.
38
requirement ratio (RRR) to be cut by a further 150bps this year and 100bps next from currently 20.0%. We also forecast a 25bps cut in interest rates and fiscal policy easing. While the latter will not be on the same scale as occurred in 2008/09, it will be sufficient to support a recovery in economic activity in Q3.
With growth turning around, we would also expect the CNY to resume appreciation, consistent with the governments overriding objective to move the economy away from its dependence on exports and investment in favor of private consumption. Furthermore, we believe international pressure on surplus countries in general and China in particular will increase, requiring them to accept greater responsibility for global rebalancing. In particular, pressure from the US is likely to intensify in the run up to the November presidential elections. Still, we expect the CNY to appreciate less rapidly than last year. Chinese authorities have been arguing that the exchange rate is approaching it equilibrium. In support of this contention they refer to a smaller current account deficit. It is also true to say that the CNY has strengthened in both trade-weighted nominal and real terms, partly as a result of its close ties to the USD and the recent rise in the greenback. Finally, slower CNY appreciation is likely given Chinas lower inflation rate which reduces the need for a stronger currency to keep imported prices down. We have already raised our USD/CNY forecast in line with the arguments above, and now expect the cross at 6.20 by year end. Prospectively, we expect the NDF and the CNH market will to trade close to the onshore spot rate or slightly below.
USD/CNY has been on the rise since May, in line with other USD crosses. The market currently discounts continued CNY depreciation with the 12 months NDF trading 1.0% above spot and the 12 months CNH forward approximately 1.3% above the deliverable CNH spot (the CNH forward is unfortunately not in the graph above due to a data base problem). Although this situation may persist for a little while longer, if our assumption on global risk appetite is accurate a reversal is likely. We therefore look to sell USD/CNH 12 months forward when the time is ripe.
39
Notes:
40
Notes:
41
Notes:
42
Contacts
Emerging Markets Magnus Lilja Emerging Markets Research Mats Lind Mats Olausson Jurgis Rosickas Head of EM +46 8 506 23 169 Fixed Income Strategist FX Strategist Analyst +46 8 506 23 351 +46 8 506 23 262 +370 526 82 418
Emerging Markets Sales /Trading Stockholm Lars-Erik Kristensen FX, Fixed Income Sales Louise Valentin FX, Fixed Income Sales Julius Dukta Fixed Income Trading Christopher Flensborg Fixed Income Sales Gothenburg Magnus Green EM Sales Malm Tomas Anelli Helsinki Henrik Typpnen Sami Huttunen Heidi Alanko Oslo Silje Ingeberg Trond Solstad Copenhagen Peter Lauridsen London ChrisBennett Nick Dorman Frankfurt Detlef Joehnk Peter Friedman Alexander N. Maximilian New York Oskar Elmgart Marcus Jansson Moscow Ksenia Uralskaya Singapore Gustaf Ljungdahl Shanghai Fredrik Hhnel
Peter Knutzen
+46 8 506 23 110 +46 8 506 23 110 +46 8 506 23 094 +46 8 506 23 295 +46 8 506 23 138 +46 31 62 22 69 +46 40 667 6958 +358 9 6162 8624 +358 9 6162 8540 +358 9 6162 8540 +47 22 82 72 81 +47 22 82 72 84 +45 3317 7734 +44 208 246 4620 +44 207 246 4676 +4969 9727 1252 +49 69 9727 11 14 +49 69 9727 7743 +1 212 286 0608 +1 212 692 4793 +7 495 662 6310 +65 65 05 05 05 +86 21 539 666 81 +86 21 539 65789 +852 97207800 +852 97207800 +852 97207800 +852 97207800 +852 39192652
43
EM Sales Acting Head of EM Helsinki FX Sales Equity Sales Head of EM Oslo EM Sales EM Sales EM Sales EM Sales FX Sales Fixed Income Sales Equity Sales FX Sales Fixed Income Sales EM sales EM Sales Head
Head of Trading Capital Markets
Hong Kong Pablo Riddell Chloe Merdjanian Kazushige Koyama Per Nordstrm Carol Au-Yeung
FX Sales FX Sales Fixed Income Sales Fixed Income Sales Fixed Income Sales
This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document Changes may be made to opinions or information contained herein without notice. Any US person wishing to obtain further information about this report should contact the New York branch of the Bank which has distributed this report in the US. Skandinaviska Enskilda Banken AB (publ) is a member of London Stock Exchange. It is regulated by the Securities and Futures Authority for the conduct of investment business in the UK.