July 2013

Compass
A good kind of madness Going cold turkey: China’s liquidity crunch Changing the itinerary: EM commodity currencies What is risk (II)?

Wealth and Investment Management Global Research & Investments

.................................................................................................................................................................... 13 RUB: Not amazing.............................................................................................................................Wealth and Investment Management Global Research & Investments Contents A good kind of madness 2 A necessary evil .......... 9 Lurking in the shadows........................................................................... 3 Barclays’ key macroeconomic projections ............................. 10 Of dilemma and trauma ............................................................................................................. 8 Not just post-holiday blues......................................................... 15 It is not only about which currency to buy.......................................................................................................................................................................... 17 Accounting for fat tails........................................................................................................................................................................................................................................................................................................................... 15 What is risk (II)? 16 Reflecting risks that matter .............. bond yields. ........................................................................ 2 Water finds its own level ............................. 3 When push comes to shove........................ 17 Global Investment Strategy Team 20 COMPASS July 2013 1 ............................................................................................................... but better than others........................................................................................................................... 12 BRL: The carnival is over ............................................. 9 Two hands to clap . 10 Awaiting the reforms ... 11 Changing the itinerary: EM commodity currencies 12 ZAR: From global beta to domestic alpha ......................... 4 TAA: fixed income likely faces the biggest headwinds Interest rates.............................. and commodity and equity prices in context Going cold turkey: China’s liquidity crunch 5 6 8 Here comes the squeeze .......................................................

investors have expediently found the reasons to trigger the current summer doldrums in risk assets – an event we alerted in recent editions of this publication. Granted that the upcoming mid-summer madness may shape up quite differently. The liquidity largesse bestowed by major global central banks via quantitative easing and the low interest rates would eventually have to be unwound. A necessary evil It is ironical because policy-makers would. the above prospect clearly bodes well for equity. and not if”. the third round of liquidity boost was never meant to be “QE-Infinity”. A normalization of monetary policies at current stage of the upswing also implicitly reflects a more entrenched economic recovery. with US households’ net worth of $70 trillion as at 1Q2013 – a new high equivalent to 4. In prior years. investors have been ruffled by a potential normalization of monetary conditions. durable goods orders and consumer confidence index continued to surprise on the upside. Thus. purportedly to be driven by the tapering in quantitative easing (QE) and a hike in interest rates. that a change in monetary conditions has made investors dyspeptic of late.yeo@barclaysasia. Shouldn’t Investors be cognizant that any reversion-to-mean efforts by policy makers remain a question of “when. Besides. split equally between Treasuries and agency mortgage-backed securities. This time round. In fact. other major central banks such as the Bank of England.0%. corporate revenue growth will translate to better earnings growth. It may now be timely as the global economy has seen its worst and continues to be bedding down. normalize its policies for the long haul. Still. not less liquidity in the system. still it is ironical. In terms of guidance. In turn.besides. CFA +65 6308 3599 benjamin. More importantly. new homes sales.4 times GDP – US consumers can afford to spend further into a recovery. the pick-up in US economic activities thus far has been rather broad-based: recent data releases on home prices. issues regarding global economy and sovereign debt issues dominated investors’ list of concerns. For instance. From its high on 21 May 2013. possibly to $70bn. they continue to inject liquidity apace. Suffice to note that the extent of any tightening in monetary policy is likely to be gradual: the rise in short rates is still quarters away (sometime in 2014 or possibly 2015). our colleagues at the Investment bank believes the Fed would announce a cut back at its September 2013 meeting. and QE will taper first before being terminated. the US Federal Reserve (the Fed) has already stated its intention to taper down the asset purchase amount from the current $85bn/month when unemployment rate reaches 7. although not for bonds. expectedly in due course. Besides. on an overall basis. the Bank of Japan and the ECB have yet to withdraw the proverbial punchbowl – on the contrary. to start off with. there is going to be more. corporations can acclimate easily to the gradual rises in borrowing costs as long as final demand conditions remain favourable. COMPASS July 2013 2 . world equity corrected about 8% as at 24 Jun 2013. although not surprising to us.Wealth and Investment Management Global Research & Investments A good kind of madness Benjamin Yeo.com Once again.

0 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y Tenor Terms Source: Bloomberg. In fact. Besides. to a certain extent. central banks tend to err on the side of caution and are not known to be pre-emptive when it comes to monetary policy tightening. The yield curve further steepened when the long end moved above 2. We would argue that a gradually inverting yield curve is a reflection.5 1. of growth deceleration on the horizon.5% despite Fed’s subsequent clarification on QE tapering. as always. They backed the US 10-year Treasury bond yield up from a low of 1.5 0. gold. Thus. over time. Street economists witnessed initially.0 0.0 3. it may be self-inflicted. At the end of COMPASS July 2013 3 . short term performance for equity could also turn out to lacklustre. and not a cause. we think the risk of an economic derailment is low: the US and the global economy recovery continue to be bedding down. tend to climb a wall of uncertainty with changes at the margin. or commodity in a sustainable economic upswing. the steepening.5 4.Wealth and Investment Management Global Research & Investments Water finds its own level It is unsurprising because investors. the implied flattening of the yield curve and conveniently worried about a potential accident of a yield curve inversion – which would mean an economic deceleration. the majority of the FOMC members still expect short rates to stay low through 2014. When push comes to shove From historical precedence. the recent sell-off in bonds seems justifiably more “right” in ushering the beginning of a longer term downtrend as the economy recovers. It resulted in a positively-sloped yield curve that kinked at the intermediate section which triggered the witch-hunt to shift down to the short end of the yield curve. when push comes to shove. Suffice to note that the elevated volatility then sustained for a quite a while before it ultimately receded. the plunge in investors’ sentiment may not be entirely baseless. a normalization of monetary conditions typically brings about a period of volatility which presents more of a strategic headwind to bonds than equity. would outperform other alternative investments such as fixed income.5 3. Such déjà-vu feeling traces back to a similar incident in the mid 1990s – as the global economy emerged from recession – when a tightening of monetary policy led to similar bouts of volatility. In addition. Forward short rates were then adjusted higher for late 2014 which imply an expected change in monetary policy (see Figure 1). we think equity. Still.0 1. just before the last FOMC meeting in mid-June. Figure 1: US forward yield curve Forward Curves % 4.5 2. Undeniably.6 to 2.0 2.2%. Bond investors – known to be astute readers of the economy –started discounting at the long end of the yield curve to reflect the improved growth outlook. and subsequently. Barclays Spot 1Y 2Y 3Y 30Y In addition.

6 2.1 1.2 -0.4 3.6 6.1 5.00 9.5 5.2pp or more for Inflation.6 1.00 7.0 2.0 2014 3.6 1.4 4.3 2.0 2.1 3.9 1.25 Q1 14 0-0.00 8.00 9.8 2.5 5.3 1.6 1.5 0. Weights used for real GDP are based on IMF PPP-based GDP (5yr centred moving averages).25 0.7 3. COMPASS July 2013 4 . lending rate Brazil: SELIC rate India: Repo rate Russia: Overnight repo rate Forecasts as at end of Current 0-0. for equity investors with a longer holding period and the appropriate risk-return profiles.8 2.5 5.3 5.25 5.25 6.5 2.9 7.50 6.10 0.9 4.5 -0.50 6.8 -0.1 2.6 6.4 7.0 1.8 1.4 2.00 7.25 6.4 5.2 5.10 0.2 1.25 0.8 7.00 7.9 5.7 6.00 8.50 Q2 13 0-0.0 1.1 2.50 5.25 0. higher interest rates reflect sustainability of growth and “a bit of inflation is always good for business owners and stock prices”. 21 June 2013 Note: Rates as of COB 17 June 2013.00 Source: Barclays Research.7 2.1 Consumer prices 2013 2.50 6.Wealth and Investment Management Global Research & Investments the day. Weights used for consumer prices are based on IMF nominal GDP (5yr centred moving averages).50 0-0.1 0.50 0.00 9.10 0.10 0. Global Economics Weekly.6 2014 3. Figure 3: Central Bank Policy Rates (%) Official rate % per annum (unless stated) Fed funds rate ECB main refinancing rate BoJ overnight rate BOE bank rate China: 1y bench. 21 June 2013 Note: Arrows appear next to numbers if current forecasts differ from that of the previous week by 0.50 0-0.1 1.50 5.6 5.3 7. Global Economics Weekly.2pp or more for annual GDP and by 0.50 6.3 2.8 0.9 0.6 Source: Barclays Research.00 5.5 5.8 4.4 3.50 0-0.4 2013 3.50 Q3 13 0-0.5 1.25 Q4 13 0-0.5 2012 2. Barclays’ key macroeconomic projections Figure 2: Real GDP and Consumer Prices (% y-o-y) Real GDP 2012 Global Advanced Emerging United States Euro area Japan United Kingdom China Brazil India Russia 3.0 1.9 5.50 6.50 0-0.10 0.3 2.25 5.4 2.25 0.6 2.25 0.

5% 10.9% 2013 (through 24 June 2013) 27.5% 2.4% -2. in midJune we cut our recommended weightings in High Yield and Emerging Market bonds to underweight. For more detail. We now use qualitative descriptions of our Tactical positions relative to their Strategic benchmarks. even after sell-off. Yields and spreads still low: at current phase of business cycle. COMPASS July 2013 5 . Investment Grade Bonds by Barclays Global Aggregate – Corporates. Has benefited from the hunt for yield: rising bond yields may mute further advances. Note: Past performance is not an indication of future performance. but the medium-term outlook for growth may be brightening and we have left our tactical overweight intact for fear of missing a likely rebound.1% -1.Wealth and Investment Management Global Research & Investments TAA: fixed income likely faces the biggest headwinds Developed stocks have been hit by the Fed’s guidance.† Figure 1: Tactical Asset Allocation tilts and Strategic Asset Allocation Benchmark (moderate risk profile) SAA Profile 3 Strong Underweight Underweight Neutral Overweight Strong Overweight Cash & Short Maturity Bonds Developed Government Bonds Investment Grade Bonds High Yield & Emerging Market Bonds Developed Market Equities Emerging Market Equities Commodities Real Estate Alternative Trading Strategies 7% 4% 7% 11% 38% 10% 5% 4% 14% Raised to neutral June 14 in anticipation of market volatility. A reduction in both intra and inter-asset class correlation should assist this asset class We are simplifying how we report our asset allocation views here. It should not be assumed that investment will be made in any specific securities that comprise the indices.1% 4. Vulnerable to outflows. Strategic weight is low. we prefer corporate equity Cut to underweight June 14 (HY down to neutral.8% 18. The benchmark indices are used for comparison purposes only and this comparison should not be understood to mean that there will necessarily be a correlation between actual returns and these benchmarks. Gold especially at risk as interest rate expectations rise. Valuations not stretched even before setback: still our most favoured asset class Valuations are attractive. Commodities by DJ UBS Commodity TR Index.2% -15. EM underweight extended).9% 3. High-Yield and Emerging Markets Bonds by Barclays Global High Yield. This is a shift away from the percentage-based reporting method we used in the past.7% Diversification does not guarantee against losses. but emerging growth is disappointing. ranging from ‘strongly underweight’ to ‘strongly overweight’. Developed Markets Equities by MSCI World Index.4% 5.1% -9. Our Tactical Asset Allocation (TAA) tilts these five-year SAA views to reflect our shorterterm cyclical views. and remain neutral on emerging equities and on diversifying assets. Source: Barclays Figure 2: Total returns across key global asset classes Cash and Short-maturity Bonds Developed Government Bonds Investment Grade Bonds High Yield and Emerging Markets Bonds Developed Markets Equities Emerging Markets Equities Commodities Real Estate Alternative Trading Strategies 2012 † 0. Alternative Trading Strategies by HFRX Global Hedge Fund. Index Total Returns are represented by the following: Cash and Short-maturity Bonds by Barclays US Treasury Bills.7% -5. Real Estate by FTSE EPRA/NAREIT Developed. Instead. They are updated annually to reflect new information and our evolving outlook. Momentum is very poor. We continue to advise a strategically underweight position in government bonds and a tactical underweight in investment grade credit (and cash). and raised our weighting in cash to neutral. Our Strategic Asset Allocation (SAA) models offer a mix of assets that over a five-year period will in our view provide the most desirable mix of return and risk at a given level of Risk Tolerance.1% -2. Developed Government Bonds by Barclays Global Treasury. Still expensive. Barclays EM Hard Currency Aggregate & Barclays EM Local Currency Government. and were overdue a correction to begin with.9% 17.2% 0.9% 15. please see our Asset Allocation at Barclays white paper and the February 2013 edition of Compass. It is not possible to invest in these indices and the indices are not subject to any fees or expenses. Vulnerable to flows. The volatility of the indices may be materially different than that of the hypothetical portfolio.1% -1. Emerging Markets Equities by MSCI EM.

5 1. bond yields.0 0.0 4.0 1.0 2.0 3. Figure 6: Global credit and emerging market yields Nominal Yield Level (%) 12 10 8 6 4 2 US UK Current Germany Japan ± one standard deviation 10-year average Investment High Yield Hard Currency Local Currency Grade EM EM ± one standard deviation Current 10-year average Source: FactSet. Barclays *Monthly data with final data point as of COB 24 June 2013.5 3.5 0.0 1. and commodity and equity prices in context* Figure 1: Short-term interest rates (global) Nominal Yield Level 3 Months (%) 9 8 7 6 5 4 3 2 1 0 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10 Figure 2: Government bond yields (global) Nominal Yield Level (%) 10 9 8 7 6 5 4 3 2 1 Jan-87 Jan-92 Global Treasury Source: FactSet.5 2. Barclays Jan-03 Jan-07 Jan-11 10-year moving average ± one standard deviation Source: Bank of America Merrill Lynch.5 4.5 2.5 3.5 Global Source: FactSet.5 Dec-96 Dec-99 Inflation Linked Dec-02 Dec-05 Dec-08 Dec-11 10-year moving average Figure 4: Inflation-adjusted spot commodity prices Real Prices (1991=100) 340 310 280 250 220 190 160 130 100 70 Jan-91 Jan-95 Jan-99 DJ UBS Commodity ± one standard deviation Source: Datastream.0 0.0 2. Datastream.0 3.5 1. Barclays Figure 5: Government bond yields: selected markets Nominal Yield Level (%) 5. Barclays Jan-97 Global Government ± one standard deviation Source: FactSet. Barclays COMPASS July 2013 6 .Wealth and Investment Management Global Research & Investments Interest rates. FactSet. Barclays 10-year moving average Jan-02 Jan-07 Jan-12 10-year moving average ± one standard deviation Figure 3: Inflation-linked real bond yields (global) Real Yield Level (%) 4.0 -0.

Datastream.8 World USA UK Eu x UK Current Japan Pac x JP EM ± one standard deviation 10-year average Source: MSCI.8 2. IBES. forward PE ratio PE (x) 28 26 24 22 20 18 16 14 12 10 8 6 Dec-87 Dec-93 Dec-99 MSCI Emerging Markets ± one standard deviation Source: MSCI. FactSet.4 2.2 0.Wealth and Investment Management Global Research & Investments Figure 7: Developed stock market.6 1. FactSet. IBES. Datastream. Barclays Figure 8: Emerging stock market. Barclays Dec-05 Dec-11 10-year moving average Dec-05 Dec-11 10-year moving average Figure 9: Developed world dividend and credit yields Yield (%) 8 7 6 5 4 3 2 1 0 Jan-01 Jan-04 Jan-07 Jan-10 Global Investment Grade Corporates Yield Developed Markets Equity Dividend Yield Jan-13 Figure 10: Regional quoted-sector profitability Return on Equity (%) 19 17 15 13 11 9 7 5 3 World USA UK Eu x UK Japan Pac x JP EM ± one standard deviation Current 10-year average Source: MSCI. FactSet. Datastream. Datastream. FactSet.0 1. IBES. Barclays Source: MSCI. IBES. Barclays Figure 11: Global stock markets: forward PE ratios PE (x) 22 20 18 16 14 12 10 8 World USA UK ± one standard deviation Eu x UK Japan Pac x JP EM Current 10-year average Figure 12: Global stock markets: price/book value ratios PB (x) 2. Barclays Source: MSCI. Datastream. forward PE ratio PE (x) 26 24 22 20 18 16 14 12 10 8 Dec-87 Dec-93 Dec-99 MSCI The World Index ± one standard deviation Source: MSCI. Datastream. IBES. FactSet. FactSet. IBES. Barclays COMPASS July 2013 7 .

however. and one such exercise by the central bank has proved particularly interesting. interbank liquidity was drying up in China While global investors were squarely focused on the outcomes of the 19 June Federal Open Market Committee (FOMC) meeting in the US. in what was the highest daily fixing since 2003.Wealth and Investment Management Global Research & Investments Going cold turkey: China’s liquidity crunch Wellian Wiranto +65 6308 2714 wellian. Breaking the addiction to credit will be neither easy nor pain free.com After years of excessive credit growth. at an agreed price. % Source: Bloomberg.2% by the end of the day from just 6.” This quote could have come from the US Federal Reserve as chairman Ben Bernanke prepared the market for the eventual QE3 exit. The market has to face up to the reality that the credit-fuelled euphoria is simply not sustainable. the recent spike in interbank market rates is an indication of how serious policymakers are about tackling the country’s financial imbalances – not least in the shadow-financing system. It’ll all be for the better. The interbank repo market is the platform on which banks agree to sell securities to other banks and then repurchase the same security. What many do not realise is that these are the kind of words that could have also come out of China. as Asian markets were digesting the hawkish FOMC statement. trust us. Gone is the liquidity largesse of yesteryears. Barclays COMPASS July 2013 8 . We now have to do what’s right. China’s 7day repo rate jumped to 11. Just when investors were fixated on the US FOMC. China’s economy is being repositioned for an era of less-generous liquidity support. On 20 June. In particular.wiranto@barclaysasia. Figure 1: China’s interbank rate has spiked recently % 12 10 8 6 4 2 0 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 China 7-day Interbank Repo Rate. where the squeeze on liquidity has already begun. be worth it. China’s interbank repurchase (repo) market was – relatively quietly – illustrating what happens when policymakers decide that enough is enough.4% a week earlier. It will. after a specified time. Here comes the squeeze “The tough decision has to be made.

000 2. Indeed. The smaller banks have had a tendency to borrow from the short-term interbank market in order to finance their exposure to wealth management and other high-yielding products. but fell sharply. which has grown significantly against the wishes of the central bank. this measure is often used as an indicator of how much cash exists in the interbank market. The chain of logic goes as follows. there is a sense that the PBOC’s delay in relieving that the liquidity crunch had a punitive tinge to it. By delaying its liquidity injection. PBOC’s refusal to relieve the liquidity crunch has a punitive tinge to it Amid expectations that the PBOC would move to relieve the sharp rise in the interbank repo rate by injecting liquidity into the system. the PBOC was warning banks that it will not support resurgent credit expansion in some parts of the economy. CNY bn Source: Bloomberg.8tn) is considerably higher than it has been over the past few years. Specifically. the authorities appear to be targeting some of the banks that have overextended themselves.Wealth and Investment Management Global Research & Investments Given that high repo rates indicate that some banks are willing to pay more to get shortterm liquidity from others. the spike in repo rates can be seen as a sign that China’s level of liquidity not only fell. the current level of TSF (more than CNY 1. Barclays 3 months moving average COMPASS July 2013 9 . they are seen as being conduits in the shadowfinancing system. Figure 2: Total social financing has been on an uptrend CNY bn 3. In particular. including the non-bank sector – showed that shadow financing has been building up more intensively over the past year. On a 3-month rolling average basis.500 2.000 1. Lurking in the shadows Growth of credit outside of the formal system is a particular concern for the policymakers Total social financing (TSF) – which measures the overall liquidity in the system. The fact that credit outside of the formal financial system continued to grow sizably – despite little official monetary easing during the period – came as a particular concern for policymakers. it is perhaps not too surprising that the PBOC reacted the way it did throughout the period – refusing to inject liquidity into the system despite a liquidity crunch that saw interbank market rates soar to 30% intraday at one point. the People’s Bank of China (PBOC) allowed the liquidity crunch to happen as a warning to some domestic banks against taking on too much balance sheet risk via excessive lending. the central bank kept the market waiting until much later in the week.000 500 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Total social financing. the PBOC’s ultimate goal is to slow the growth of shadow financing – by targeting an important funding lifeline of the smaller banks. Overall.500 1. Not just post-holiday blues Apart from the holiday effect – China had a 5-day weekend from 8-12 June – the liquidity squeeze appears to have happened by design. Hence. By engineering a squeeze on the interbank funding. Essentially.

domestic financial repression has made the situation worse. the smaller banks remain involved in the relatively murky process of circumventing official banking regulations and helping to perpetuate credit growth outside of the banking channels. Having tried moral suasion and regulatory means. knowing that these institutions are a lot more dependent on interbank funding than their larger peers. financial liberalization appears to be a key plank of the reform agenda set out in May. Specifically. there is a pack of yield-hunters on the other end While much can be said about how some of the banks are complicit in aiding the growth of shadow financing. Specifically.Wealth and Investment Management Global Research & Investments To begin with. Awaiting the reforms It takes more than just liquidity squeeze to root out shadow financing Given the role that financial repression plays in the growth of shadow financing. and yet seeing signs that these shadowy instruments continue to grow. Avenues for investment outside of China also remain largely closed. For one. it will take more than a liquidity squeeze by the PBOC to root out the issue. However. Two hands to clap It takes two hands to clap: For every supplier of high-risk loans. Specifically. Banks cannot readily offer higher rates to attract depositors if they choose to. While these banks may not be directly extending the shadow financing themselves. While the deposit rate will still be pegged. the hunt for yield has also fed the growth of shadow financing. for China. for every supplier of high-risk loans. in what is a still a controlled financial system. there is a sense that they have been actively perpetuating it via various creative instruments. which allow banks to act as guarantors for short-term debt instruments issued by companies. Given the limited ways for those with excess cash to invest. the new measure would give banks wider berth in competing for deposits. the PBOC decided that a harsher message needs to be sent to the smaller banks. compared to 1. In other cases. Even though the ample supply of global liquidity in recent years has kept a lid on yields in most parts of the world. the simple truth is that such instruments are popular because there is genuine demand for them. It takes two hands to clap and. the interest that households receive for depositing their money in the banks remains tied to benchmark rates. there are some expectations that the PBOC may raise the ceiling for banks’ deposit rate to 1. (a process whereby a trust company receives funds from wealthy individuals or companies) to invest in ventures that promise high yields. COMPASS July 2013 10 . banks may have been acting as middlemen for selling trust loans. despite repeated official urgings. there is a pack of yield-hunters on the other side of the transaction. the central bank decided that a strong signal that enough is enough can be found in making them pay a lot more for their funding than before. and subject to significant risk. among other euphoric investment recipients such as the still-buoyant property market.2 times the benchmark. These would include bank acceptance bills. it is no surprise that. While these are considered offbalance sheet items for the banks – and therefore do not show up as normal bank loans – the banks are still liable if the issuers default. it is positive to see that top officials remain committed to resolving some of the structural financial imbalances. this remains a relatively unregulated part of the financial flows. To that end. restricting those with the financial means to invest overseas.1 times currently.

the last time the PBOC adjusted its benchmark rates was in mid-2012. Of dilemma and trauma Reforms are not without risks… …especially given the slower growth rate Tackling financial imbalances in the system is not without risk. a program called QDII2 may be launched to allow qualified individuals to invest in overseas securities.56 and 0.0 4. the economy is not about to decelerate uncontrollably. % Source: Bloomberg. the PBOC wants to see enough of a squeeze to serve as a strong signal of its hawkish intentions.4%. At the broad level. Despite the fact that headline inflation remains subdued. Indeed. but largely unregulated. at around 2%. % COMPASS July 2013 11 . % y-o-y Source: Bloomberg. it also reflects their trauma about the impact of hyperstimulus. The country must now face the realities of the trade-off between short-term growth and long-term sustainability. China’s new policymakers appear to be taking the view that going ‘cold turkey’ is worth it if it means curing the economy of its addiction to credit.8% to 7.0 7.0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 CPI inflation. allowing investors to seek opportunities abroad will help to curb enthusiasm for high-yielding. such restraint suggests that policymakers are relatively comfortable that. Going by the latest data (Q1 2013). % y-o-y Benchmark lending rate. Q2 GDP growth – due to be published in mid July – is also likely to be lacklustre by Chinese standards. However. judging from the robustness of the PBOC’s warning to the market – via the interbank system – the government appears to be building up a strong impetus for reform. At the same time it cannot afford to ignore the fact that too much of a squeeze could perpetuate the economic slowdown. Barclays Benchmark deposit rate. our researchers have revised down their growth forecast for 2013. In particular. to be sure.0 6.Wealth and Investment Management Global Research & Investments Further financial reforms are crucial too Apart from that. In fact. We concur. from 7.0 1. Gone are the days when the world’s second-largest economy can clock double-digit growth in a seemingly effortless manner. respectively. there have been more active talks about further capital account liberalization. All these measures will take time. However.0 5.0 2.50 percentage points. while growth will be slower than before. the central bank has refrained from lowering rates.0 3. The next step for China will not come easy… …but well worth the effort Figure 3: Both growth and inflation have come down % y-o-y 14 12 10 8 6 4 2 0 -2 -4 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Figure 4: Benchmark rates have been on hold recently % 8. As discussed. Chinese GDP growth has fallen below 8% for four consecutive quarters (for the first time in 20 years). The next step for China’s growth will not come easy. For instance.0 0. when it comes to liquidity. trust products that form a significant portion of shadow financing in China. highlighted by the shadow-financing problem. Barclays GDP growth. during which period it cut the lending and deposit rates by a conservative 0.

RUB remains a currency with potential support. Tanya Joyce. This has led to a rise in US yields and stoked concerns about the pace of flows into EM assets. CFA +44 (0)20 3555 8398 petr. the decoupling of this asset class from equity markets and calls about the end of the commodity super-cycle led investors to review the return expectations on commodity currencies. it is not prudent to put all commodity currencies in one basket.com Normalisation of US monetary policy will make life for EM currencies a lot harder ZAR: From global beta to domestic alpha ZAR – previously a high-beta currency with an ability to benefit from benign global sentiment – has been battered by ongoing domestic uncertainty.Wealth and Investment Management Global Research & Investments Changing the itinerary: EM commodity currencies Petr Krpata. EcoWin. Figure 1: RUB looks the least vulnerable of the three to liquidity concerns. this currency segment is represented by Russia’s rouble (RUB). the euro (EUR) and the Japanese yen (JPY) than against USD. Not all commodities are likely to embark on a structural downtrend (such as those RUB is exposed to). differentiation will matter more from now on and there are differences in the domestic outlook and fundamentals of the three currencies. Beyond the commodity angle. such as labour strikes. IMF) 20% 16% 12% 8% 4% 0% -4% -8% ZAR TRY INR RON PEN PLN CLP COP EGP IDR CZK BRL MXN ILS ARS THB HUF HKD CNY PHP KRW RUB MYR TWD SGD Source: Barclays. Against USD.krpata@barclays. RUB has better fundamentals. Moreover. Moreover. IMF COMPASS July 2013 12 . the South African rand (ZAR) and the Brazilian real (BRL). ZAR is most at risk. however.com Investors in search of exotic destinations this summer may find the slopes of Sochi more attractive than the beaches of Copacabana. BRL is somewhere in the middle. the year-to-date fall in commodity prices. In our view. we do not see its current weakness as a buying opportunity. while ZAR is the most exposed Current account as % of GDP (2012 data. ZAR. we are less optimistic about the prospects of the EM currencies as we move towards an environment of USD strength and rising US yields. RUB). CFA +44 (0)20 3555 8405 tanya. In EM FX. Of the three main EM commodity currencies (BRL.joyce@barclays. Emerging market (EM) currencies have been under selling pressure since May amid mounting expectations that the Fed would start tapering its quantitative easing programme sooner than previously expected. All three should. perform better against the Swiss franc (CHF). Despite being the worst performer in EM FX this year (down by 15% against USD).

but for good reasons. BRL. risks associated with its external funding needs. the commodity angle is not particularly upbeat either. .. Thirdly. increasing supply capacity from other regions (such as Australia) should cause prices to decline in the coming years. ZAR remains one of our least favourite currencies in the EM space. for iron ore. the prospect of the Fed tapering asset purchases is haunting EM assets and makes ZAR particularly vulnerable. As Figure 2 shows. while RUB and BRL look expensive Real Effective Exchange Rate (REER). the generally soft outlook for its commodity exports and political risks make the ZAR outlook challenging. Material external funding needs pose further risk to ZAR. While the country has plenty of geological potential. EcoWin. But a weak economy. Second. With one of the largest current-account deficits in the EM space (Figure 1) – and a history of large portfolio inflows (bonds. and vice verse. we think that the period of rapid GDP growth is over and that South Africa will only marginally outgrow the US both this year and next. positive number signifies overvaluation.Wealth and Investment Management Global Research & Investments First. % deviation from a long-term average. it faces significant problems due to the increasing instability in the mining sector. in particular) – ZAR may weaken further should concerns about the provision of global liquidity intensify and investors further scale down their positions in EM assets. sold off during the recent EM FX meltdown and would have probably been even weaker had the local authorities not intervened. Figure 2: ZAR cheapened. This remains the case despite its more attractive valuation (which is no surprise given its fall over the past quarters). The favourable medium-term outlook for iron ore and coal output could also be disrupted by strikes and political uncertainty in the short-term. however. but even there South Africa’s industrial unrest may constrain mining output and its ability to capitalise on that strength. BIS 50% 40% 30% 20% 10% 0% -10% -20% MXN CLP PEN BRL Source: Barclays. As a result. BIS Latin America EMEA EM Asia ZAR ILS PLN HUF TRY RON CZK RUB TWD HKD KRW INR MYR IDR SGD THB PHP CNY COMPASS July 2013 13 . given its external funding needs. both in terms of global supply-demand dynamics or the domestic outlook. Moreover. We think that gold prices (South Africa’s main commodity export – 10% of total) may trend lower as global economic growth picks up: the sharp fall seen already following the FOMC’s June meeting is a reminder of how exposed it is to monetary normalization. clashes between supporters of the two main labour unions may continue to hamper the production of precious metals in the years to come. In particular. the trade-weighted rand is cheap.while outlook for its commodity exports is not benign BRL: The carnival is over The big party on the beaches of Copacabana is over.. Ongoing demand from Asia should underpin coal prices. in line with most of the EM currencies. The outlook for platinum prices (9% of SA exports – Figure 3) looks much more constructive to us given its stronger end-user fundamentals...

our economists see a high probability of Brazil being downgraded early next year – this is not likely to add to the attractiveness of BRL. The outlook for Brazil’s commodity exports is mixed. the move is likely to limit economic recovery. the rising global supply and modest rate of demand growth from China makes the outlook for ore prices fragile. On a positive note. BRL is not cheap based on an inflationadjusted basis (Figure 2) because of the high inflation of the past years. As a result. However. the uninspiring growth. Although this has been positive for the bank’s credibility.000 $500 $2000 2002 2004 2006 2008 2010 2012 Platinum price Source: Johnson Matthey Figure 4: Brazil's and Australia's global ore exports September 2012 mine strikes Mt 900 800 700 600 500 400 300 200 100 0 2011 2012 2013 E 2014 E 2015 E 2016 E 2017 E 2018 E Australia Source: Bree.7% and 0. COMPASS July 2013 14 .7% this year. Iron ore (Figure 4). However. deteriorating fiscal situation. As seen over recent weeks.Wealth and Investment Management Global Research & Investments Figure 3: Historical world platinum price $/oz $2. Brazil’s soybean production accounts for about 31% of global supply. and rising domestic consumption will likely weigh on Brazil’s overall impact on the global oil market going forward.500 $2. Following its average growth rate of around 4% between 2002 and 2010. Among other things. Although growth is expected to pick up to 2. Demand from China (importing about 70% of Brazil’s soybeans) should also remain robust. rising prices have translated into domestic protests. the central bank has now taken steps to regain its credibility – it has hiked rates by 0. cut rates despite price pressures.9% in 2011 and 2012 respectively. Given that it accounts for such a large proportion of global soybean output. stubbornly high inflation (a notable factor in a world where inflation is generally falling) continues to eat into domestic real incomes.000 $1. All in all. the recovery is not strong. the fiscal situation has been deteriorating. Brazil’s oil supply has risen substantially over the past decade and may increase in the medium and long term. While we expect Brazilian iron ore exports to modestly rise over the coming years.75 basis points so far this year and further tightening is likely to come. due to uninspiring growth and large public spending. For agricultural commodities. making it the world’s biggest producer. we expect Brazil to be a key component for demand growth. output slowed sharply to 2. UNCTAD Brazil The Brazilian economy appears to be running of out steam. rising interest rates and the recovering central bank’s credibility may limit its downside. current account deficit (though not as high as in South Africa or Turkey) and the mixed outlook for its commodity exports makes us cautious on BRL. over the course of the last year. Brazil’s deteriorating fiscal situation may warrant a sovereign downgrade Moreover. the increasing frequency of adverse weather locally could pose upward risks to prices. One reason for the high inflation is a loss of credibility of the Brazilian central bank which. oil and soybeans account for nearly 30% of Brazil’s total export values.500 $1.

This makes RUB the least exposed of the three major EM commodity currencies to concerns about global liquidity. causing net exports to increase only modestly.. we remain positive on oil prices as supply growth is unlikely to match the increase in demand. domestic consumer demand is currently one of the key drivers of Russia’s output (with real wage growth in positive territory). From the commodity angle. the roles have reversed and. but better than others In many respects. Russia’s fiscal position is not a concern for RUB (compared to BRL). iron ore prices are likely to trend lower as noted. Russia has a current account surplus. with Brazil hiking rates. supportive for economy Current account surplus. Russia is running a current account surplus (largely attributable to oil).high inflation erodes real value of BRL Active: history of interventions COMPASS July 2013 15 . we do not see an urgent need to go long EM FX as a bloc given the current market volatility. The robust US economy. domestic demand has also risen. prospects for Russian exports are brighter. We prefer funding EM longs via CHF. the CBR is expected to cut. but rising spending on social security is offsetting rising revenues: the budget balance is broadly neutral. Russian net oil exports may actually decline in the coming years as domestic consumption continues to pick up. unlike Brazil and South Africa. EUR or JPY in the G10 FX space due to their low funding costs and expected depreciation. While the Central Bank of Russia (CBR) was the only big EM central bank to hike rates in the second half of the last year. Although we expect RUB to struggle against USD as investors remain concerned about EM assets in general. but benign outlook for soybeans Expensive . their work is not over. oil and oil-product exports account for over 50% of total export values. It is not only about which currency to buy. This year. Outlook for RUB’s commodity prices better compared to ZAR & BRL The outlook for commodity exports for both countries is different: while we retain a constructive outlook on oil (Russia’s main export). While a fall in real wages weighed on Brazilian domestic growth. USD no longer the funding currency of choice for EM longs Once investors find an EM currency (commodity-driven or not) on which they have a degree of conviction (a difficult task amid the current EM sell-off). We believe the trend of recent years – for USD to be used as a funding currency – is over. the choice of which developed currency to sell is becoming more important. Russia’s oil production accounts for nearly 12% of global supply. In terms of its commodity exposure.. Russia could be seen as the flip side of Brazil. rising US yields and attractive funding costs elsewhere argue for a shift. but in part justified by the outlook for oil prices Mixed: limited activism Low trending growth: low productivity Tightening: but rate hikes due to high inflation Mild current account deficit. Brazil was easing. While oil output has increased over recent years. Looking ahead. Moreover. This may tighten the global market balance. domestic production for others at risk Cheap. broadly neutral budget balance Oil prices to remain underpinned Expensive. Figure 5: RUB looks the best positioned among the major commodity currencies Brazil Economy Monetary Policy Current Account & Budget Balance Commodities FX Valuation Central bank activism Source: Barclays South Africa Slow growth: risks of waning demand & labour unrest Neutral: inflation rising but need to support economy Twin deficit (both current account and budget balance) Gold to struggle. faces fewer political risks and is in a relatively better fiscal position than South Africa or Brazil (at least for now). we see scope for it to outperform both ZAR and BRL (Figure 5). In our view. In the medium term. deteriorating fiscal position Iron ore prices to fall.Wealth and Investment Management Global Research & Investments RUB: Not amazing. but for a reason (domestic risk and weak fundamentals) Central bank does not tend to intervene Russia Stabilising growth: driven by consumer demand Easing: inflation expected to fall. That said.

This definition of risk means that any technique used to minimise risk will penalise potential good outcomes as much as it will potential negative outcomes. assuming that good outcomes increase the risk to investors is unrealistic … and yet this assumption still underpins the majority of optimisation techniques used in the industry. Determining whether the average expected reward is sufficient to compensate for the risks taken requires an understanding of precisely what is meant by risk.Wealth and Investment Management Global Research & Investments What is risk (II)? Greg B Davies +44 (0)20 3555 8395 greg. COMPASS July 2013 16 . and the thought of -10% causes the investor considerable stress. This means that the possibility of getting plus 5% instead of 0% actually adds to the risk of the investment – in fact it adds the same amount to perceived risk as getting -5%.davies2@barclays. On average those who take risk are rewarded for doing so – but ‘on average’ provides no guarantees and there remains the possibility that the outcome will be worse than expected. -5% by somewhat more. however. To recap: standard deviation is a poor measure of risk. Figure 1: Implied psychology of risk as volatility Contribution to risk Expected return 0% Worse returns Better returns Source: Barclays However. add to the perceived risk of the investment. Any possible outcomes less than this. The worse the outcome. Following on from last months’ Compass where I explained why risk is not the same as volatility.com It is a truism of investing that achieving higher returns requires taking more risk. in this edition I describe our Behavioural Risk measure in more detail. And as returns get better and better they add more and more to the measured risk of the investment! Clearly. To see why. consider Figure 1. Investors’ risk budgets will be used up protecting against potential outcomes that they just do not see as risky. This shows how investors would evaluate the risk of possible future returns if they really did interpret risk as standard deviation. the more it adds to the perceived risk – for example. there would be no contribution to perceived risk associated with the expected outcome (here 0% to keep things simple). As shown. the possibility of getting -1% instead of 0% increases the risk by a small amount. note that the curve is symmetric around 0%.

by contrast. However. However. It is based on psychologically plausible assumptions from research into the psychology of risk and financial decision making. but also to take on the upside variation that they would rather embrace than avoid. the distributions of the possible future outcomes of many investments.Wealth and Investment Management Global Research & Investments Reflecting risks that matter Our behavioural risk measure is.1 1 We have only to think of the absurd claims that September 2008 was a ‘one in three thousand year event’ to see the failure of standard risk measures to account for the likelihood of extreme movements. the psychological measure gets steeper at a faster rate as outcomes get worse and worse. As before. and extreme downward movements in particular. Using this measure means that portfolios are optimised to reflect the risks that are most important to investors. tend to have features that cannot be captured by standard deviation. meaning that large negative outcomes happen slightly more frequently than large positive outcomes. And secondly they exhibit fat tails: extreme outcomes. the potential for catastrophic losses in the left tail of the returns distribution. whether negative or positive happen more often than is predicted by using standard deviation as the risk measure. add to risk. a much more psychologically accurate and intuitive response to risk. outcomes that are better than expected actually detract from the perceived risk of the investment. COMPASS July 2013 17 . In particular. since it enables us to overcome a further significant failing of standard deviation as a risk measure: it cannot fully measure the risks of distributions of different shapes. Firstly they are typically not symmetric: instead they are usually somewhat negatively skewed. Figure 2: Actual psychology of risk Contribution to risk Expected return 0% Worse returns Better returns Source: Barclays Another difference between the psychological approach to risk and the traditional volatility measure is more subtle but just as important: for most of the downside the two curves are fairly close to each other. potential outcomes that are worse than expected. and at an increasing rate. This means that extra emphasis is placed on those possible outcomes that people most fear. Investments with potential upside thus increase the risk budget so real risks can be taken elsewhere in the portfolio. Accounting for fat tails This last aspect of the behavioural risk measure is extremely important. Figure 2 shows the intuition behind this measure without going into the mathematical formulation (for which see our Asset Allocation White Paper).

which has a 46% probability of occurring. The one on the left is designed so that all the variability is picked up by standard deviation: it is perfectly symmetric around 0% and does not have fat tails.6%.3%.3% and 1. It follows what is known as the normal distribution. If the distribution of outcomes follows the theoretical ideal of normal then behavioural risk is identical to standard deviation. The behavioural risk of this distribution is also 4.Wealth and Investment Management Global Research & Investments Figure 3: Standard deviation can’t detect fat tails Example distribution 50% 50% Fat tails Probability of occurring 40% 30% 20% 10% 0% -15% Probability of occurring -10% -5% 0% Return 5% 10% 15% 40% 30% 20% 10% 0% -15% -10% -5% 0% Return 5% 10% 15% Source: Barclays Because the behavioural risk measure is deliberately asymmetric and downward focussed. each with a 22% chance of occurring. but behavioural risk accounts for differences in skewness just as easily as differences in extreme outcomes. though occurring with the same probability. or expected outcome. the outcomes of -5% and 5% are both equally likely. of 0%. However. and least likely (each at 5% chance) are the two extreme outcomes of -10% and 10%. examine the two simple distributions in Figure 3. and because investors naturally focus on the extreme negative outcome when evaluating risk. these two distributions have the same standard deviation! Any traditional portfolio optimisation based on standard deviation as a risk measure would treat them exactly the same. However.2 It has just five possible future outcomes: the most likely is the average (expected) outcome of 0%.6%. these two are now closer to the average: there is the same 22% chance for each.3%. though as noted it’s actually rather uncommon in reality! For simplicity we’ll ignore skewness here. Instead of getting either -5% or 5%. the good and bad outcomes are shifted. one that introduces fat tails. since there are no fat tails or skewness to compensate for. Let us examine a simple variation on this distribution. To illustrate this briefly. This distribution has very fat tails. is reality this is seldom the case. However. it accounts for both negative skewness and fat tails. and because it places greater attention on the far left tail. This distribution has a standard deviation of 4. but now on -1. as though they have the same risk for the investor. are now much more extreme: there is a 5% chance of getting either 14. That is. whereas standard deviation will not pick up these features at all. we should very naturally expect that this second distribution is riskier than the first.3% or -14. a distribution of possible future outcomes that has these common features will be measured as being more risky on our behavioural measure. 3 2 COMPASS July 2013 18 . And the extreme outcomes.3 This distribution has the same mean.

by contrast recognises that the danger of -14. and therefore appropriately indicates an increase in risk. This risk increase means that the optimisation process will penalise the fat tail investment more. To build portfolios that give investors the best possible returns for the risk they need to take. and reduce the optimal holding. Indeed doing the calculation for a low risk tolerance investor shows that the risk increases to 4.3%.8%. COMPASS July 2013 19 . or to ignore outcomes that really matter to investors (the extreme negative outcomes).6% from 4. and therefore deliver greater efficiency in our solutions. Our use of behavioural risk enables us to ensure that our asset allocations fully reflect the risks that count. it makes no sense to strive to suppress outcomes that aren’t actually risky (good/positive outcomes).Wealth and Investment Management Global Research & Investments Our behavioural risk measure. making more space in the portfolio for investments with less tail risk. rather than -10% matters more to investors than the other changes in the distribution.

com +44 (0)20 3555 8415 Antonia Lim Global Head of Quantitative Research antonia.com +44 (0)20 3555 3296 Greg B Davies.krpata@barclays.com +44 (0)20 3555 8405 Amie Stow Fixed Income Strategy amie.scarpa@barclays. Europe kevin.com +65 6308 3178 COMPASS July 2013 20 . Americas hans.gardiner@barclays. PhD Behavioural Finance emily.hobbs@barclays.com +44 (0)20 3555 8398 Christian Theis Macro christian.com +1 212 412 3805 Peter Brooks.davies2@barclays.brooks@barclaysasia.com +65 6308 3599 Wellian Wiranto Investment Strategy wellian.yeo@barclaysasia.com +44 (0)20 3555 8409 Laura Kane Investment Strategy laura.joyce@barclays.com +44 (0)20 3555 8395 Tanya Joyce Commodities tanya.com +1 212 526 4695 Kristen Scarpa Investment Strategy kristen.theis@barclays.com +44 (0)20 3134 2692 Emily Haisley.wiranto@barclaysasia. PhD Head of Behavioural and Quantitative Finance greg.com +44 (0)20 3555 8412 William Hobbs Equity Strategy william. PhD Behavioural Finance specialist peter.haisley@barclays.com +1 212 526 2589 David Motsonelidze Investment Strategy david.stow@barclays.Wealth and Investment Management Global Research & Investments Global Investment Strategy Team ASIA Benjamin Yeo Chief Investment Officer.com +65 6308 2167 Eddy Loh Equity Strategy eddy.com +1 212 526 4317 EUROPE Kevin Gardiner Chief Investment Officer.kane@barclays.com +44 (0)20 3555 8057 Petr Krpata FX petr.motsonelidze@barclays.com +65 6308 2714 AMERICAS Hans Olsen Chief Investment Officer. Asia and Middle East benjamin.loh@barclaysasia.olsen@barclays.lim@barclays.

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