Global Markets Monthly

AUGUST 2021

MUFG Bank, Ltd. & MUFG Securities EMEA

Members of MUFG, a global financial group

[Type text]
2021 Mitsubishi UFJ Financial Group
 Cross Asset

DEREK HALPENNY
Head of Research,
Global Markets EMEA and International
Global Markets Monthly
Securities
Global Markets Research
Global Markets Division for EMEA
E: Derek.Halpenny@uk.mufg.jp 17 August 2021

LEE HARDMAN
Currency Analyst
Global Markets Research
Global Markets Division for EMEA
E: Lee.Hardman@uk.mufg.jp

LIN LI Contents
Head of Global Markets Research Asia
Global Markets Division for Asia
E: Lin_Li@hk.mufg.jp Global Macro – Emerging Markets 3
EM assessment: cautiously shifting up a gear 3
EHSAN KHOMAN Economic growth: hot and cold 4
Head of Emerging Markets Research – Inflation: transitory vs. permanent 5
EMEA
DIFC Branch – Dubai Monetary policy: rate tightening timelines 7
E: Ehsan.Khoman@ae.mufg.jp External balances: healthy improvements 8
Fiscal balance and debt: easing but scarring 8
GEORGE GONCALVES
Overall assessment: winners and losers 9
Head of U.S. Macro Strategy
Institutional Client Group MUFG
US Fixed Income: The rates bottom, it’s a process 11
Securities Americas, Inc
E: George.Goncalves@mufgsecurities.com Quick mid-quarter thoughts 11

CARLO MAREELS
FX 13
Director Base case expectations, JPY, EUR & CNY 13
Credit Trading Group USD/JPY – Bullish BIAS 13
European Banks
E: Carlo.Mareels@mufgsecurities.com
EUR/USD – Bearish BIAS 14
USD/CNY – Bullish BIAS 15
KONRAD BOSZKO
Director European Credit 18
Credit Trading Group Spreads Stabilised at the tights in the summer 18
European Banks European Banks 20
E: Konrad.Boszko@mufgsecurities.com

A member of MUFG, a global financial group

2 17 August 2021
EHSAN KHOMAN Global Macro – Emerging Markets
Head of Emerging Markets Research
– EMEA
Emerging markets face a testing growth-inflation nexus with markets
MUFG Bank torn between “benign” and “vindictive” reflation narratives. The former
T: +971 (0)4 387 5033
is growth supportive with inflationary pressures proving transitory,
E: ehsan.khoman@ae.mufg.jp whilst the latter surrounds more permanent and stickier inflation with
rates as well as volatility elevated. This is being accentuated by a
slowing pace of global liquidity growth and apprehensions about the
A member of MUFG, a global financial group
Fed’s tapering impact which loom large for EMs. Policymakers across
the EM complex are endeavouring to make the right cyclical choices
by neither keeping policy so loose that they lose market credibility
and let inflation expectations slip, nor tightening so fast that they
stymie the recovery still vulnerable to fresh COVID-19 setbacks.

EM ASSESSMENT: CAUTIOUSLY SHIFTING UP A GEAR

The scale of the global economic rebound unfolding since the first successful vaccine
efficacy announcements in early November 2020 has been marked. Key since then
has been the sheer velocity of inoculations being rolled out and the scale of fiscal
policy support. However, if growth has lurched higher, so too has inflation in many
places, and it is inflation that has been dominating the reflation narrative, particularly
whether it will prove to be transitory or more long-lasting. This backdrop has
generated mixed blessings for EMs thus far in 2021. Critically, the lack of
expansionary policy space, alongside that EMs remain at the back of the global
queue on vaccine rollouts – which has led to COVID-19 headwinds propelling
renewed mobility restrictions in several major countries – have capped the growth
prospects across the EM complex.

Having said that, the traffic light is not red yet. First and foremost, EM activity should
benefit from the ongoing vaccination programmes and further global reopenings,
even though this could be delayed in certain parts. We also see a better European
outlook, which would be very supportive for EMs, given the strong trade and capital
ties between them (see here). Second, the risk premium that was eroded during the
pandemic is coming back fast as more EM economies tighten monetary policy, front-
loading rate hikes even though inflationary pressures are mostly cost- push in nature

EM’S CURRENTLY CONSTITUTE ~55% OF THE WORLD’S EM MOBILITY MORE RESILIENT IN LATEST VIRUS WAVE
CURRENT THIRD WAVE OF COVID-19 AS INDIVIDUALS HAVE ACCEPTED VIRUS REALITIES
DAILY COVID-19 CASES, 7 DAY MOVING AVG (THOUSANDS) EM – GOOGLE MOBILITY IN RETAIL/RECREATIONAL SITES (BASELINE
LEVEL 3 JAN – 6 FEB 2020) AND NEW VIRUS CASES (7 DAY MOVING AVG)

900 700 EM mobility 30

DM Asia levels
Google mobility indicator –
COVID-19 cases (7 day MA,

800 20
600
North America
recreation and retail

700 10
500 EM COVID-19
Western Europe
thousands)

DM Asia cases 0
600
EM EMEA 400 -10
500 N. America
LatAm 300 -20
400 W. Europe
EM Asia -30
200
300 EM EMEA -40
100
200 -50
LatAm
0 -60
100
Apr-20

Aug-20
Sep-20
Oct-20
Nov-20
Dec-20

Apr-21
Jun-20

Jan-21

Jun-21
May-20

May-21
Mar-20

Mar-21
Feb-20

Jul-20

Feb-21

Jul-21

EM Asia
0
Apr-20

Aug-20
Sep-20
Oct-20
Nov-20
Dec-20

Apr-21

Aug-21
Jan-20

May-20
Jun-20

Jan-21

May-21
Jun-21
Feb-20
Mar-20

Jul-20

Feb-21
Mar-21

Jul-21

COVID-19 cases (7 day moving average) (Left Axis)

Google mobility indicator (Right Axis)
Source: ourworldindata.org, MUFG Research Source: Google, ourworldindata.org, MUFG Research

3 17 August 2021
 (see here). Third, EM external positions are robust and in some cases getting even
stronger, particularly for the commodity producers (see here). It is not only the trade
balance but also remittances that are solid for many EMs. We have for long been
arguing that the gap between large terms-of-trade gains and commodity FX
performance should close. We believe this story still has legs and will favour some
EM FX unless commodities collapse or the USD soars – neither of which is our base
case.

ECONOMIC GROWTH: HOT AND COLD

The first half of 2021 has been mixed as far as EM activity is concerned. EM GDP
growth was at a robust 9.6% y/y, albeit largely due to China, where the pace of
economic activity surged to 13.1% y/y. Parts of the GDP data in H1 2021 is masked
by base effects – which in tandem with the resurgence of COVID-19 cases in some
major EMs, fresh lockdowns and supply shortages – suggests that the performance
has not been all rosy despite the benign headline readings. On a relative basis, EM
PMIs averaged 51.7 in the first half of this year, well below developed markets (DM)
58.1. The underperformance seems to have been broad-based with both EM new
orders and new export orders hovering well below DM figures. Having said that, it’s
been the employment index where the average for the first half was below 50
(threshold level that separates expansion from contraction), which points to still-weak
labour market conditions. We are also mindful of the lasting economic consequences
of last year’s slump on EMs and the economic burden that foregone growth, lost
investment and higher levels of public debt represent.

Despite the varied first half performance, we are optimistic for the second half for
EMs and beyond for three core reasons:

1. EM vaccine rollouts are gathering momentum. The first half of the year
demonstrated that countries with better vaccine rollouts have performed
much better in the recovery process. The vaccine rollouts were slow in EMs
in Q1 2021 but the latest data point to an acceleration in vaccinations during
Q2 2021, which is likely to continue in the remainder of the year. Notably,
the GCC and Central and Eastern European (CEE) economies, along with
Brazil, China and Turkey, have seen a large increase in vaccine rollouts,
which should mean a swifter normalisation of their economies.
2. Reopenings supporting EM manufacturing activity. The fallout from the
pandemic has been felt the most in the demand for services, while goods
demand has been quite strong, thanks to consumer goods, which have
been mostly supplied by EM economies – Asia in general and China in
particular. As economies open up, it is likely that the demand for goods will

VACCINE ROLLOUTS ACROSS EM’S HAS ACCELERATED GLOBAL GOODS DEMAND REMAINS ROBUST, THANKS
WITH H2 2021 TO WITNESS A SURGE IN INOCULATIONS TO CONSUMER PRODUCTS, MOSTLY SUPPLIED BY EM’S
COVID-19 VACCINE DOSES PER 100 POPULATION GLOBAL GOODS DEMAND AND EM IND. PROD. (REBASED 100 = JAN 2019)

180 110.0

160 107.5

140 105.0
102.5
120
100.0
100
97.5
80
95.0
60
Global average 92.5
40
90.0
20
87.5
0
85.0
Chile
Israel

Czech R.

S. Korea

Tawian
Ukraine
UAE

China

S. Arabia

Peru
Indonesia
Brazil

Russia
Malaysia
Turkey

Egypt

EU
Romania

Colombia

India

US
Hungary

Philippines

S. Africa
Argentina

Mexico

Vietnam

Sep-19
Nov-19

Sep-20
Nov-20
Jan-19

May-19

Jan-20

May-20

Jan-21

May-21
Mar-19

Jul-19

Mar-20

Jul-20

Mar-21

Jul-21

Q3-21 Q2-21 Q1-21 Global average Global goods demand EM industrial production
Source: Bloomberg, IMF, MUFG Research Source: Bloomberg, CPB, MUFG Research

4 17 August 2021
 give way to services, though manufacturing activity should still keep doing
well. A core reason relates to the supply and demand gap, given ongoing
supply disruptions in key products (semiconductors, etc), which should
support manufacturing activity. Also there are signs that some corporates
are moving from just-in-time manufacturing to just-in-case manufacturing, to
minimise the risks stemming from supply disruptions. Finally, recovering
inventories should pave the way for re-stocking and higher output.
3. EM investment outlook is strengthening. Gross fixed capital formation
(GFCF) across EMs already turned positive before the turn of the year,
while the latest figures for H1 2021 signal a further acceleration of this trend.
LatAm seems to be leading the GFCF recovery, which largely reflects the
capacity investments into the mining sector. GFCF growth has been also
strong in Asia, thanks to China, where infrastructure investments have
accelerated as part of the government’s support programmes. In EM EMEA,
GFCF growth remains positive, though lags its EM peers. Going forward,
the EM investment recovery will continue for two reasons, in our view. First,
there is still a wide investment gap, implying that there is room for capacity
build up in EM. Second, the export outlook appears to be moving in lockstep
with GFCF. Whilst H2 2021 is expected to bring some shifts in the mix of
goods exported (from consumption goods to investment goods), there is still
a solid case for robust EM export growth performance for the rest of 2021.

On a weighted average basis, we forecast EM growth as a whole running at 6.7%

(consensus 6.5%) this year. Beneath the surface, however, the picture is highly de-
synchronised. Economic growth rates across EMs are set to be fairly erratic on a
quarterly basis and they will vary enormously between economies and within them.
Much will depend on a series of factors including; (i) whether governments prefer a
strategy of eliminating or suppressing the pandemic; (ii) access to – and the pace of
rollout of – effective vaccines; (iii) the structure of each economy; (iv) the willingness
of individuals to spend their accumulated savings; and (v) the scale and mix of policy
stimulus. From an EM regional perspective, our modelling estimates suggest that the
recovery in Asia will continue leading from the front, whilst the rebound in parts of
EMEA has been sharp is some places, and finally LatAm economies (albeit with
considerable heterogeneity) continue to lag.

INFLATION: TRANSITORY VS. PERMANENT

EM inflation has picked up sharply over the past few months, largely on the back of a
low base from the previous year, along with higher volatile food and energy prices, as
well as faster momentum in transport costs. It is not just the headline CPI – core

HIGHER COMMODITY PRICES IN 2021 HAS BEEN COMMODITIES ARE A KEY DRIVER OF EM INFLATION AS
FEEDING THROUGH INTO EM HEADLINE INFLATION THEY ACCOUNT FOR A LARGE SHARE OF IMPORTS
COMMODITY PRICES, REBEASED 100 = 1 JANUARY 2021 VALUE OF 27 COMMDOITIES IN 2019, IN % OF TOTAL EM IMPORTS

220 40
Coal
35
200
30
180
25
160 Brent oil
20

140 15
Natural Gas
Copper 10
120
Soybeans 5
100
Gold
0
Iron ore
Chile

Ukraine
S. Korea
China

Peru

Ghana

Lebanon

S. Arabia
Egypt

Malaysia

Indonesia

Brazil

Ecuador
UAE

Kenya

Colombia

Czech Rep

Russia
India

Turkey

S. Africa

Philippines

Romania
Thailand

Argentina

Poland

Hungary
Vietnam

Nigeria

Mexico

80
09-Apr
23-Apr

13-Aug
01-Jan
15-Jan
29-Jan

04-Jun
18-Jun
02-Jul
16-Jul
30-Jul
12-Mar
26-Mar

07-May
21-May
12-Feb
26-Feb

Source: Bloomberg, IMF, MUFG Research Source: Bloomberg, IMF, MUFG Research

5 17 August 2021
 inflation has also risen, given the recovery in domestic demand owing to the easing
of mobility restrictions, although the pick-up has been more modest.

The rise in headline EM CPI inflation can, to some extent, be attributed to the surge
in producer price inflation (PPI), i.e. the cost side. Indeed, after reaching its lowest
level since the 2008-09 global financial crisis (GFC) in mid-2020, EM PPI has been
on a sharp uptrend, and recently hit its highest level since 2008. Moreover, the rise
has been broad-based across regions and countries, though in LatAm PPI has
soared to its highest level in two decades. Although the correlation between CPI and
PPI has seen a decline following the GFC, particularly in Asia, our causality analysis
implies a statistically significant pass-through from PPI to CPI in up to 2-3 months.
Moreover, we calculate that EM PPI helps explain ~30-40% of the variance in CPI,
though regional differences remain high.

In what will likely transpire as a positive development, we believe that EMs are
approaching peak inflation concerns, as commodity prices begin to stabilise and core
inflation starts to roll off as supply-side constraints ease. On net, we do not expect a
long-lasting uptrend in inflation and envisage price pressures diminishing once the
disruptions in supply chains are restored. Having said that, we have modestly revised
our EM CPI forecasts up to 4.1% y/y from 3.4% y/y (in April). Risks are however
skewed towards price pressures remaining elevated for a more protracted period,
especially in parts of LatAm here PPI explains more than 70% of the variance in CPI
on a 12 month basis – signalling that upside inflationary risks from PPI are more
evident in LatAm than in other regions. Inflation continues to also surprise to the
upside even in some structurally low EM inflation countries, such as Israel.

The combination of a reduction in optimism surrounding growth and increasing

concerns about DM inflation is typically negative for EMs given it normally results in
the adverse mix of a slowdown in external demand and higher DM (notably US)
yields. However, the current environment is suggesting a different development. DM
yields have not increased on the back of recent higher inflation prints (in many places
yields have in fact fallen). There are two explanations of this. First, markets expect
supply-side factors that push up prices to be resolved in months ahead. The phasing
out across economies of the different support schemes for unemployed/furloughed
absent workers for example could relieve labour market tightness. Second, upside
inflation surprises have provoked a moderately hawkish tilt in central bank’s
communication which has reassured markets that there won’t be a higher inflation
risk over the medium term. As such, markets envisage the strength of the recovery
as transitory and that central banks won’t get policy rates to levels that could justify
higher yields. We therefore view that concerns around a protracted period of higher
inflation may be close to peak levels with a moderation likely in H2 2021.

2021 WILL WITNESS A PICKUP IN INFLATION IN MOST INFLATION IS MOVING ABOVE TARGET IN EM’S – LIKELY
EM’S BUT 2022 WILL EXPERIENCE A MODERATION PROMPTING MORE CENTRAL BANKS TO RAISE RATES
HEADLINE INFLATION IN MAJOR EM’S (% Y/Y) EM INFLATION (% Y/Y), CENTRAL BANK TARGET RANGE (%)

16 24
14 22
12 EM Asia EM EMEA LatAm
20
10
EM average 18
8
inflation 16
6
2021: 4.1% 14
2022: 3.6% 4 12
2020: 2.6% 2 10
0
8
-2
6
-4
4
Israel

Qatar
Taiwan

Czech Rep.

Ukraine

Chile
Indonesia
China

Peru
Malaysia
Phillipines

Brazil
Kenya
Egypt

Ecuador
South Korea

UAE
Saudi Arabia

Kuwait

Russia

Iraq
Turkey

Colombia
India

Romania
Oman
Pakistan
Thailand

Poland

Hungary

Nigeria

Mexico
South Africa

2
0
-2
Ukraine

Chile

S. Korea
S. Arabia

Israel
Malaysia

Czech R.

Taiwan
Egypt

Indonesia
Brazil

Russia

China

EM
Turkey

Philippines

LatAm
India

Romania

Colombia

Asia
Nigeria

Mexico

Hungary

S. Africa
Poland

Thailand

Vietnam

EM EMEA

EM Asia EM EMEA LatAm

Change in 2022 Change in 2021
2020 Average 2020
Average 2021 Average 2022 Nominal policy rate range since 2008 (%) Latest End 2019
Source: Bloomberg, EM Central Banks, MUFG Research Source: Bloomberg, EM Central Banks, MUFG Research

6 17 August 2021
 MONETARY POLICY: RATE TIGHTENING TIMELINES

The Fed’s hawkish pivot has given markets further impetus to side with the more
“vindictive” version of reflation stemming from US overheating and sticky inflation,
against the more “benign” reflationary narrative, centred on a synchronised global
upturn which will not generate persistent demand-side inflation pressures beyond
near-term spikes (see here). The Fed has clearly telegraphed that any tapering of its
asset purchases and eventual rate hikes will be “orderly, methodical and
transparent”. However, EM economies remain highly sensitive to any Fed guidance,
with the USD’s knee-jerk reaction to the Fed’s hawkish surprise already having
reverberations across the EM complex – we recently examined the impact on EM
assets from higher US rates (see here).

EM monetary policy leaders – those that are in the camp of front-loaded rate
normalisation paths by initiating rate hikes recently, with markets rewarding such
proactive tightening – are increasingly gaining traction. In EM EMEA, Russia, Turkey
and Ukraine are already several months into front-loaded hiking cycles – although we
caution that the neo-Fisherite rebellion narrative could push Turkey towards a
premature easing cycle in Q4 2021 – see here). What’s more, the Czech Republic
and Hungary have combined rate hikes with hawkish forward guidance. Meanwhile,
in Asia, the monetary policy narrative has shifted sharply for South Korea, with
policymakers setting the stage for a policy lift-off in the not-too-distant future. For
LatAm, Brazil remains the stand-out EM, proactively hiking since March, whilst
Mexico is turning to hikes with hawkish impulses. Finally Chile followed through on its
hawkish discussions with a hike last month. On net, markets have been rewarding
such hawkish monetary policy shifts, against the backdrop of an aggressive
steepening in the US yield curve, with Brazil, Mexico and Russia (high yielders with
ongoing hiking cycles), having outperformed peers, whilst hikes in EM low yielders,
Czech Republic and Hungary, have contributed to increased stability across risk
assets, notably in the FX space.

Monetary policy normalisation for all other EMs though could be delayed given virus
uncertainties and slow vaccination rates and, with it, dampening hopes of a speedy
economic recovery. This still delays the inevitable scaling back of liquidity provisions
and rate rises, and not only during a less accommodative Fed, but also when EM
peers have already embarked on a tightening cycle. Such a delay runs the risk of
building up in term premium and steeper curves, at least for EM high yielders.
Indeed, the front-end of the many EM rates curve implies a solid degree of tightening
by the end of 2022, and most have implied rates that reflect a return to the average
policy rate over the past five years. Such an implied policy path of normalisation
though needs to be validated by EM central bank action or certain EMs run the risk of

MONETARY POLICY NORMALISATION INCREASINGLY
TAKING HOLD ACROSS EM’S, WITH SEVERAL LEADERS
CHANGE IN EM INTEREST RATES BY TIME PERIOD (BASIS POINTS)
Rate hikes
EM REAL RATES REMAIN NEGATIVE THOUGH HIKES AND
(LIKELY) EBBING INFLATION WILL REVERSE THE TREND
EM WEIGHTED AVERAGE POLICY RATES (%) VS EM CPI (% Y/Y)
16

300 EM leaders front-loading rate EM real rates (%)

200 14
hikes thus far in 2021 EM headline rate (% y/y)
100
0 EM policy rates (%)
12
-100
-200 Q3 2021
-300 10
-400 Q2 2021
Rate cuts

-500 8
EM inflation
-600 Q1 2021
6 EM policy
-700
H2 2020 rates
-800
-900 4
-1000 Q2 2020
-1100 Total 2
-1200
EM real
Ukraine

Czech Rep.

Qatar

Israel
Chile

Taiwan
Peru

Indonesia
Brazil

Malaysia

China
Turkey

Egypt
Russia

UAE

Colombia

Saudi Arabia
Philippines

South Korea

Romania
India
Hungary

Mexico

Pakistan

Poland

Morocco
Thailand

Vietnam
South Africa

0
rates
-2
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021

Source: Bloomberg, MUFG Research Source: Bloomberg, EM Central Banks, MUFG Research

7 17 August 2021
 being more susceptible to a disorderly exist of accommodative policy and inflation
becoming unhinged beyond just temporary bottleneck surges in prices.

The real rate cushion, while increasing, may still be insufficient to stem the risks of a
much more hawkish Fed, which could amount to a sharp reversal of capital flows.
This is not our base case and this risk is also in part mitigated as EMs’ external
balances are in good shape.

EXTERNAL BALANCES: HEALTHY IMPROVEMENTS

With Fed tapering looming, the focus will likely shift to EM external positions and
financing requirements. These were one of the main sources of concern for EM
investors in 2013, when the Fed stated that it would start tapering its asset
purchases. The announcement – leading taper tantrum – witnessed a sharp re-
pricing of risks and there was an acute sell-off in markets with large external
imbalances. Fast forward to now – EM external balances are much leaner compared
to 2013 (even among many high-yielding EMs that traditionally run current account
deficits) and, therefore, the EM complex is less reliant on external financing. Indeed,
there has been a sizeable improvement in structural current account balances in
almost all major EMs over the last couple of years.

Even in economies where the current account deficit has always been a major
source of concern, the improvement is quite stark. This is particularly true for high-
yielding EM economies, such as Brazil, India, Indonesia, South Africa and Turkey. In
Turkey, for example, the structural current account deficit has narrowed from 6.3% of
GDP during 2012-2013 to 2.0% as of end 2020 (we expect the current account deficit
to widen to 2.9% of GDP in 2021, implying only a mild deterioration). In South Africa,
the structural current account deficit has come down to 1.3% of GDP from an
average of 4.6% during the 2013 taper tantrum episode.

On balance, the structural side looks in much better shape particularly when
compared to 2013’s taper tantrum episode. Though, in some economies, external
financing requirements will remain sizeable, due to the sheer stock of external debt
and low international reserves, which could still remain a source of vulnerability.

FISCAL BALANCE AND DEBT: EASING BUT SCARRING

Beyond the broadly supportive monetary backdrop, the pressure for fiscal tightening
also looks moderate. In part this reflects still-strong global risk appetite which has
continued to support access to international funding in both domestic and foreign
currency. However in aggregate, we see the EM fiscal deficit narrowing to 4.8% of

EM FISCAL DEFICITS WILL REMAIN SEQUENTIALLY EM DEBT PROFILE CONTINUES TO RISE WITH 2021
TIGHTER IN 2021 LEADING TO FURTHER INCREASES
CONTRIBUTIONS OF EXPENDITURES AND REVENUES TO CHANGE IN EM PUBLIC DEBT 2019-21 (% OF GDP)
FISCAL DEFICITS, PP CHANGE FROM 2020 TO 2021 (% OF GDP)

8 8 140 Change in 2021 Change in 2020

2019 2019 Average
Higher 6 120 2021 Average
6 Improving
revenues
4 deficit 100
4
2 13pp average increase between 2019-21
80
0 2 from 51% to 64% of GDP
60
-2
Lower 0
40
expend. -4
-2 Deterior,
-6 20
deficit
-8 -4 0
Israel

Ukraine
Ghana

Bahrain
Iraq

Kuwait
UAE

Russia
Saudi Arabia

Turkey
Iran
Romania

Kenya
Jordan
Egypt
Poland

Hungary

Morocco
Czech Rep

Uzbekistan

Oman

Angola

Algeria
Kazakhstan

Nigeria
South Africa

-20
Israel
Chile

Ukraine
Indonesia

China

Ghana
Malaysia
Kuwait

Turkey
Russia

UAE

Czech Rep

S.Africa

Egypt
Brazil
Bahrain
Romania
Uzbekistan

Poland

Morocco
Oman

India

Angola
Thailand
S.Korea

Mexico

Hungary
Kazakhstan
S.Arabia

Nigeria

Total Expenditures Total Revenues Fiscal Balance

Source: Bloomberg, EM Statistical Offices, MUFG Research Source: Bloomberg, IMF, MUFG Research

8 17 August 2021
 GDP this year, as the COVID-19 shock fades – a 2.8ppt improvement on the 2020
outturn. Our forecasts suggest the EM fiscal deficit narrowing further still in 2022
(4.3% of GDP) – a trend we view should be sufficient to see public debt stabilise.
Also, while debt levels remain elevated on their pre-virus levels, our expectations are
that debt servicing costs will trend lower as a percentage of GDP, as reduced interest
rates more than offset the rise in the stock in all but a few EM economies – a view
supported by the continued drop in average EMBI yields.

Whilst it would seem that the pandemic is gradually moving into the rear view mirror,
the significant deterioration of fiscal balances and public debt build-up across EMs is
a legacy that will confront markets and challenge policymakers for years to come. For
most EM economies, returning fiscal balances to pre-virus levels is likely to be a
multiyear endeavour. Reversing the sharp increase in debt will likely take even longer
(if it ever happens). After all, the historical record shows that large fiscal expansions
seldom fully mean-revert, increasing the EM risk premium commanded by investors.
Granted, the probability of full-blown near-term EM debt crises is low and contained
low below-neutral real rates and stronger external balances. Moreover, most of the
increase in EM public debt has taken place in local currency, which reduces the risk
of an abrupt external funding halt. However, most EMs will face a painful adjustment
of fiscal balances in the aftermath of the virus and it is striking how wide the range of
outcomes across countries is likely to be.

OVERALL ASSESSMENT: WINNERS AND LOSERS

Looking ahead, despite our constructive conviction that we hold on EM growth, the
rebound trajectory is uneven and unbalanced – in effect the recovery is increasingly
turning more sequenced than synchronised. Our broadly constructive forecasts rest
on three core assumptions: (i) that commodity prices will stabilise but remain high as
global demand normalises; (ii) domestic inflation will roll off as supply-side
constraints ease, and; (iii) global policy will tighten only gradually as core DM central
banks look through transitory price spikes to focus on securing growth and
employment. On top of this, we expect regional policymakers to make the right
cyclical choices – neither keeping policy so loose that they lose market credibility and
let inflation expectations slip, nor tightening so fast that they stymie off a recovery still
vulnerable to fresh COVID-19 shocks.

Whilst we are hopeful of this, we are also conscious that the specific characteristics
of the virus-driven economic cycle leave each element vulnerable to setbacks. We
forecast the CEE, core GCC, Egypt and Israel performing best, weaker energy
producers muddling through, whilst sub-Saharan Africa (SSA) and Turkey

EM LEADS THE GLOBAL RECOVERY BUOYED BY CONSIDERABLE HETEROGENEITY REMAINS ON THE

OUTPERFORMANCE IN ASIA GROWTH PROFILE ACROSS MAJOR EM’S
REAL GDP LEVEL, INDEX Q4 2019 = 100 REAL GDP (% CHANGE VS 2019)
112.5 22.5 2020 2021 2022
Asia
Forecast 20.0
110.0 N. America 17.5
EM Growth to return to pre- Growth to
107.5 Index Q4 2019 = 100 15.0 virus levels by 2022 remain pre-virus
EM EMEA 12.5 even by 2022
105.0 World
MENA / EU 10.0
102.5 LatAm 7.5
5.0
100.0
2.5
97.5 0.0
-2.5 Growth
95.0 undeterred by
-5.0 the virus
92.5 -7.5
Qatar
Israel

Czech R.
Ghana

Indonesia
China

Bahrain
Egypt

Malaysia

Russia

UAE

S. Arabia

Kuwait
Kenya

Turkey

Romania

India
Poland

Hungary

Philippines

S. Africa
EM EMEA

Oman
Thailand

90.0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
19 19 19 19 20 20 20 20 21 21 21 21 22 22 22 22
Source: Bloomberg, IMF, MUFG Research Source: EM Statistical Offices, IMF, MUFG Research

9 17 August 2021
 remaining the focus of our apprehensions:

1. Leading. The economies we have the greatest comfort in are those that are
delivering speedy vaccine rollouts and those that continue to possess some
policy flexibility. Much of the CEE fits this category, notably Poland. Not
only has the CEE witnessed an easing of COVID-19 concerns, but also the
most marked improvement in the quality of investment spending which is
emerging as a core driver of the recovery. Moreover, the prospects for the
next phase of the recovery are also enhanced by the expectation of
strengthening eurozone demand given the disbursement of Next Generation
EU funding. Separately, we hold Israel is similarly high regard given the
phoenix-like vaccine inoculation spurring the rebound in growth,
notwithstanding the recent resurgence of virus cases and fatalities.
Elsewhere, we are upbeat on Egypt’s prospects, which we expect to
maintain real interest rates high and fiscal policy tight, keeping inflation at
target in the months ahead, and putting the budget deficit and public debt on
an encouragingly downward path. Finally, within the leaders group, we
bucket core GCC nations – especially Saudi Arabia and the UAE – which
have gained on the back of the marked improvement in energy prices which
has laid the groundwork for stronger growth in 2021 and into next year. In
conjunction, with vaccination programmes well advanced, the oil revenue
gains have set the stage for a stronger recovery with policy set to turn more
expansionary, boding well for National Vision strategies.
2. Muddling through. Outside the core GCC countries, whilst pressures have
eased on weaker commodity producers within EM EMEA, the lasting impact
of the COVID-19 shock, alongside stern fiscal consolidation will delay the
recovery. In particular, for Bahrain and Oman, the pick-up in energy prices
has brought timely relief from large double-digit twin deficits that posed a
threat to fiscal and monetary stability last year. However, in both cases, the
imbalances remain large and the build-up in debt last year was
disconcerting, necessitating further growth weakening consolidation in the
years ahead. Meanwhile, policy in Russia will remain tight despite the
robust balance sheet it commands, and with fiscal policy broadly restrictive,
potential growth gains will be capped.
3. Laggards. Our concerns generally lay within SSA and Turkey. In Nigeria,
the strains on public finances calls for policy adjustment and consolidation
of a scale that will prove testing given still weak growth. Away from Nigeria,
whilst we are becoming more comfortable on the immediate outlook for
Ghana following its success in securing large long-term funding from
international debt capital markets, which has offered the currency support
and turned inflation lower, the underlying fiscal dynamics remains strained
and debt is high. Meanwhile, in South Africa, already weak near-term
recovery prospects owing to fiscal pressures and macro vulnerabilities have
recently been tainted by a renewed surge in the virus against a backdrop of
a slow vaccination strategy, which has led to new mobility restrictions. On
the plus side, commodity gains have brought material respite to public
finances and the external account, slowing the pace of deterioration and
giving policymakers more room for manoeuvre. Finally, in Turkey, whilst
growth continues to surprise on the upside, the economy is tainted by a
deteriorating currency, inflation running more than 10ppt above target, large
short-term foreign currency liabilities (more than 25% of GDP), depleted FX
reserves and significant policy uncertainty. The macro backdrop warrants
Turkish policymakers to tighten rates to stabilise prices and allow the
balance sheet to recover, but it would appear that risks of premature rate
cuts are firmly on the table as soon as annual inflation passes its peak,
which could trigger fresh outflows and a further depreciation in the currency.

10 17 August 2021
GEORGE GONCALVES
Head of U.S. Macro Strategy
Institutional Client Group
MUFG Securities Americas Inc.
T: +1-212-405-6687
E: george.goncalves@mufgsecurities.com
MUFG Securities
A member of MUFG, a global financial group
US Fixed Income: The rates bottom, it’s a process
Macro Thoughts: We have had some misses (Q2 GDP) and some
major beats (both strong jobs growth and high inflation) but overall
the economy marches on to the beat of the reopening developments.
The risk of new variants could serve as catalyst for disruptions, but as
chair Powell mentioned in his latest press conference that the
economy has “learned to handle” and operate as time goes on. If
there are disruptions to growth from something like delta it’s more
likely to stem from global slowdowns versus how US responds to it.
Fed Policy: The taper launch window approaches with each passing
month where in August we will be combing through the July FOMC
meeting minutes for any clues on tapering plans. Similarly, we will be
listening attentively for further potential announcements and monetary
policy evolution at Jackson Hole. With many Fed speakers sounding
more hawkish lately (and almost seemingly looking as if they are
trying to physically talk up long-term rates) we will be watching to
what extent could Fed rhetoric (and then action) lead to higher rates.
Our Views: After a failed attempt at breaking to even higher rates in
early August, the strong 10yr Treasury auction in August (as well as a
decent 30yr the day after), highlights there is still robust demand for
US government bonds (even at these low yield levels). We were
using the August refunding mid-month event as a litmus test for how
high rates could go. Thus far, US long-term (L/T) rates seem to be
trying to form a bottom (but it has been very choppy to say the least).
Until we clear the key Fed August events, positive bond seasonals
and linger uncertainties from geopolitics to concerns over the delta
variant can keep US L/T rates bid. For now we are comfortable with
our below consensus forecast on the path for long-term rates,
however the risks still remain two-way and thus we stay neutral
duration and expect curves to be directional until the Fed tapers.

QUICK MID-QUARTER THOUGHTS

We are at roughly the midpoint of the quarter and have already digested some major
updates as seen in the Q3 timeline and past milestones chart below. Overall, it has
not been a dull moment thus far this summer. Yet certain pockets of the US bond
markets have seen some divergences from what other risky assets are suggesting.
That said US high yield spreads have been leaking a bit (after hitting very tight levels
earlier) thus it is not all hunky dory out there. Meanwhile the US economy continues
to march on, looking forward to further reopening benefits at the start of the autumn
school season. Such a backdrop should lead to an eventual turn up for US L/T rates.

However, a series of one-off “technical factors” (i.e. an over-stretched Q1 sell-off

flipping to momentum trading in late Q2/early Q3 along with structural demand due to
regulatory reasons and/or asset allocation shifts) combined with non-stop Fed
liquidity (as seen by the RRP usage) have been powerful at dragging rates down and
then keeping them there. Each conversation we have with investors usually starts off
with why rates continue to trade lower than what “fundamentals” would suggest. The
fact we keep fielding such questions means we are still in a bottoming phase and

11 17 August 2021
 rates will only meaningfully snap back up once we get past some major hurdles
(upcoming Fed events) and signs that the labor market continues to see substantial
further progress (both in the quantity of jobs and health of the internals).

US RATES STILL STRUGGLE FOR DIRECTION AT THE MID-POINT OF 3Q2021

Source: Bloomberg, MUFG U.S. Macro Strategy

As seen below, the Fed pivot towards a more neutral (which feels hawkish after the
uber-dovish policy prescriptions since 2019) to actually many Fed speakers sounding
more hawkish of late, means that the ball is really in their court if they truly believe
the economy can handle both lower liquidity injections and slightly higher rates from
here. Mind you, we think the Fed should have tapered a while ago, but it is not what
the Fed should do, it is what they have done and will do that matters (that plus what
is “priced-in”). For now US rates will take each new Fed development one at a time.

As we go deeper into Q3, we remain on track to an eventual announcement of the

Fed tapering its QE bond purchases in 2021. In addition to the Fed events (the July
minutes and Jackson Hole at the end of August) the next payroll report, CPI and how
the debt ceiling impasse is progressing will determine when Fed officially release its
tapering plans and timing. September is clearly now in play, but we caution our
readers by reminding them it is easier to push back taper versus pulling it forward.

FED IS USUALLY DOVISH LEANING BUT RECENT TURN HELPS SETUP TAPER

Source: Bloomberg, MUFG U.S. Macro Strategy

12 17 August 2021
 FX
DEREK HALPENNY
Head of Research,
Global Markets EMEA and The US dollar on a DXY basis is close to the same level when we
International Securities
published our last Global Markets Monthly on 21st July. The period
Global Markets Research
Global Markets Division for EMEA
since included an initial USD drop followed by a rebound, reflecting in
T: +44 (0)20 7577 1887 general the move in UST bond yields. Going forward, the FX market
E: Derek.Halpenny@uk.mufg.jp
will remain most sensitive to guidance in relation to the tapering of QE
LEE HARDMAN by the Fed with our bias favouring the dollar remaining supported
Currency Analyst
through to the next FOMC meeting in September. Technically we are
Global Markets Research
Global Markets Division for EMEA
close to important levels on the upside. On three occasions now this
T: +44 (0)20 7577 1968 year, DXY has failed to hold levels over 93.000 – around the end of
E: Lee.Hardman@uk.mufg.jp
March, July and again last week. However, the correction of the dollar
lower at the end of last week may not prove sustained given the
LIN LI
Head of Global Markets Research macro backdrop seems favourable for the Fed to continue on its path
Asia to announce a tapering plan. At some point once confirmed, the dollar
Global Markets Research should weaken back on the realisation of the Fed being cautious by
Global Markets Division for Asia
T: +852 2862 7005
proceeding slowly with tapering.
E: Lin_Li@hk.mufg.jp

BASE CASE EXPECTATIONS, JPY, EUR & CNY

USD/JPY – BULLISH BIAS

 Range: 106.00-112.00

MUFG Bank, Ltd.
A member of MUFG, a global financial group
The USD/JPY rate is marginally lower than when we last published consistent
therefore with our “Bearish Bias” guidance in the July edition. We are flipping that
view for the month ahead and see scope for the dollar to advance versus the yen.
We are now close to getting through the seasonal period of downside bias for
USD/JPY and assuming there is no risk-off event lurking that suddenly hits
confidence, we believe the near-term direction will be dictated by events on the USD
side rather than the JPY side.

As stated above, the drop of the US dollar on Friday on the disappointing consumer
confidence report looks over done and appeared more technical than a sustained
fundamental move. US consumers’ sentiment does not necessarily reflect how
spending patterns evolve and we doubt the Fed will place too much importance on
the data. In other words, the move higher in the 10yr UST bond yield looks
sustainable and if that’s correct then USD/JPY should remain well supported. The
near-term outlook provides ample opportunities for the Fed to update guidance that
signals we are closing in on the timing for tapering – a town-hall meeting tonight for
Fed Chair Powell followed by the minutes of the July meeting tomorrow and Jackson
Hole next week. We see upside risks to US yields covering these events.

The primary risk on the US side remains an escalation of the Delta variant. That’s
what spooked the US consumer in the consumer confidence data and a further
escalation could spook the Fed and prompt a change in communication tone.

On the Japan side, the year-to-date capital outflow into foreign bond and equity
markets has been quite subdued and points to the potential for increased foreign
security purchases going forward. On a year-to-date basis, Japanese investors have
bought just JPY 1,093bn worth of foreign bonds and sold JPY 5,380bn worth of
foreign equities. You’ve got to back to 2013 to find the last occasion when over the
first seven months of a calendar year there’s been a larger combined net selling of
foreign securities. For foreign bonds alone this year-to-date has seen the smallest

13 17 August 2021
 amount of purchases since 2014. Based on our assumption of a gradual grind higher
in the 10-year UST bond yield we see scope for those purchases to pick up. While a
portion of these purchases will be hedged, increased buying would also provide
support for USD/JPY with investors hedging less at lower USD/JPY levels.

Since March USD/JPY has traded largely in a 108.00-111.00 trading range and we
see that as likely continuing. If our view on the US holds, then we can see a gradual
grind higher while the risk of the downside is a hit to investor confidence probably
related to the further spread of COVID. JPY cross selling can act as a drag on
USD/JPY as evident by the large sell-off of NZD/JPY today in response to a COVID
case in New Zealand.

USD/JPY VERY MUCH A USD STORY AT PRESENT

Source: Bloomberg, Macrobond, MUFG GMR

EUR/USD – BEARISH BIAS

 Range: 1.1500-1.1950

We are maintaining a bearish bias for EUR/USD in the month ahead. The pair
bounced on Friday but is again grinding lower and could soon retest the year to date
low at 1.1704 from the end of March. The USD leg is continuing to derive support
both from building speculation over the Fed’s plans to begin QE tapering, and
building concerns over downside risks to the global growth outlook from the spread of
the Delta COVID variant especially in Asia. The relatively slow vaccine rollout in Asia
and government plans to eliminate the virus increase the risk of more disruptive
measures to contain the spread. At the same time, the US economy is continuing to
recover strongly with employment growth picking up in recent months. It leaves the
Fed on course to make a QE taper announcement before the end of this year. Fed
Chair Powell’s upcoming Jackson Hole speech at the end of the month will be
eagerly awaited for further policy guidance. Long-term US yields have put in place a
near-term bottom in our view which is helping to encourage a stronger USD as well.
We do not expect upcoming uncertainty over the US debt ceiling to materially
weaken the USD in the month ahead.

The paring back of optimism over the global growth outlook has been weighing on
the euro which has failed to strengthen even as economic activity in the euro-zone
continues to surprise to the upside. We expect the euro-zone economy to continue to
outperform in the near-term boosted by the easing of COVID-related restrictions,
catch up potential, and looser fiscal policy. After lagging in the initial vaccine roll out

14 17 August 2021
 phase, Europe has now caught up and is overtaking the US. It should help limit the
risk of further disruption ahead. However, the euro is not benefitting from the
improving growth outlook as the ECB has strengthened their commitment to maintain
loose monetary policy by adopting a higher hurdle for rate hikes in their new forward
guidance. The widening policy divergence between the ECB and Fed will encourage
a weaker euro. We do though expect the ECB to end their PEPP programme in Q1 of
next year, and are awaiting details over how they plan to step up APP purchases
th
next year to provide an offset. The German election is also scheduled on the 26
September with polls pointing to a closer race. It should garner more market attention
early in September and the uncertainty could weigh modestly on the euro, although
we view any euro weakness on the back of the German election as likely to prove
temporary

SHORT SPEC EUR POSITIONING CONTINUES TO BE BUILT UP

Source: Bloomberg, Macrobond & MUFG GMR

USD/CNY – BULLISH BIAS

Range: 6.3000–6.7000

The direction or the speculation on the direction of monetary policy may play a role in
near term currency movement, after we saw a set of tighter liquidity numbers and
weaker than expected key macro-economic variables for July. The new increase of
total social financing in July was RMB1.06 trillion, lower than both the consensus
expectation and the July average between the 2017-2019 period. July usually is a
seasonal off-season, usually with a lower net increase of total social financing
compared with that of June, however, this July’s decline in both on-balance sheet
credit and off-balance sheet financing outsized the usual seasonal decline. The new
increase in RMB loan under the aggregate financing definition was only RMB0.839
trillion this July, much lower than June’s RMB2.3 trillion. In addition to the sharp
decline in loan number, the sharp decline in government bond issuance also dragged
on the new increase of aggregate finance. Although there was a sizable RMB296
billion new increase in corporate bond issuance in July, net increase in government
bond financing dropped to RMB182 billion in July from the RMB751 billion in June.

The growth rate of the stock of total social financing decelerated by 0.3ppt to
10.7%yoy in July, the growth rate of M2 decelerated by 0.3ppt as well to 8.3%yoy
after its short-lived rebound in June. This July, the growth rates of social financing
stock and M2 declined to their respective pre-pandemic levels. In recent China’s ‘The
Second Quarter Monetary Policy Implementation Report’, PBOC mentioned that in
the first half of this year, the intensity of monetary policy has basically returned to the

15 17 August 2021
 normal state in pre-epidemic time, which is consistent with the levels of July’s growth
rates of total social financing stock and M2.

In this PBOC’s new report, policy guidelines were stated. The report emphasized on
implementing normal monetary policy, maintaining the stability of monetary policy,
and enhancing the cross-cycle policy design and macro policy autonomy. PBOC
reiterated that it will resolutely refrain from "overwhelming flooding". The tone of
monetary policy sounds “tight’ as government put emphasis on strictly controlling the
scale of credit for high-energy-consuming and high-emission projects, and that real
estate should not be used as a short-term means of stimulating the economy.

However, recent weak economic performance may raise market’s speculation on the
implementation of monetary policy in near term. Due to the continuous pandemic
outbreaks both externally and internally, flooding, and regulations on various
industries, downward pressure on the economy increased recently. Newly published
July macro numbers were weaker than both respective values in prior month and
consensus expectations. Particularly, 2-year average growth of industrial production
(2-year CAGR) decelerated by 0.9ppts to 5.6%yoy in July and infrastructure
investment remained weak. Details of banks’ lending data show a consistent picture
of weaker economic performance in July, both short-term and medium & long term
new increases in loan experienced sharp decline, for both households and non-
financial institutions. This may be partly explained by the policy tightening on real
estate related lending activities. “Five red lines” will continue pressure on real estate
sector, although the report also insisted on stabilizing land prices, house prices, and
expectations on the industry, as well as the consistency and stability of real estate
financial policies, the deceleration of the real estate sector likely remains.

While we think that PBOC’s monetary policy will remain largely stable, due to the
persisting and recently increasing downward pressure on Chinese economy, we still
maintain our view of marginal monetary policy relaxation in near term, and think that
inflation and inflation expectation could accommodate such policy implementation,
from PBOC’s point of view. In this report, PBOC concluded that inflation pressure in
China is largely controllable, which benefited from the fact that China’s money supply
growth rate has been gradually returning to normal levels since May last year.

GROWTHS OF AF STOCK AND M2 RETURNED TO PRE-PANDEMIC LEVELS

Aggregate Financing, %yoy

13
M2, %yoy

11

Source: CEIC, MUFG GMR

KEY RISK FACTORS IN THE MONTHS AHEAD

 The primary downside risk to our mildly bullish USD/JPY outlook is that the turn
lower in UST bond yields persists and the recent bounce turns out to be a blip
rather than a more sustained move higher in yields. Two factors will determine

16 17 August 2021
 whether this risk becomes more probable. Firstly, the rhetoric from the Fed on
QE tapering. A sudden shift back to a more cautious timeline on the timing of
tapering could drive yields further still and that could see USD/JPY decline
further. Secondly, the upturn in the Delta variant globally could intensify and that
would likely fuel demand for UST bonds which again could help support risk-off
currencies like CHF and JPY. While these risks are credible, any turn higher for
the yen would likely still be modest with USD/JPY set to remain range-bound.
 The main upside risk to our bearish EUR/USD view is that the current market
concerns over global growth and the Fed’s QE taper plans ease triggering a
reversal of recent USD strength. The moderation in US core inflation in July
provided encouragement for the Fed’s view that the overshoot will prove
transitory and keeps them on track for only gradual tightening which would be
less supportive for the USD. There is also the risk that the US debt ceiling
showdown could put more of a dampener on USD performance in the months
ahead.
 Risks to our modest bullish bias for USD/CNY include macro policy
implementations and the pandemic. Should the market’s worry on Delta variant
dissipates, the risk of a weaker US dollar could put downward pressure on
USD/CNY.

17 17 August 2021
CARLO MAREELS European Credit
Director
Credit Trading Group Markets remain steady during the summer months on lower volumes.
European Banks
The Iboxx EUR IG Corporate Index has barely moved from its 97bp z-
T: +44 (0)20 7577 4092
E: Carlo.Mareels@mufgsecurities.com spread levels of July 1st as economies and borders continue to re-
open. Some investors remain concerned about new variants of
KONRAD BOSZKO
Director
COVID, but generally they seem to be calmer and only the most
Credit Trading Group directly exposed of sectors seem to react now. European credit
European Corporates
remains supported by CSPP and PEPP, and investor appetite
T: +44 (0)20 7577 2352 remains even as investors experience very modest, albeit positive,
E: Konrad.Boszko@mufgsecurities.com
YTD total returns on senior credit.

SPREADS STABILISED AT THE TIGHTS IN THE SUMMER

Mitsubishi UFJ Securities
A member of MUFG, a global financial group
July proved, once more, to be a pretty steady, flattish month and August has so far
been very resilient, synthetic credit has seen Main trade sub 50 in July and August
and seems to have settled in the 46bps area for now. Cash credit was equally strong
in the period and remained flat at around z-spread 96bps whilst still absorbing
EUR8bn in senior corps of new issuance in July. Company fundamentals are
improving and while valuations are continuing to test the limits, hovering at their
recent highs; investors are still willing to participate. With European mid year results
out of the way now the market seems set to continue its path of solidity driven by the
economic recoveries around the world and in Europe on top of the particularly strong
market technical on the back of the large Central Banks bond purchase programs.

Credit performance has continued its recent theme; HY indices outperformed IG and
a continuation of the compressed higher beta sectors. EUR, GBP and USD senior
indices returned to a positive territory on a YTD basis recovering from their losses
earlier in the year. In EUR the subordinate indices are still showing the better
performances. New issue markets calmed down for the summer lull with EUR8bn in
senior corporates in July on top of EUR28.9bn in June, and almost EUR26bn in the
month of May.

TABLE 1: 2021 YTD TOTAL RETURN PERFORMANCE

Source: Bloomberg, ICE BofAML, MUFG

18 17 August 2021
YTD 2021 TOTAL RETURNS BY ASSET CLASS

Source: Bloomberg, ICE BofAML, MUFG

19 17 August 2021
 EUROPEAN BANKS

European banks remain relatively attractive within the credit space post mid
year results and a very supportive the EBA/ECB stress test result
We don’t change our stance on European banks credit as we maintain our
constructive view on the sector on the basis of satisfying results in 1H21, resilient
balance sheets and the continually improving economic backdrop. The overall
resilience of the banks gives comfort around any potential setbacks on the covid
recovery path. The chart here below sums it up quite neatly. The dramatic
underperformance of the European banks’ equity at the time of the Covid 19
outbreak has now been recovered with an impressive and steady increase in the
equity valuations since November 2020. Even the fears from the delta variant of the
virus and any potential new restrictions on the economies have now been overcome,
further helped by the good 2Q21 performances reported by most banks.

EUROPEAN BANKS EQUITY TOTAL RETURN VERSUS CREDIT

Source: Markit, MUFG

We’ve pointed out that in recent years the main trend for European banks has seen
strengthening balance sheet but underwhelming profitability. With low interest rates
and high regulatory costs as well as stringent capital requirements and competition
from non-bank fintechs profitability will remain challenging but the outlook is now
starting to improve. We would expect the many cost reduction programmes and
optimisation strategies to bear some fruit. The chart below shows the 1H21 return on
equity for the main banks in our universe and how these are still to a large extent in
single digit territory. The bulk of the banks aim for double digit returns over the
coming two year period.

A big part of the recovery in equity valuations of European banks is due to the lifting
of restrictions on dividends and buy backs. Most banks have now capital levels
above their own targets and will give some of this back to the shareholders.
Nevertheless, overall valuations for European banks remain still relatively low.

20 17 August 2021
 EUROPEAN BANKS 1H21 RETURN ON EQUITY AVERAGES AROUND 7.5%

22.9%
25.0%

18.9%
18.2%
Return on Equity 1H20

15.0%
20.0%

13.4%
13.2%
13.1%
12.6%
11.8%
11.0%
10.6%
10.2%
15.0%

9.9%
9.8%
9.3%
8.8%
8.8%
8.6%
8.5%
8.2%
8.0%
7.8%
7.5%
7.2%
6.8%
6.6%
6.1%
5.6%
10.0%

5.6%
5.4%
5.1%
4.7%
4.7%
4.1%
3.6%
3.3%
3.2%
2.7%
2.6%
2.2%
1.2%
5.0%

0.6%
0.4%

-11.9%
-6.0%
-2.4%
0.0%

Banco Bilbao Vizcaya…

Skandinaviska Enskilda…

Mediobanca Banca di…

Goldman Sachs Group…

Banca Monte dei Paschi di…

CaixaBank SA
Morgan Stanley

Societe Generale SA
HSBC Holdings PLC

Natwest Group PLC

AIB Group PLC

ING Groep NV

Intesa Sanpaolo SpA

Belfius
JPMorgan Chase & Co

Swedbank AB

Erste Group Bank AG

Banco Santander SA

Banca IFIS SpA

Banco de Sabadell SA
BNP Paribas SA

UniCredit SpA
Credit Agricole SA
UBS Group AG

BPER Banca
Bank of America Corp

Barclays PLC
DNB Bank ASA
Svenska Handelsbanken AB

Wells Fargo & Co

KBC Group NV

Commerzbank AG
Nordea Bank Abp

Bank of Ireland Group PLC

Virgin Money UK PLC

Credito Emiliano SpA

Raiffeisen Bank International

Danske Bank A/S

Standard Chartered PLC

BAWAG Group AG

ABN AMRO Bank NV

Banco BPM SpA

Credit Suisse Group AG

Deutsche Bank AG
National Bank of Greece SA
Lloyds Banking Group PLC
-5.0%

-10.0%

-15.0%

Source: Company results, Bloomberg, MUFG

2Q21 results have been surprising on the upside but with hardly any impact on
already technically compressed spreads
In a nutshell the 2Q21 results were good across most banks and numbers tended to
be much better than expected by consensus. This only further contributed to the
existing strength in the sector. The main message from this season in our view, is
that banks seem mostly comfortable with the fallout from the lockdowns and the
various restrictions on the economy. The top lines are normally growing on the back
of better fee income and the NIIs are still a mixed bag as the banks still suffer in the
low rates environment and from the drag from excess deposits. These are not always
fully offset y/y with the benefits from increased TLTRO take up and from re-
invigorated volume growth in mortgages and company lending.

On a quarterly sequential basis most banks’ NII showed good signs of stabilisation
and even q/q improvements. This suggests that the NII trough is now behind us.
Generally costs are lower y/y and the main propulsion forward in the y/y net income
comparisons mostly came from much lower y/y provisions (often with partial unwinds
of Covid provisioning overlays from last year). The provisioning costs tended to be
much lower than expected, helping many of the pre-tax profit beats versus
consensus. The table below shows the how, except for three banks, the sector has
significantly outperformed to the upside compared to expectations.

21 17 August 2021
 EUROPEAN BANKS 2Q21 SHOWED SIGNIFICANTLY BETTER THAN EXPECTED PRE-PROVISION PROFITS

120%

103%
Pre-tax profit beat or miss
100%

80%

66%
66%
64%
55%
50%
49%
60%

46%
45%
45%
44%
43%
40%
37%
35%
34%
33%
29%
28%
40%

26%
23%
22%
20%
20%
19%
18%
18%
17%
17%
15%
14%
13%
11%
11%
11%
10%
10%
20%

9%
7%
6%
6%
4%
-15%
-18%
-45%
0%

Metro Bank PLC

AIB Group PLC

HSBC Holdings PLC

Bankinter SA
Societe Generale SA

BNP Paribas SA

ING Groep NV

Banco Santander SA
JPMorgan Chase & Co

Intesa Sanpaolo SpA

Natwest Group PLC

Morgan Stanley
UniCredit SpA

Credit Agricole SA
Banco de Sabadell SA

Banca IFIS SpA

Swedbank AB

Erste Group Bank AG

Banco Comercial Portugues SA

Bank of Ireland Group PLC

BPER Banca
Barclays PLC

Commerzbank AG

Bank of America Corp

Virgin Money UK PLC

Nordea Bank Abp

DNB Bank ASA

Banco BPM SpA

Banco Bilbao Vizcaya Argentari

UBS Group AG

Svenska Handelsbanken AB

Credit Suisse Group AG

ABN AMRO Bank NV

KBC Group NV
Raiffeisen Bank International
Deutsche Bank AG

Standard Chartered PLC

Skandinaviska Enskilda Banken

Mediobanca Banca di Credito Fi

Danske Bank A/S

Eurobank Ergasias Services and

BAWAG Group AG
Lloyds Banking Group PLC

National Bank of Greece SA

Goldman Sachs Group Inc/The
-20%

-40%

-60%

Source: Bloomberg, MUFG

Amongst the many good results we would highlight a few stand outs, including DB,
Unicredit, BPM and Societe Generale. Even MPS did significantly better than
expected and made a EUR200m profit in 1H21. Sabadell made EUR147m net profit
in 2Q versus EUR52 last year and is now on track to deliver its year end targets. On
the weaker end we would say that Commerzbank was a small disappointment but
they are in the midst of their restructuring plan still and it is hard to make any
conclusions on the outcome from that. Standard Chartered is also a little bit weaker
then, say HSBC, in the quarter and their longer term profitability still seems quite a
stretch. Should continue to trade at a discount. We were pleased with Danske Bank
but the numbers were in line and the AML situation is still not showing much
progress. Profitability is still comparatively less than peers with its RoE at around 7%,
whilst nordic peers are all solid double digit returns.

The results of UK banks were strong across the board with all, Barclays, Lloyds,
Natwest and Virgin Money posting solid quarters.

ECB/EBA 2021 European banks stress test broadly a non-event, neutral for the
spreads

The overarching message from the stress test is that, apart from Monte dei paschi,
the European banks as a whole are now a very resilient sector, also in the face of a
severe and prolonged downturn. As a reminder the stress test is done only on static
end 2020 data and doesn't factor in any progress that banks have made since then
or any other mitigating elements. The stress test is done on the top 50 banks from 15
EU/EEA countries covering 70% of the assets.

Under a very severe scenario, the EU banking sector would stay above a CET1 ratio
of 10%, with a capital depletion of EUR 265bn against a starting CET1 ratio of 15%.

Credit losses, like in previous such exercises, would explain most of the capital
depletion. The “lower-for-longer” scenario narrative would also result in a significant
decrease in the contribution of profits from continuing operations, especially from net
interest income.

22 17 August 2021
 On individual banks standing out, the ones with the lowest 2023 adverse scenario
Fully Loaded CET1 ratios include DB at 7.4%, BancSabadell at 6.5%, Societe
Generale 7.5%, HSBC Continental Europe 5.9%, Banco BPM 7%

There is no minimum pass rate in this stress test but the results will be used by the
EBA/ECB to further fine tune the pillar II capital requirements which are tailor made
for each individual bank. We would expect that there are no real surprises in these
outcomes and that theadjustments to next year's SREP requirements (which are
driven by the pillar two component) will see only modest adjustments.

The one outlier is, as expected Monte dei Paschi with a CET1 ratio going to - 0.1% in
the 2023 adverse outcome. In our calculations that requires a capital increase of
around EUR2bn to be brought back to a CET1 level of at least 7.5%. The
management already published a plan for recapitalisation of EUR2bn and the
government may be the one injecting the capital, given that it is also the controlling
(65%) shareholder.

The Portuguese banks came out strongly in the 2023 adverse scenarios with Caixa
Geral CET1 at 15.3%, but also BCP relatively fine at 8.1%. Also the two Polish banks
Bank Polski and Kasa Opieki end with a 15% and 15.3% CET1 ratio and in the
Netherlands ABN is the one with the highest CET1 in advers at 13.5% (ING 11% and
Rabo 10%).

In France Societe Generale is the weakest at CET1 7.5% but BNP is not far off at
8.2%. Credit Agricole ends at 10.6% and BPCE at 10.2% with BFCM at 13.4% whilst
the Irish banks also handle the situation well and end up at 8.1% for BoI and 8.8% for
AIB.

Austrian banks also fine with Raiffaisen at 9% and Erste at 10.2%and Germany also
mostly fine with DB still the weakest at 7.4% but Commerzbank now ended up above
8% at 8.2%, just like BNP.

In Italy Intesa and Unicredit and Mediobanca ended up at 9.4%, 9.2% and 9.7%
respectively, versus Banco BPM and Monte at 7% and -0.1% and in Spain BBVA,
Santander and Bankinter showed 8.7%, 9.3% and 11.2% respectively whilst Sabadell
was the weaker brother at 6.5%.

Altogether the results give us an indication of relative strength but much of this is
already reflected in the current spreads.

Perhaps one element to point out is that Banco BPM is still significantly wider than
Sabadell in Senior preferred and NPS, whilst Sabadell turned out to be a bit weaker
in the stress test... Of course there are the considerations on the relative sovereign
spreads to be taken into account but for the time being these seem to be well
anchored.

Relevant credit development: Monte dei Paschi now officially being looked at
by Unicredit for a potential take-over of substantial parts of the business
In early August, the finance minister of Italy, Mr Franco, answered questions in
parliament on its plans to sell the good commercial bits of MPS to Unicredit. There is
a lot of political animosity on the topic but the outcome of the stress test is pretty
severe and will require potentially another significant public sector bail out in the form
of a pre-emptive recapitalisation. Under EU State Aid rules this can be done as long
as an entity is solvent (which MPS clearly is at the moment) but normally should
entail burden sharing of subordinated debt and equity. The latter is a quite delicate
and political item, and there are examples of public sector backed recapitalisations of
banks that didn't lead to sub burden sharing, such as the cases of Caixa Geral in
Portugal and NordLB in Germany.

Hence the fate of the MPS subs is very uncertain at the moment. Much will depend
on what Unicredit is prepared to do in case of a take-over. In the Unicredit 2Q conf
call last week Friday the CEO said that in the case of a take-over of a large chunk of
the MPS business it would also take over balance sheet which would suggest that it

23 17 August 2021
 may include some of the subs, on top of the senior, but there is still much to be done
on that front. The outcome is far from certain.

Issuance
The trend we have observed, and have been expecting, continued in recent months
with the overall decline in issuance versus 2020 driven by a net decline in Senior
non-bail-in, which should be in excess of the growth issuance growth in bail-in senior.
This is, hence, not sufficient to be offset by positive net new issuance in bail-in senior
(Senior Non-Preferred and Holdco Senior). So far this year this expectation has
come true. The chart below shows issuance and redemptions over the last 12
months period and clearly there is significant positive net new issuance in the senior
bail-in space across all currencies in Euro equivalent and a marked net negative
issuance pattern in the Senior non-bail-in paper.

LAST 12 MONTHS REDEMPTIONS AND ISSUANCE, NEXT 12 MONTHS REDEMPTIONS, EUROPEAN BANKS IN
EUR EQUIVALENT ACROSS ALL CURRENCIES

Source: Bloomberg, MUFG

In the month of July issuance clearly slowed down with only EUR7bn issued in
senior bail-in paper and EUR6.5bn equivalent issued in non bail-in senior format.
No Tier 2 have been issued since the beginning of July. We believe that the
majority of the issuance for the year has been frontloaded and we would expect
issuance to pick up again in September but perhaps at a less sustained pace as
the one seen in the first half of the year, especially in in the bail-in senior format.
Altogether this should continue to support strong market technical and
compressed spreads.
Valuation
As in previous months the sector continues to be highly compressed but
some marginal further compression in the positive yielding part is possible.
We reiterate that our preferred approach to the sector remains cautious on
duration (shorter to medium end of the curves) but in higher beta names, as
a carry trade it is worthwhile. No immediate catalyst for a re-pricing in USD
or EUR on the horizon for now. We don’t expect significant moves in the
EUR curve and continue to prefer the 5 year as the sweet spot. In USD we
think that the 10Y part of the curve is now wide enough to extend the
duration a bit more.
All the spread and yield charts below show that Banks senior and subordinated

24 17 August 2021
 spreads have remained highly compressed and remain at recent years’ tights.
Looking at these same indeces from a yield perspective show how yields have
recompressed a somewhat after having backed out a bit, especially in USD on the
back of the rates moves. Now the USD subordinated banks yield is closer to 2.5%
from the 2.7% seen in May. A similar move can be observed in the USD senior
space. This higher slightly tighter yield has left the spreads stable at their multi-
year tights. We expect the spreads to continue to trade sideways.

In Euro the space is even less appealing as the rates movements have been more
modest. In a credit environment heavily intervened by the ECB the volatility
remains very low and any shorter term fluctuations seem to be driven by new
issuance for. We continue to see the best value in subordinated paper and we
would continue to focus on some of the recovery stories, such as DB, Societe
Generale, Banco Sabadell whilst monitoring evolutions at BCP and Commerzbank
which at some point will become attractive in terms of relative value. We favour the
belly of the curve in EUR with a sweet spot for maturities around 2025/26 and
2028/30 in the USD curves.

YANKEE BANKS SPREAD SUBORDINATED AND SENIOR YIELDS AND ASW SPREAD

Source: iBoxx. Bloomberg, MUFG

The charts below show European banks’ various subordinations in ASW spreads
differentials and spread multiples. In EUR the absolute differential in spread
between the subs and the bail-in senior has settled at around 36bp which equates
to a multiple of 1.7X. We don’t expect much movement on these at the moment.
Same picture on the USD side where the spread differential has now been for many
weeks at around 47bp which corresponds to a multiple of 1.5X.

In other words, we expect a sideways carry trade to continue into the second half of
the year. In our opinion it will take changes in messaging from the Central Banks to
see any movement, probably mostly driven by the rates.

25 17 August 2021
 EUR BANKS SUBORDINATED VS SENIOR COMPRESSION ASW

EUR Subordinated vs Bail-in

160.0 2.0
140.0 1.8
ASW Spread differential

1.6
120.0

ASW Spread Ratio

1.4
100.0 1.2
80.0 1.0
60.0 0.8
0.6
40.0
0.4
20.0 0.2
0.0 0.0
02-Apr-19

02-Oct-19

02-Apr-20

02-Oct-20

02-Apr-21
02-Jan-19

02-Jul-19

02-Jan-20

02-Jul-20

02-Jan-21

02-Jul-21
Differential Multiple

Source: iBoxx, Bloomberg, MUFG

EUROPEAN BANKS YANKEE SUBORDINATED VS SENIOR COMPRESSION IN SPREAD OVER ASW AND YIELD

USD Subordinated vs Bail-in

100.0 1.8
90.0 1.6
ASW Spread differential

80.0 1.4
70.0

ASW Spread Ratio

1.2
60.0
1.0
50.0
0.8
40.0
30.0 0.6
20.0 0.4
10.0 0.2
0.0 0.0
02-Apr-19

02-Oct-19

02-Apr-20

02-Oct-20

02-Apr-21
02-Jan-19

02-Jan-20

02-Jan-21
02-Jul-19

02-Jul-20

02-Jul-21

Differential Multiple

Source: iBoxx, Bloomberg, MUFG

26 17 August 2021
Global Markets Research

FX
Head of Research, Global Markets EMEA Currency Analyst (Europe)
and International Securities
LEE HARDMAN
DEREK HALPENNY Vice President
Managing Director T: +44 (0)20 7577 1965 E: Lee.Hardman@uk.mufg.jp
T: +44 (0)20 7577 1887 E: Derek.Halpenny@uk.mufg.jp

Head of Global Markets Research, Asia Head of Emerging Markets Research, EMEA

LIN LI EHSAN KHOMAN

Managing Director Director
T: +852 2862 7005 E: Lin_Li@hk.mufg.jp T: +971 4 387 5033 E: Ehsan.Khoman@ae.mufg.jp

Currency Analyst (Asean) Head of U.S. Macro Strategy

SOPHIA NG GEORGE GONCALVES

Associate Director
T: +65 6918 5537 E: Sophia.Ng@sg.mufg.jp T: + 1-212-405-6687 E: George.Goncalves@mufgsecurities.com

Global Markets Division for China

MARCO SUN
Director
T: +86 21 6888 1666 E: Wu_Sun@cn.mufg.jp

Credit Strategy

Corporate Credit (Europe) Financial Credit (Europe)

KONRAD BOSZKO, CFA CARLO MAREELS

Director Director
T: +44 (0)20 7577 2352 E: Konrad.Boszko@mufgsecurities.com T: +44 (0)20 7577 2927 E: Carlo.Mareels@mufgsecurities.com

Investment Grade Healthcare, TMT, Consumer (US) Investment Grade Utilities, Energy, Industrials (US)

ERIC RUFF DANIEL VOLPI

Director Director
T: +1 212 405 7489 E: Eric.Ruff @mufgsecurities.com T: +1 212 405 7328 E: Daniel.Volpi@mufgsecurities.com

High Yield (US)

BILL MATTHEWS
Director
T: +1 212 405 7486 E: Bill.Matthews@mufgsecurities.com

27 17 August 2021
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