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Emerging Markets Cross Assets

Binary Risks Looming Relief

EM FI Enjoys macro support EM Equities Cheap could get cheaper EM FX Buy options now, spot later
4 JUNE 2012

Emerging Markets Cross Assets

General backdrop: Binary risks looming relief ................................................................................................................................... 4 Financial gains evaporated ................................................................................................................................................................. 4 Global economy set to avoid a recession.......................................................................................................................................... 4 Sharply lower inflation enables policy flexibility .............................................................................................................................. 6 Political risks.......................................................................................................................................................................................... 8 Eastern Europe vulnerable to deleveraging ...................................................................................................................................... 8 EM bond fund flows resilient............................................................................................................................................................... 9 The long-term case for EM......................................................................................................................................................................11 Fixed Income: Supportive macro .......................................................................................................................................................... 16 Lower inflation supports local bonds............................................................................................................................................... 16 Structural case intact ......................................................................................................................................................................... 16 Eurozone still a risk for EM ................................................................................................................................................................ 18 Inflation outlook revised down ......................................................................................................................................................... 19 Good environment for bonds in high-inflation economies .......................................................................................................... 19 Equities: Cheap to become even cheaper............................................................................................................................................ 23 EM equity flows................................................................................................................................................................................... 25 Valuation ranking model ................................................................................................................................................................... 27 EM vs. DM, P/E discount.................................................................................................................................................................... 27 Technical Analysis MSCI EM Index (USD).......................................................................................................................................28 Currencies: Potential for major recovery in Q3 ................................................................................................................................... 30 EM FX look cheap in trade weighted terms..................................................................................................................................... 30 EM FX drivers ahead........................................................................................................................................................................... 32 External financing vulnerability ........................................................................................................................................................ 33 SEB EM FX forecasts........................................................................................................................................................................... 35 Investment strategy ........................................................................................................................................................................... 35 Cautious near term trade it through options............................................................................................................................... 35 Still a bumpy road ahead ................................................................................................................................................................... 36 How to trade it .................................................................................................................................................................................... 36 Cut-off date: 1 June, 2012
Editors: Mats Lind Mats Olausson Contributors: Julius Duksta Dag Mller Jurgis Rosickas Anders Sderberg The long-term case for EM: Kristina Styf SEB X-assets Research Contacts: see page 43.

Emerging Markets Cross Assets

Executive summary: Binary risks looming relief

Emerging market (EM) asset values rose sharply in January but collapsed in May. On both occasions, Europe was the root cause with investor concerns regarding the implications of the Eurozone debt crisis for the global economy driving sentiment changes. In the near term, we regard risks as binary and explosive in terms of potential market impact. While the Greek election on June 17 and the current problems affecting the Spanish banking system are certainly not the only events driving market, they are the key focal points right now. If Greece elects a government determined to reject the bail-out package and Spanish banks fail to secure sufficient support the market outcome may be similar to the Lehman crisis. In that case, we would expect the May sell-off to continue with markets being solely driven by flight-to-liquidity. Indeed, the near-term technical outlook for EM assets is almost unequivocally bearish, with investors quite prepared to ignore their strong fundamentals and attractive interest rates. Nevertheless, despite the very real possibility of such developments occurring, they are not our main scenario. Instead, we think it more likely that the Greek election will return a new coalition willing to adhere to the EU/IMF agreement in return for the countrys all too necessary bail-out funds. We also expect Spain to receive a EUR 150bn support package and Portugal and Ireland to secure less onerous repayment conditions. If so, based on current market pricing, we would anticipate a relief rally across financial markets, with further support during Q3 from additional quantitative easing by the US Fed and more substantial stimulative policies in China. Overall, our global leading economic indicator (GLEI) suggests continued weak markets in the very near-term but improved momentum between August and the year end. Consequently, while risks are binary, our main scenario implies that the door is ajar for a substantial recovery mainly in Q3. Of course, with the underlying problems facing the Eurozone unlikely to be resolved by then, we should expect further periods characterised by flights to liquidity. Still, the long-term EM case remains intact. In this report we also present the research findings of our SEB X-Asset colleagues including key conclusions for asset allocations within EM. Of course, our own recommendations contained in this report do not make for an easy, uncomplicated trading experience. In our previous edition of EMXA in February we argued that the January rally had gone too far, too fast and that a correction was imminent. It came later and was larger than we expected. For now, we recommend remaining defensive pending a solution to the immediate problems besetting Europe while at the same time preparing for a potential relief rally, tentatively during Q3. EM bonds, on a currency-hedged basis are more resilient and are likely to continue to gain from their structural undervaluation with further help from a benign inflation environment. We favour bonds in high-inflation economies. While we regard EM equities as inexpensive in both absolute and relative terms, we expect them to become even cheaper in the near-term. Within EM, we remain overweight in Asia and underweight in EMEA. Concerning EM FX, we recommend buying a EUR/MXN butterfly for the downside and buying a USD/HUF call spread now. We expect positioning, fundamentals and carry to progressively replace flight-to-liquidity as driving forces in FX markets, creating several beneficial opportunities. For now, we prefer the possibility of missing out on the earliest stages of the expected rally rather than risk catching the falling knife.


Moderate growth together with a benign inflation environment helps EM bonds while global riskaversion weighs. We see the structural case to once again deliver positive FX-hedged returns.

MSCI EM & GBI EM (unhedged USD)

1400 1300 MSCI-EM (Equities) 1200 1100 1000 900 800 700 600 500
Source: Bloomberg

320 300 260 240 220 200 MSCI EM GBI-EM 180 160 140 120 GBI-EM Div. Global (Local Bonds) 280


EM equities look cheap in both absolute and relative terms, but current risks force us to just look to buy.


Given binary and explosive risks now, we buy a 6m EUR/MXN butterfly for the downside and buy a 1m USD/HUF call spread. FX drivers will turn more EMconducive later providing various good opportunities to buy EM spot.

400 2006 2007 2008 2009 2010 2011 2012

Emerging Markets Cross Assets

General backdrop: Binary risks looming relief

EM stocks, bonds and currencies look cheap after the sell-off in May, both fundamentally and from a strategic perspective. For now, however, the outlook for EM assets is largely dependent on developments in the Eurozone. Risks are binary and potentially explosive. Victory in the Greek election on June 17 by parties that reject the bailout package could trigger an uncontrolled breakup of the Eurozone creating a flight to liquidity reminiscent of the post-Lehman period. EM assets would suffer greatly in such a situation. In our opinion however, the Greek vote will favour adherence to EU/IMF demands and remaining in the Eurozone, at least for the time being. Given current market pricing, this could pave the way for a substantial relief rally which we expect will be further supported by other European initiatives (in the case of Spain, Portugal, Ireland and Cyprus), US QE and Chinese economic stabilisation. Furthermore, our global leading indicator predicts improving momentum from August. Nevertheless, the deep-seated problems affecting the Eurozone will continue to haunt the markets. We therefore expect periods in which drivers favouring EM (fundamentals, valuation and carry) are temporarily replaced by flights to liquidity. While this situation will limit the recovery of currently cheap EM assets, we see scope for substantial gains in coming quarters.

currencies that we often refer to is down by 2.1% vs. USD YTD after having lost a massive 6% during May.
1400 1300 MSCI-EM (Equities) 1200 1100 1000 900 800 700 600 500
Source: Bloomberg

320 300 260 240 220 200 MSCI EM GBI-EM 180 160 140 120 GBI-EM Div. Global (Local Bonds) 280

400 2006 2007 2008 2009 2010 2011 2012

With the benefit of hindsight, we overestimated the positive impact of the ECBs two LTROs and underestimated the risks posed by Greece at the time of our last EMXA report. Spains (probable) journey towards a bail-out package is, however, consistent with our long held expectation.

Is this the time to enjoy the ride?

So, the correction we expected finally arrived and did so with a vengeance. The question now is whether this is the time to increase exposure to EM assets, i.e. to Enjoy the ride, but buckle up! as the title of our previous report read. Retrospectively, we certainly buckled up but have so far not yet begun to enjoy the ride. For answers to this question therefore, we must consider the outlook for a global economy which is still struggling to recover from the Great Recession. In particular, we focus on key risks from the Eurozone, the Middle East and commodity prices. Others, such as the still largely untouched US fiscal deficit remain crucial parts of the equation.

What did we say last time?

In our previous report, published on February 16, we argued that the rally in higher risk assets in January had gone too far, too fast and that a correction was imminent. The correction began in April and exceeded what we had anticipated during May.

Global economy set to avoid a recession

Behind the near term fluctuations in the global economic cycle, we think it important to bear in mind several key facts concerning the current business cycle. The recovery following the Great Recession a few years ago has been unusually weak by historical standards. Disappointingly, global growth has merely risen to trend, despite having applied record fiscal and monetary stimulus measures throughout large parts of the global economy. With economic policy ammunition now largely depleted, the global immune system is weak. Meanwhile, excessive leverage, that partly supported the so-called super cycle in the middle of the last decade, has simply been switched between different sectors. In reality, it has been made the responsibility of governments. The question therefore concerns whether it will be passed on to pension savers and others, as it has been in Greece. Deleveraging is ongoing and must continue, effectively restricting growth in affected countries.

Financial gains evaporated

Significant gains by EM stocks and currencies at the beginning of the year have largely disappeared, leaving EM equities in particular down -2.5% in USD terms so far this year, which happen to be matched to the first decimal by an equally big fall in DM equities. EM local bonds have performed well in USD hedged terms, increasing 2.2%, i.e. satisfactory for such a relatively stable investment. However, including currency effects, EM bonds have gained only 1.0% since the start of the year, which we regard as unsatisfactory given its frequent high volatility. Similarly, currencies have failed to perform, having returned -0.4% vs. USD including carry, according to the ELMI index. Excluding carry, our basket of 15 EM

Emerging Markets Cross Assets

US: Home prices and debt

Index, per cent of disposable income
200 175 150 125 100 100 75 50 88 90 92 94 96 98 00 02 04 06 08 10 90 80 70 140 130 120 110

others too, current high indebtedness implies relatively restricted room for manoeuvre. Further, the EUs new Fiscal Compact will also set clear boundaries.

QE3 from the Fed in the fall

We expect more action from G3 central banks based on demands for more policy action, given current low inflation, lacklustre economic recovery in the US and Japan, and a recession in the EU. We forecast QE3 from the Fed this fall while Japan will also continue to increase its balance sheet. The ECB will do whatever is necessary to provide banking sector liquidity although the euro-system is already awash with cash. Discussions regarding raising the inflation target continue.
Central bank balance sheets
Per cent of GDP
35 35 30 25 20 15 10 5 02 03 04 05 06 07 08 09 10 11 12

Home prices, S&P Case-Shiller (LHS) Household debts as a percentage of income (RHS)
Source: Standard & Poor's, Federal Reserve

Going forward, we expect global growth to fall below a bit below trend this year and to rise just above next with our forecasts at 3.4% and 4.0% respectively in purchasing power parity (PPP) terms. The improvement in the US economy last autumn appeared to be spreading to other countries at the end of last year and the beginning of this. This perception obviously invigorated the market rally in January. However, it failed to follow through in March and especially April. Our own SEB EM Surprise Indicator, for example, shows a sharp drop.
SEB economic surprise indicator, Emerging markets
1.0 0.5 0.0 -0.5 -1.0 -1.5
3-month average

30 25 20 15 10 5

1.0 0.5 0.0 -0.5 -1.0 -1.5


Bank of England

Federal Reserve
Source: ECB, Fed, Bank of England









Overall, the global economy is weak. Further economic policy stimuli will dampen the effects of continued deleveraging. We still believe the global economy can avoid recession. Worldwide growth increasing from just below to just above trend appears reasonable based on positives such as the fact that many EM and Northern European economies are fundamentally sound and that many companies enjoy very strong balance sheets.

More accommodative policies ahead?

Meanwhile, two separate scenarios support the case for more accommodative economic policies going forward. Firstly, inflation has slowed even faster than we had expected (see p. 19) and looks to stabilise at or below targets in many EM. This will help facilitate further monetary easing in countries such as China and Brazil. Also, importantly, even in other countries, current inflation is less of a restriction against using monetary policy measures if growth disappoints. Secondly, the new French president Franois Hollande presumably won the recent election on a platform promising to switch economic policy from austerity to growth. His ideas are shared by various colleagues within the EU as well as policy makers and economists in international organisations and in academia. Steps in that direction are therefore likely. Those countries that have already lost the confidence of markets will not have the luxury of following that route. For many

SEB EM growth forecasts

Given recent economic and political developments, and based on assumptions set out in this report, we expect below trend global growth this year to accelerate to just above trend next year. With the EU climbing out of its mild recession by 2013 and the US taking one more, small step towards recovery, we forecast that the OECD region will increase GDP growth from 1.6% this year to 2.1% in 2012 2013. In our Nordic Outlook report published on May 8, we reduced our aggregate EM growth forecast from 5.7% and 6.0% this and next year to 5.6% and 5.9% respectively. A disappointing data harvest in April worse GDP readings in Q1 than expected in some key countries justifies a further downward adjustment to 5.2% in 2012 and 5.7% in 2013. This downgrade revision coincides with increasing concerns regarding industries in Emerging Asia. Q1 GDP figures for much of the region were below expectations

Emerging Markets Cross Assets

with China at 8.1% and India at a nine-year low of 5.3%. Further, Q2 PMIs generally declined, particularly in China.

followed by sequentially improving momentum from August through the end of the year. Significantly however, this still comfortably qualifies as a soft landing with EM growth of 7.3% in 2010 partially reflecting base effects from the very weak performance in 2009 and 6.2% growth reported in 2011 still benefiting from overall lax policy prescriptions.
SEB GDP forecasts
2010 China Indonesia India EM Russia Mexico World (PPP) South Korea Poland South Africa Turkey Brazil Ukraine Singapore Lithuania Latvia Iceland OECD Estonia Romania Czech Rep. Hungary 10.4 6.2 10.6 7.3 4.0 5.5 5.3 6.3 3.9 2.8 9.2 7.5 4.2 14.8 1.4 -0.3 -4.0 3.1 2.3 -1.7 2.7 1.3 2011 9.3 6.5 7.2 6.2 4.3 3.9 3.9 3.6 4.3 3.1 8.5 2.7 5.2 4.9 5.9 5.5 3.0 1.7 7.6 2.5 1.7 1.7 2012 8.1 6.0 6.0 5.2 3.8 3.5 3.4 3.5 3.1 3.0 3.0 2.9 2.9 2.7 3.0 2.5 2.5 1.6 1.5 0.5 -0.2 -1.0 2013 8.4 6.5 6.6 5.7 4.1 4.0 4.0 4.0 3.6 4.0 4.5 4.3 4.0 3.9 3.5 4.0 3.1 2.1 2.5 2.5 2.0 1.5

The stabilisation/bottoming out that we expected during Q1 now looks more likely to occur in Q2. We have therefore downwardly revised our respective full year 2012 and 2013 growth forecasts for China (to 8.1% from 8.5%; 8.4% from 8.7%) and India (to 6.0% from 7.0%; 6.6% from 7.3%). We have also slightly lowered our Brazilian GDP estimates due to weaker than expected data at the beginning of the year. We now expect growth to increase only slightly from 2.7% in 2011 to 2.9% (previously: 3.5%) this year with recent major stimulus measures impacting in 2013 when growth will accelerate to 4.3% (same as before). Our forecasts for many other countries remain unchanged. This is the case for Russia but we have downgraded our growth forecasts for Ukraine.
BRICS PMI manufacturing, SA
70 65 60 55 50 45 40 35 Jan Mar May Jul 11 Sep Nov Jan Mar 12 70 65 60 55 50 45 40 35

Source: OECD, SEB

Sharply lower inflation enables policy flexibility

EM inflation rates have plummeted since February. We are surprised, as the decline in both headline and core inflation has been sharper than we had anticipated. Our forecast remains that inflation will decrease more gradually. Falling prices of both food and crude oil and other commodities explain much of the decrease though reductions in prices of core items have also contributed to a surprising extent. Softer economic conditions are therefore probably a factor. However, we think it is encouraging that core inflation has responded so rapidly on the downside. What this shows is that the credibility of EM central banks is stronger and that knock-on effects from sharply higher food prices over the past two years have not materialized. This kind of stable, non-inflationary consumer price dynamic is a valuable and relatively new fundamental asset for EM economies. Its benign long term impact on both currencies and bond yields should not be underestimated. From a macroeconomic perspective, lower inflation creates room for manoeuvre should the need for more stimulative

Russia South Africa

India 50

Brazil China,Official
Source: Reuters EcoWin

Our expectation that growth momentum will improve from H2 2012 is based on the belief that more stimulative policies in countries such as China and Brazil are progressively implemented. Overall, EM growth appears more likely to bottom out in Q2 rather than Q1 2012, which is more consistent with the implications of our Global Leading Economic Indicator, GLEI, developed by Mattias Sundbom. The GLEI points to continued weakness in the very near term to be

Emerging Markets Cross Assets

policies arise. Furthermore, the supply situation is benign going forward. For foodstuffs, most La Nina effects have according to forecasters dissipated while inventories have greatly improved. As regards crude oil, the Iranian situation still represents a risk.
SEB forecasts of policy rates until Q1 2013, %
May, 2012 EMEA Poland Czech Hungary Turkey 1W Turkey O/N S. Africa Romania Russia LatAm Brazil Mexico Asia China China RRR Korea India Indonesia 8.50 4.50 8.00 4.50 7.50 4.50 7.50 4.50 7.50 4.50 7.50 4.50 4.75 0.75 7.00 5.75 11.50 5.50 5.25 5.25 4.75 0.75 7.00 5.75 11.50 5.50 5.25 5.25 4.75 0.25 7.00 5.75 11.00 5.50 5.25 5.25 4.75 0.25 6.50 5.75 10.25 5.50 5.25 5.25 4.75 0.25 6.00 6.25 9.50 5.50 5.25 5.50 4.75 0.25 6.00 6.50 9.00 5.50 5.25 5.75 Q2, 2012 Q3, 2011 Q4, 2012 Q1, 2013 Q2, 2013

Consequently, EM assets generally look cheap. However, this does not in any way rule out the possibility that they may become even cheaper. Certainly, the near term outlook is very likely to be governed by developments in Athens, Madrid, Brussels and Frankfurt. In particular, the Greek election on June 17 has the potential to trigger significant positive or negative changes in EM asset valuations. Victory by parties that reject the bail-out package could trigger an uncontrolled break-up of the Eurozone creating a flight to liquidity reminiscent of the post-Lehman period. EM assets would suffer considerably in such a scenario.

Near term uncertainty demands caution...

Greek opinion polls have changed recently. Current readings may not be accurate in guiding the eventual result including what a governing coalition formation might look like. Risks are therefore biased towards markets discounting an even greater likelihood of an extremely negative scenario in the very near-term. EM exposure should therefore be treated with care. In our main scenario, however, we expect the Greek vote to favour compliance with EU/IMF demands and remaining in the euro, at least for the time being. A second inconclusive election result is, of course, also a possibility. If it occurs, we do not expect markets to give the Greeks the benefit of any doubts pending the holding of a third vote. Instead, we believe it will react quickly and defensively.

6.56 20.0 3.25 8.00 5.75

6.56 19.5 3.25 8.00 5.75

6.31 18.0 3.25 7.50 5.75

6.31 17.5 3.25 7.50 5.75

6.31 17.5 3.25 7.50 5.75

6.31 17.5 3.50 7.50 5.75

Source: Bloomberg, SEB

Positively however, Saudi efforts to increase oil supply to maximise the effect of sanctions against Iran have been successful supported by Libyan and Iraqi developments. According to our main scenario, crude oil prices will increase only slowly going forward, while food prices will continue to fall.

but our main scenario is EM bullish over the next 3-6 months
Given current market pricing, a victory for Greeces previous pro-austerity coalition parties ((New Democracy and PASOK) should pave the way for a substantial relief rally. Towards the end of June and no later than Q3 we expect four factors to provide further momentum to such a recovery: Additional support for peripheral Europe US QE3 Accommodative Chinese economic policies A turnaround in leading indicators, however shallow, in August (SEB proprietary GLEI-indicator).

Eurozone developments to dictate the next EM market move whats in store?

Turning back from the macroeconomic outlook to financial market developments, we recall that EM assets fell substantially during May. By now, they arguably discount a scenario worse than is justified by our assumptions regarding global growth and the most likely developments in peripheral Europe. However, in our recently published Nordic Outlook we point to asymmetric and negatively tilted risks and emphasise that the next chapter in the single currency saga could still go horribly wrong. The global economic recovery remains extremely lacklustre and the worlds economic and financial immune systems are weak.

Regarding support for Europe, we expect Spain to receive EUR 150bn intended to bolster its banking system. Cyprus is also expected to apply for and receive financial support from the EU and IMF while Portugal and Ireland are likely to receive somewhat leaner repayment conditions. Meanwhile, we do not expect the new French president to rock the boat by implementing any destabilising reforms. His emphasis on shifting policies from austerity to growth will, however, be recognised by strengthening European Investment Bank resources with a further EUR 50bn, to be leveraged up to EUR 300bn, at least in our opinion.

Emerging Markets Cross Assets

In the US, a third round of quantitative easing this fall looks likely as Operation Twist ends, inflation risks remain remote, and the labour market recovery loses traction (see Nordic Outlook from 8 May). A policy shift is due in China with recent developments arguing for a shift from fighting inflation to supporting growth. We expect authorities to implement wide ranging monetary and fiscal policies although less so than in 2008/09. It will, however, suffice to engineer a soft landing, evidence of which we expect to see in Q3 (see our Strategy Focus EM from 24 May). Finally, leading indicators have been bearish to mixed following signs of improvement late last year and during Q1 in many EM. Our leading indicator on the OECDs own leading indicator (GLEI) has still pointed to a turnaround, however shallow, in August. However, it will be insufficiently strong to cause the indicator to show expansion before the end of this year. In other words, we should expect a slowdown tending to bottom out but not before the end of the forecast horizon.

could be interpreted as an increased threat to extend its nuclear program beyond its civilian capabilities. In part at least, it is reassuring that the position has so far been contained. Sanctions against the country have effectively hindered their efforts. Still, the situation will remain fragile going forward. The political window for military action against Iranian sites will not be closed before the end of the summer. Thereafter, the US election campaign enters its final stages making a strike less opportune. Crude prices have declined despite the embargo against Iranian oil having been put in place.

Political risks
Political risks have moved further up the agenda in China with the purge of influential Chongqing major Bo Xilai from the countrys political scene. Rather than being a part of a popular unrest indicating or driving potentially adverse economic outcomes, this should be seen more as an intrigue within the highest echelons of the Party. As such, its economic consequences should be limited. It nonetheless stands by its mandate to deliver continuous strong growth, a task to which it will remain strongly committed. From a general perspective, the risk of widespread instability in EM has decreased as food prices have fallen. Ongoing normalization of crops should continue according to our forecasts, representing a key positive for the region. Nevertheless, countries such as Romania and Serbia are experiencing a combination of economic pressure and post election political tensions. Meanwhile, recent opinion polls in the run-up to the Mexican presidential election have shown that the PRDs candidate narrowed the gap to the PRIs Pea Nieto, a development badly received by markets. Nevertheless, we still believe Pea Nieto will win the election on July 1. In Russia, Vladimir Putin has been reinstalled as President. While we expect the status quo to be largely maintained concerning both economic and political reforms, risks are probably biased to the downside. In conclusion, the key risks to EM in coming quarters are as follows: Eurozone crisis escalates Middle East tensions trigger an oil price hike Food prices turn around and rise substantially, depriving EM central banks of room for maneuver Political risks

Eurozone challenges still unresolved

Crucially, the progress made so far in ring fencing the crisis in peripheral Europe and the additional support measures likely to follow in the near future do not finally resolve the Eurozone debt crisis. At the end of the day, the euro project was launched as a political project and that is where the main challenges lie going forward. We have many more EU summits to look forward to, probably with angst, even in the best possible scenario. Furthermore, as regards Greece, we believe that even if the vote on June 17 produces a government willing to adhere to agreements with the EU/IMF to continue future bail-outs, the country is eventually more likely than not to abandon the single currency.

and will disturb or possibly ruin the party

Consequently, while the relief rally will gain momentum this fall for the reasons listed above, eventually outstanding unresolved challenges for the euro and the economies of its Mediterranean member states will return to haunt the market. In our main scenario, we expect these problems to be dealt with. We therefore do not look for a fresh onset of a prolonged period of flight to liquidity. However, bumps on the road will create a difficult trading environment and prevent EM assets from increasing particularly rapidly beyond Q3 without new active measures towards a solution of the Eurozone crisis, we think.

Eastern Europe vulnerable to deleveraging

Risks to Eastern European EM have by now been thoroughly highlighted. With the Eurozone crisis accelerating, the issue however needs to be reviewed once again. Large refinancing requirements leave such

Iran still a risk, but sanctions bite

The situation in the Persian Gulf still represents a risk. Iranian rhetoric towards the international community

Emerging Markets Cross Assets

economies heavily dependent on foreign banks at a time when they are seeking to improve financial ratios. The results of targeted de-leveraging could have highly adverse consequences. Also, borrowing may become more difficult in the event of a disorderly Greek exit from the Eurozone. IMF calculations based on official leverage targets from European banks produced fairly bearish conclusions reported in its Global Financial Stability Report (April). According to the IMF, the most vulnerable countries are Hungary, Poland and Turkey. If capital inflows to EM economies were to reverse as they did post-Lehman, the IMF estimates that their currencies might depreciate vs. USD by 15% per annum. A slightly more positive message was issued concerning EM funding by the banking industry organisation, the IIF. According to its EM Loan Survey in Q1, an EM counterpart to the Federal Reserves Senior Loan Officer Survey in the US, banks are now more willing to lend. However, loan demand from clients has declined, according to the survey, a worrisome development indicating that the impact of stimulative monetary policies is weakening. To help the economy, fiscal policies must fill this void, substituting private demand for funds and investments. However, fiscal room for manoeuvre is limited in several of the worst hit economies. In EM giant China, however, we expect continued cuts in reserve requirement ratios for banks and a rate reduction in Q3 to be complemented by a more accommodative fiscal policy.

Regionally, outflows have been reported by EMEA bond funds so far this year while Latin America and Asia have continued to attract high levels of investment. Furthermore, in recent weeks, flows have increasingly switched from EM Asia bond funds to their Latin American counterparts.

Regional cumulative flows to EM Bonds, 2011-YTD EMEA Asia LatAm

60 50 40 30 20 10 0 19/01/2011 30/03/2011 08/06/2011 17/08/2011 26/10/2011 04/01/2012 -10 -20 -30 Source: EPFR 14/03/2012 23/05/2012

However, during the week ended May 30, EM bond funds posted their third biggest weekly outflow YTD. Absent decisive action by European policymakers, fund investors have continued to reduce their exposure to higher risk asset classes, while downgrading their expectations and looking ahead to Greeces new elections on June 17. Flows into bond funds, which usually remain more resilient to market turmoil, lost momentum as safe haven demand drove US and German debt prices even higher and investors reduced exposure to several riskier fixed income asset classes.
USD bn 6.00 5.00 4.00 3.00 2.00 1.00 0.00 15/02/2012 25/01/2012 28/03/2012 07/03/2012 -1.00 -2.00 -3.00 30/05/2012 18/04/2012 04/01/2012 EM Equities EM Bonds

Net flow of funds EM FI & EQ, YTD (weekly)

EM bond fund flows resilient

Since our last edition of Emerging Market Cross Assets (EMXA) in February, both EM and (to only a slightly lesser extent) DM bond funds have reported generous inflows. At the same time, equities have suffered substantial outflows. Higher Q1 demand for EM equity funds began to reverse as early as March. Consequently, during Q2, EM equity outflows totalled 2-3% of AUM. Conversely, flows to EM bonds increased faster than to other asset classes.

Source: EPFR

18 15 12 9 6 3

Flows to all asset classes in EM & DM, 2011-YTD

EM Bonds EM Equities DM Bonds DM Equities

Source: EPFR

0 19/01/2011 30/03/2011 08/06/2011 17/08/2011 26/10/2011 04/01/2012 14/03/2012 -3 -6 23/05/2012

During the week before, high yield bond funds reported their biggest outflow in more than nine months at over USD 3bn, becoming the worst performing asset in the Bond Fund category. At the same time, EPFR-tracked EM bond funds posted a total outflow of USD 0.48bn while EM equity funds suffered a loss of USD 1.55bn. EM bond fund redemptions were evenly divided between local and hard currency mandated funds.

Emerging Markets Cross Assets

bn USD

Net flow of funds EM FI & EQ, 2011-YTD (monthly)

Asset allocation next 3-6 months and key message each asset class
For EM asseets in general we see large downside risks. At the same time, there are good fundamental value in many markets and a good medium term return potential. Our recommendations imply a low allocation to riskier assets for now, while at the same time maintaining a readiness to expand exposures if the risk picture would improve. Looking at the least risky assets in our universe, the currency-hedged local bond yields, we maintain a constructive veiw. Going into FX, we are more cautious even though we look to buy downbeaten currencies. Option strategies to hedge against adverse scenarios are our first recommendations there. In equities, we warn against getting trapped into strong values that soon might find themselves even stronger; again our recommendations are on a look to buy basis. While being cautious on Europe for all asset classes, we favour Asia in equities. Brazil and Indonesia look attractive both from a yield and currency perspective, while we look positively on Chinese equities. So, while repercussions from the Eurozone debt crises periodically triggers substantial outflows from EM funds and EM countries in general, we firmly maintain our long term bullish view on this part of the world. In the following section we present the findings of a recent study by our colleagues at SEB X-assets Research looking at The long term case for EM with implications for asset allocation in EM.

EM Bonds

8 4 0
30/04/2011 30/06/2011 31/08/2011 28/02/2011

EM Equities



-4 -8 -12 -16 -20

Source: EPFR

Superficially, the current situation may appear similar to the sell-off that occurred last August and September when EM equity funds suffered severe outflows and even bond funds faced losses. However, current withdrawals are far smaller with last years mass exit impacted by investors reacting to the recent US sovereign debt downgrade, persistently high oil prices, the aftermath of the Japanese earthquake and tsunami, and of course the Eurozones escalating debt problems.
USD bn

EM Bonds: Flows cumulative by currency, 2011-YTD

Hard Currency Local Currency Blend Currency

12.0 10.0 8.0 6.0 4.0 2.0 0.0 19/01/2011

Source: EPFR








Since our last EMXA in February, hard currency bond funds have been in high demand, attracting flows of around USD 3bn, compared with USD 0.2bn and USD 0.4bn by local and blend currency funds, respectively, with a few interim weeks posting net outflows. Hard currency funds are likely to continue to attract higher flows for some time yet provided investors maintain their preference for liquidity over carry. With EMEA remaining at greatest risk of contagion from the European credit crunch we retain our cautious view on the region. However, as Spanish problems are increasing, Latin Americas relative attractiveness may also be hurt. We expect Asian bond funds to continue to attract inflows, particularly given the regions relatively greater resistance to slowing global growth, and its geographical distance from the epicentre of the highly problematic Eurozone debt crisis.





Emerging Markets Cross Assets

The long-term case for EM

There are two key long-term arguments for emerging market currency exposure high interest rates and currency upside. Both arguments have received a boost from the debt crisis in the large industrial economies. Western interest rates are effectively at zero, increasing the attraction of higher EM rates, and money printing is now the only policy tool left and this will ultimately hurt currencies. It hasnt happened yet because non-G7 countries have been recirculating their surplus into G7 assets. This is a key reason why global imbalances have not reversed yet and we have seen 15 years of uninterrupted debt build-up in the West due to overvalued exchange rates. But there are limits to how much debt the West can take, and the de-leveraging will require a lot more money printing.
Central bank balances, USD trn, and policy rate

10Y funding needs and 10Y bond yields


Transition G7 currency war losers


Carry countries have relatively weak fundamentals, but also substantially higher yields to compensate for the risks, G7 currency war losers countries have the same kind of weak fundamentals as the Carry group, but without the high yield. Upside countries have strong fundamentals accompanied by lower yields. These countries have significant appreciation potential the day the rebalancing process begins in the G7 countries. Transition countries are in between the two other groups, but their problem is too little carry and not enough upside.
2011 10Y yields & 1996-2011 inflation
35% 30% 25%
1996-2011 inflation


15% 10% 5% 0% -5% 0% 2% 4% 6%

10Y yield 2011
Singapore Taiwan Thailand USA China South Korea Malaysia Chile Indonesia Mexico Poland India South Africa Brazil

Meanwhile, creditor countries now feel the side effects of holding exchange rates and interest rates too low for too long: high inflation, property bubbles, debt crises and misallocation of capital. This will eventually force them to let G7 currencies go if the G7 central banks keep printing money. The end result is likely to be a currency crisis, but we dont know when: economists have called the imbalance unsustainable for years. Until G7 currencies have been devalued, zero rates will increase the attraction of higher rates in currencies with weak fundamentals. For now, both arguments work but they work in different ways.




Source: Ecowin , GFD and SEB X-asset

Three groups
Not all emerging market countries are equally exposed to both types of return potential. In order to get building blocks to structure we group the universe into three emerging market groups: those with carry, those with upside potential and those in between. Fundamentals and pricing of risk underpin ranking countries in terms of global currency and bond market. The chart below shows accumulated current account and budget balance for the past 11 years and bond yields at the end of 2011. Based on shared characteristics we can group the countries into three broad types of exposure.

The difference between the groups is also evident in inflation history. In the past, many emerging market countries have experienced currency crises followed by high inflation and bond yields. Since then, structural reforms and more sound fiscal management have over time contributed to a more stable economic outlook. Current low bond yields for Upside countries are a result of a long period of low inflation and strong internal and external balances, and entering this group will thus take a long time.

The case for EM

In theory, the total return from spot and carry should on average cancel out over long time horizons. However, uncertain and variable emerging market inflation and the reserve currency status of thje major currencies means there will be a risk premium: carry above exchange rate decline. Over the last 15 years most countries have been paying a bit carry on top of their exchange rate, more than canceling out any currency depreciation.


Emerging Markets Cross Assets

2000 and 2011 interest rates relative to US

25% 20% 15% 10% 5% 0%

We include Nordic currencies as a reference as they are the developed market equivalent to the Upside group.
Money market risk and return, real USD, 2000-2011
10% 8% 6% Real return
Carry: India, Brazil, Turkey, South Africa, Russia Transition: Mexico, Poland, Chile, Indonesia Upside: China, Singapore, South Korea, Taiwan, Thailand, Malaysia


Average 2000

Transition Nordic money market


Average 2011

4% 2% 0% US T-bills -2% Upside

Ch in a ga So por ut e h Ko re a Ta iw a Th n ail an d M ala ys ia M ex ico Po lan d Ch ile In do ne sia In di a Br az il Tu rk So ey ut h Af ric a Ru ss ia

Upside ex China




Source: Ecowin , GFD and SEB X-asset

The question going forward is whether the current low interest rate environment will offer a risk premium. With most countries reducing their interest rates over the last couple of years investors might expect carry to have come down. Comparing carry in 2000 with carry in 2011 it is evident that the risk premium was actually lower in 2000 with most countries paying higher carry in 2011. With current US interest rates close to 0%, carry can virtually only be positive. It is not possible to reflect appreciation potential with negative carry in this kind of environment.
2000 and 2011 10Y yield spreads relative to US
14% 12% 10% 8% 6% 4% 2% 0% -2% -4%
Average 2000 Average 2011




6% Standard deviation




Source: Ecowin , GFD and SEB X-asset

Over the last 10 years investing in money markets outside US has involved higher risk, but also higher returns. Both return and risk increases as we move from Upside to Carry and the differences are significant: Carrys risk is almost twice as high, but the annual return is 7% higher. Nordic currencies have in fact been more volatile in USD terms than all EM groups, with a return in the low end of the range. An investor afraid of a G7 debt crisis should thus consider if capital protection from Upside will add risk at low returns for longer than he or she is prepared to wait: the longer it takes, the more attractive the direct returns from Carry look. But the historical data obviously fail to capture the missing carry argument: if currencies are likely to rise over time, even a carry of zero would suggest a long-term return well above the historical one. And with US rates at zero, there carry must be at least zero.

Ch in Sin a* ga So por ut e h Ko re a Ta iw an Th ail an d M ala ys ia M ex ico * Po lan d Ch In i do le ne sia * In di a Br az Tu il r So key ut * h Af ric a Ru ss ia*

*From: China: 2002, Mexico: 2001; Indonesia: 2004, Turkey: 2005, Russia: 2003

Source: Ecowin , GFD and SEB X-asset

Cyclical risk: FX losses clustered in cyclical bear markets

10 years is a long time in the real world, where most investors are measured over significantly shorter time horizons. Average long-term risk is interesting but as always we want to emphazise cyclical risks and how losses are distributed over time. To do this in a structured manner we turn to the SEB Waves allocation framework - allowing us to look at risks over different time horizons. We note that the underlying data sample is limited, especially the strategic cycle is not represented by a large number of data points in each phase and we should be cautious in drawing too strong conclusions. The higher number of tactical cycles makes the tactical results more robust. Our strategic analysis is based on a simple model that breaks the outputgap cycle into four phases, depending on whether growth is above (expansion) or below trend (recession) and wheter credit conditions are easing or tightening. Over the past 40 years, recessions have lasted 2-4 years, while expansions lasted from 4-8 years.

Another consequence of more stable economic outlooks are lower bond yields. As with carry, the bond yield risk premium is a relative game and with very low US bond yields the risk premium in bond spreads still exists. Average yield spreads at the end of 2011 were at the same level as in 2000.

Starting point: money market exposure in the 3 groups

We look at three options for investors to access emerging markets in this report: the money market, the bond market and the equity market. We start by looking at the performance of basic money market positions before we add asset class risk from bonds and equities. The chart below shows performance since 2000 for emerging market money markets with open FX for a USD-based investor. We include a new group Upside ex China because Chinas capital controls prevent access for international investors.


Emerging Markets Cross Assets

Strategic money market returns, real USD, 2000-2011





excess return is small. Carry has experienced close to equity like risks, but also a return close to normal equity market returns and far above the realised US equity return. Of course, the same argument applies here as in money markets when it comes to the long-term return potential of the Upside group.
Emerging market risk and return, real USD, 2000-2011


-20% Early recession US T-bills Transition Late recession Upside Carry Early expansion Late expansion Upside ex China Nordic money market
Carry Transition Carry


Transition Nordics

Upside Upside ex China

Real return

Source: Ecowin, GFD and SEB X-asset

Early recession is the worst phase from an investment perspective, with elevated volatility and large losses from risky assets. A cyclical safe haven, like US, has its losses distributed to other phases than early recession. Emerging market money markets have their largest losses concentrated to early recession and are obviously not safe haven investments from a cyclical point of view. Decomposing money market returns into the underlying components we find that emerging market exchange rates are cyclical which shines trough in the stratgic money market results.
Tactical money market returns, real USD2000-2011
25% 20% 15% 10% 5% 0% -5% -10% Early downturn US T-bills Transition Late downturn Upside Carry Early upswing Late upswing Upside ex China Nordic money market
Source: Ecowin, GFD and SEB X-asset


Upside ex China Transition Upside USA Nordics Upside Upside ex China




-5% 0% 5% Money market 10% 15% Standard deviation Bonds 20% 25% Equities
Source: Ecowin , GFD and SEB X-asset


Emerging market equities have had much higher risk than bonds and also far above US equities. All groups have outperformed US equities over the last decade with significantly higher risk-adjusted returns, but there is not a clear-cut risk/reward pattern as we found for both the money market and bonds. In spite of the much higher risk, the historical return from EM equities has only been modestly higher than the return on EM bonds.

Cyclical risk: Upside bonds reduce cyclical losses

Strategic bond returns, real USD, 2000-2011
30% 20% 10% 0% -10% -20% -30% Early recession US bonds Upside Late recession Upside ex China Early expansion Transition Carry Late expansion Nordic bonds

The tactical inventory cycle is also broken down into four phases, depending on whether short-term leading indicators are rising or falling and whether the change is accelerating or decelerating. Over the past 40 years, each phase has lasted on average 4-6 months. Early downturn is the most critical phase with elevated volatility and large losses. Tactical money market returns have showed less distinctive cyclicality than the strategic cycle. Upside has had its largest losses in early downturn while both Transition and Carry show defensive characteristics. Underlying exchange rates have been less cyclical in the tactical cycle, lowering the risk of losses in early downturn.

Source: Ecowin, GFD and SEB X-asset

Adding bond and equity exposure: more risk

Emerging market bonds, denominated in local currency and with 10 years duration, have offered higher returns than local US bonds over the last decade. Bonds from the Upside groups have even achieved this with lower risk than US bonds, but the

Turning to the strategic investment cycle we find that local bonds have defensive characteristics and have had their highest return during early recessions. Open FX exposure increases cyclicality for all emerging market groups, but only the Upside has delivered positive returns in early recession while both Transition and Carry have experienced losses: the fundamental strength of Upside economies makes their local currency returns behave more like thoese in the US, which also decline in recessions. Carry bonds have had losses close to 15% in early recession, significantly higher than the other groups. Nordic bonds are also cyclical, but less than both Transition and Carry.


Emerging Markets Cross Assets

Tactical bond returns, real USD, 2000-2011



Tactical equity results are relatively similar to strategic, the main difference being the close to flat returns in the late part of the downturn phase. Equity returns have recovered in early upswing with extra ordinary high returns.



Constructing an optimal long-term emerging market portfolio

Early downturn US bonds Upside Late downturn Upside ex China Early upswing Transition Carry Late upswing Nordic bonds
100% 90%
Source: Ecowin, GFD and SEB X-asset


Emerging market allocation along the efficient frontier, 20002011

Tactical bond cyclicality is less pronounced than strategic. Local as well as emerging market bonds have had positive returns in early downturn over the last decade, mainly due to less cyclical exchange rates characteristcs.

80% 70% 60% 50% 40% 30% 20% 10% 0% 6.5% 8.5% 10.5% 12.5% 14.5% Standard deviation Transition MM Transition bonds Transition equities 16.5% 18.5% Carry MM Carry bonds Carry equities
Source: Ecowin , GFD and SEB X-asset

Cyclical risk: first part of recessions very painful for equities

Strategic equity returns, real USD, 2000-2011
40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Early recession US equities Late recession Upside Upside ex China Early expansion Transition Carry Late expansion Nordic equities


Upside MM Upside bonds Upside equities

In order to illustrate how an investor can allocate within and between the three emerging market assets we have optimised portfolios based on Upside, Transition and Carry. The optimisation is based on historical data over the last decade and uses resampling in order to avoid some of the well known problems with traditional Markowitz optimisation. The results should be used as indications.
Optimal portfolio at 10% standard deviation
1% 5%
Source: Ecowin, GFD and SEB X-asset

1% 19% Upside MM Transition MM Carry MM Upside bonds Transition bonds Carry bonds Upside equities Transition equities Carry equities 42%


Local equities are cyclical and systematically underperform in the worst part of the strategic cycle with historical losses around 30% in early recession. Equity returns in USD show cyclical characteristics, but the inverse relationship between appreciating currency and equity returns leads to somewhat dampened losses. Nordic equities have been as cyclical as Carry equities, with losses around 45%. Equity returns have recovered in the late recession phase and stayed positive throughout the expansion phases.
Tactical equity returns, real USD, 2000-2011
100% 80% 60% 40% 20% 0% -20% -40% Early downturn US equities Upside Late downturn Upside ex China Early upswing Transition Carry Late upswing Nordic equities
Source: Ecowin, GFD and SEB X-asset




Source: Ecowin , GFD and SEB X-asset

The pie chart shows the optimal historical long-term allocation at 10% risk, giving an annual real return of 7.7% over the last 10 years. The portfolio is relatively balanced with 60% allocated to bonds and the rest split between money market and equities. Within the asset classes Carry dominates the money market exposure, Upside bonds and Transition equities. On an aggregated level close to half the portfolio is allocated to Upsidemaking the portfolio more robust and better prepared if there is a debt crisis.


Emerging Markets Cross Assets

Adjusting the portfolio to cyclical climate

Strategic efficient frontiers, 2000-2011
35% 30% 25% Real return 20% 15% 10% 5% 0% -5% 0% 5% Early recession 10% 15% 20% 25% Late expansion
Source: Ecowin, GFD and SEB X-asset

with equal weights we end up in our current overlay recommendation, illustrated in the matrix. Our main scenarios in both the strategic and tactical cycles are reflected in overweights to both Upside and Transition money market and bonds, at the cost of mainly Carry. Active views should be seen as ballpark qualitative indicators of direction rather than specific detailed portfolio recommendations.


Standard deviation Late recession Early expansion

The long-term portfolio can be adjusted to fit the specific strategic regimes. Money market and bonds are preferred at lower risk levels while the end of the efficient frontiers are tilted towards equities and Carry but 10% standard deviation means you can not go far out on the curves in all climates.
Tactical efficient frontiers, 2000-2011
70% 60% 50% Real return 40% 30% 20% 10% 0% 0% 5% Early downturn 10% 15% 20% Late upswing
Source: Ecowin, GFD and SEB X-asset

Standard deviation Late downturn Early upswing

On the tactical level money market and bonds are overweighted in downturns, with a tilt towards Upside. Equities regain strength in, mainly allocated to Upside.

Adjusting the portfolio to the current climate

Current combined weight deviations from long-term benchmark

MM Bonds Equities

Upside 1% 8% 2%

Transition 4% 1% -7%

Carry -5% -4% 0%

Red < -1%, Orange (-1%) - 1%, Green > 1%

Based on the phase specific benchmark deviations above and our currenct views on where we are in the strategic and tacitcal cycles we calculate two overlays reflecting our current medium- and short-term benchmark deviations. Combining the two overlays


Emerging Markets Cross Assets

Fixed Income: Supportive macro

EM fixed income markets have been hurt by recently increased risk-aversion. However, consistent with our structural case for EM bonds, currency hedged bond positions still show healthy gains so far this year, unlike most other risk bearing asset classes. Furthermore, from a local currency bond perspective, several aspects of the present macroeconomic situation, most notably the inflation environment, remain benign. Nevertheless, EM bonds, especially from CEE countries, remain vulnerable to Eurozone risks.

Hard currency index gains have also been eroded, although the EMBI has still reported a 3.4% return since the end of 2011. Gains in hard currency bonds earlier this year mirrored (albeit subject to a lag) the stronger performances of other risky assets in January, largely as we predicted in our last EMXA.
GBI-EM local bond Indices Index = 100 on Jan 2003 320 310 300 290 280 270 260 250 240 230 220 Jan-10 180


165 unhedged hedged

Source: Bloomberg

Lower inflation supports local bonds

As we forecast in our February EMXA report, international inflationary pressure has further abated as a result of lower prices on food and commodities in general. Indeed, inflation rates have decreased faster than we expected. Furthermore, moderate growth forecasts for several countries that are neither strong enough to accelerate inflation, nor sufficiently weak to endanger sovereign solvency, support EM bonds. Nevertheless, overall, increasing risk aversion has produced a slight rise in EM local currency bond yields in May. Due to flight-to-liquidity driven demand for developed market (DM) bonds, spreads have increased more than yields. While the currency hedged GBI-EM index has decreased after hitting a record high in early May, it is still a solid 2.2% higher than at the beginning of the year, a strong performance for such a relatively stable index.

150 Dec-10 Dec-11 Sep-11 Mar-12 Apr-10 Apr-11 Oct-10 Jun-12 Jul-10 Jul-11

Structural case intact

Reverting to currency-hedged performance, the robust positive risk-adjusted return so far this year indicates that our structural case for EM bonds remains intact. Several factors probably explain the asset class consistently strong risk-adjusted outperformance over a long period. Prices are lower and both yields and returns consequently higher potentially due to: The home bias of wealthy DM investors Risk aversion by local investors unable to diversify away from local inflation and political risks A still incompletely developed local investor base Price insensitivity of issuing governments being prepared to pay a premium to build a local bond market and diversify funding.
EM Bond Returns, USD Hedged Index = 100 Jan 1 2003 180 170 160 150 140 130 120 110 100 2003 2004 2005 2006

Currencies and credit spreads weighed

Regarding more volatile indices that include currency effects, the erosion of gains during May has produced less impressive returns. In particular, the non-hedged GBI-EM index has posted a YTD 2.0% gain which we regard unfavourably given its relatively higher risk.
EM and DM bond yields 8 GBI-EM yield GBI-EM yield % p.a. Treasury yield % p.a. 7.5 7 6.5 6 Source: Bloomberg 5.5 Jul-10 Jul-11 Jan-10 Sep-11 Apr-10 Apr-11 Dec-10 Dec-11 Mar-12 Jun-12 Oct-10 0.5 5y Treasury yield 2.5 2 1.5 1 3

Source: Bloomberg 2007 2008 2009 2010 2011 2012

International investors that have been able to overcome their home bias and diversify away local risks have secured very attractive risk-adjusted returns. So far these profits



Emerging Markets Cross Assets

have mainly stemmed from low prices. Going forward; capital gains from bond prices increasing toward equilibrium levels could further add to strong returns. But so far, how much is still left of the return generating price discount on EM bonds? Comparing EM inflation with an index of EM local yields, as we do in the diagram below, we see that markets hardly at all have priced-up EM bonds to reward the so far successful inflation targeting in EM economies.

EM bonds outperformed 2 months out of 3

To illustrate the risk adjusted outperformance of EM bonds, we have used the standard hedge-fund metrics share of positive months. It simply states in how many months out of the total sample an asset has outperformed its risk-free funding cost. Looking at the big EM indices since their inception in January 2003, EM bonds look as strong in this measure as when comparing slightly more complex measures such as sharpe-ratios. A non-rewarding investment gives a return in excess of funding costs only in half of the months. Both EM and DM stocks have been slightly better than this. However, currency hedged EMbonds have had positive excess returns in 2 months out of 3!
Share of Positive Months after Carry Jan 2003 - May 2012
70% 65% 60% 55% 50% EM-Bonds unhedged DM-Bonds hedged EM-Bonds hedged DM-Stocks unhedged EM-Stocks unhedged

Picture: Hyperinflation in a still not Emerging Market Bond yields remain well above current inflation rates, indicating that markets still offer a solid premium return to those willing to bear EM inflation risk. Returns connected to inflation risk-premia are even more apparent at the country level, as discussed in the February 2011 EMXA report.

EM hard currency bonds affected by higher volatility

Increased risk aversion and higher forward looking volatility indices (e.g. VIX) immediately hit EM hard currency spreads in May, in sharp contrast to the temporarily lagging relationship between the VIX and the hard currency spreads after Januarys risk rally from which we profited based on our recommendations in the February EMXA report. EM hard currency bonds have also been harder hit than BBB corporate credits during the bear-rally in May.
EMBI Spread to UST, bps 500 450 400 350 300 250 200 May-10 May-11 May-12 Nov-10 Aug-10 Aug-11 Feb-11 Nov-11 Feb-12 EMBI-spread US BBB-spread 310 270 230 190 150 BBB Spread to UST, bps

EM Inflation and Yield 10 9 8 7 6 5 4 3 2 1 EM yield Inflation 10 9 8 7 6 5 4 3 2 1

rate/yield, % p.a.

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Regarding the historical relationship between VIX fluctuations and variations in the hard currency spread, the reaction affecting the latter appears slightly exaggerated.


Emerging Markets Cross Assets

EM Hard Ccy Spread and VIX

500 450 50

hard currency space, which is further supported by our macro view on the region.

spread, bps

400 350 300 250

VIX vola, % p.a.

EMBI spread VIX


Depreciating currencies increase inflation pressure but help growth

Generally, EM countries have seen their currencies depreciate in May as global risk appetite once again has started to deteriorate. In the longer term, this exacerbates inflation pressure, both directly through more expensive imports, and indirectly through a positive effect on growth. Local bonds will therefore be negatively affected while hard currency bonds could be helped somewhat by the positive effects on the growth outlook.

Source: Bloomberg 200 10




Regional differences
Significantly, we note differences in regional fundamentals. As we and others have observed several times, CEE countries are especially vulnerable to the ongoing crisis in the Eurozone. It should come as no surprise if CEE hard currency spreads were most severely hit if problems intensify. Still, mitigating factors may apply. Hungary has progressed toward initiating formal negotiations with the IMF. Production data for Polish products potentially part of supplychains possibly leading to Asia via Germany have remained resilient. Nevertheless, financial vulnerabilities pose regional risks justifying the widened Hungarian spreads.
Regional Hard Currency Spreads 550 500 450 400 350 300 250 200 150 100 Dec-10 Sep-10









Eurozone still a risk for EM

Continuing problems in the Eurozone create macroeconomic risks for EMs, especially those in Europe. We, the World Bank, the IIF and others have previously highlighted the regions dependence on Eurozone bank lending, recommending particular caution in the case of CEE countries. Countries most at risk from deterioration in credit markets due to the Eurozone crisis include Hungary, Poland and Turkey, according to the IMFs Global Financial Stability Report (April) as discussed in the General section of this report.

Inflation development shows value in local bonds

Both headline and core inflation have been well below our expectations. Reductions in the former have been geographically diversified, with countries such as China, Russia and Brazil all reporting significantly slower price increases. It is tempting to regard currency appreciation in January as the reason for lower inflation. However, currency movements have a much slower impact; we recall for example the EM currency depreciation last autumn which failed to prevent inflation rates from falling back after peaking. Lower inflation towards the end of winter was much sharper than the gradual fall we had (and continue to) forecast. While lower commodity prices are the main contributors (with the crude rally in February 2011 adding a favourable base effect), we have seen an even more conspicuous decrease in otherwise usually stable EM core inflation. We regard this as an example of how EM central banks currently enjoy solid trust citizens and corporations. We should otherwise have expected more stubborn core inflation following global market commodity price increases over the past two years. However, EM inflation dynamics now appear much less influenced by highinflation expectations and compensation demands, and more by supply-demand balances. This is extremely important both for EM assets, for which it is long-term

bps p.a.

Asia LatAm Europe



For less impaired regions such as Latin America and Asia, fundamentals look stronger. During the winter, hard currency spreads outside Europe did not increase as much as they did in Europe; according to local EMBI indices (see nearby diagram). This spring, regional spreads have moved in tandem, with those in Europe not increasing more than elsewhere. In fact, so far this year, the European hard currency index has narrowed while its Latin American counterpart has increased. This, together with the lack of improvement in the European situation, leads us to favour Latin America in






Emerging Markets Cross Assets

bullish, and EM policymakers, for whom it provides room to manoeuvre.

EM Inflation and Yield-spread 7 rate/yield, % p.a. 6 5 4 3 2 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
EM spread Inflation

7 6 5 4 3 2 1

slowly and with a lagged effect, as shown in diagrams nearby showing both local EM yields and their spreads above Treasuries relative to the inflation path. To complete the pattern, it is time for EM yields to begin significantly decreasing, adding capital gains to positive carry where yield curves slope upwards. Bonds gaining most from this development include those in high-inflation countries with large premiums due to recently high inflation rates. Of course, other factors usually present risks, particularly a potential risk-off driven slump in lower grade bonds. Note on inflation measure: Our CPI measure for EM comprises a weighted average for China, Brazil, South Korea, Taiwan, Russia and Poland. These countries have been selected based on their relative importance and data availability. Weights are based on the MSCI Equity index.
Current inflation, target and forecast, %
April CPI, CB target Av. inflation Av. inflation SEB f-cast, SEB f-cast, y/y 2012 2010 2011 av. 2012 av. 2013 EMEA Poland Czech Hungary Turkey S. Africa Romania Russia Estonia 4.0 3.5 5.7 11.1 6.1 1.8 3.6 4.0 2.8 3.2 0.6 2.5 2.0 3.0 5.0 4.5 3.0 5.5 2.7 1.4 4.9 8.6 4.3 6.1 6.9 2.7 -1.2 1.2 9.4 4.3 1.8 3.9 6.5 5.0 5.8 8.5 5.1 4.2 4.1 8.0 3.8 3.2 5.5 9.5 6.1 3.0 4.5 4.0 2.5 2.5 3.6 2.8 1.8 3.5 6.5 5.5 4.2 5.5 5.0 2.1 3.0 7.0

Inflation outlook revised down

We reduce our inflation forecasts. Surprisingly low core inflation indicates a less inflationary price-wage environment. With growth moderating it is therefore reasonable to expect weaker core inflation going forward. As for headline inflation, we forecast a continued decline driven by further decreases in food prices as seen by our commodities analysts. Crop levels are normalizing as is the weather, as La Nina effects are now probably over for this time.
Average inflation in major EM countries 7 Inflation rate, % p.a. 6 5 4 3 2 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Core Headline 7 6 5 4 3 2 1

Latvia Lithuania Ukraine LatAm Brazil Mexico Asia China Korea India* Indonesia Singapore

4.3** 3.4

4.5 3.0

5.0 4.2

6.6 3.4

5.2 3.6

5.2 3.5

3.4 2.5** 7.2 4.5** 5.4

4.0 3.0 5.0 **May CPI

3.3 3.0 12 5.1 2.8

5.4 4.2 9.4 5.4 5.2

3.5 3.3 6.8 4.5 3.5

3.8 3.1 7.2 5.0 2.3

*Wholesale prices

Source: Bloomberg, IMF, SEB

Good environment for bonds in high-inflation economies

Furthermore, we would like to emphasize how important the inflation outlook is for EM asset prices. Particularly as regards EM bonds, strong inflation expectations together with a high premium on inflation risk often weigh on prices. Indeed, this is part of our structural buy-case for EM-bonds. From a tactical perspective, we believe there is a good case for buying, on a currency hedged basis, considering the historical sensitivity of EM bonds to inflation developments. Yields have tended to rise after increases in inflation rates. Conversely, yields have tended to decrease as inflation eased, albeit more

Hungary: doubly at risk

We focus specifically on Hungary as it represents a core geographical area for us and because it has high, volatile yields. After a recent field trip to Budapest we conclude the following, both risks and yields are currently elevated. Periodically, Hungarian markets have weakened, being especially vulnerable following the abolition of the second pension pillar. Consequently, the investor base for Hungarian government bonds is insufficiently diversified and dominated by foreigners. This is especially problematical as the country has huge debts and large refinancing requirements. The local economy is depressed not only by the need to repay debt. Unpredictable fiscal reforms increase risk premiums and dampen investment


Emerging Markets Cross Assets

appetite. These reforms are driven by the need to improve finances by a government committed to its promise to implement a costly flat-tax reform and to hold property-taxes at zero.

base where long positions are concentrated. Downside risks tend to follow from such situations.

Baltic: Latvia still our regional favorite

Latvia remains our Baltic favourite due to its lower export dependence and strong political management. S&P agrees and has increased the countrys debt rating to investment grade; BBB- from BB+ on May 2. So far, markets have been unresponsive to such developments. As a result, we continue to recommend buying Latvian hard currency bonds vs. Lithuanian ditto. See our May edition of Baltic Fixed Income for further details.
Latvian and Lithuanian 5-yr USD 6 Yield, % p.a. Lithuania Latvia 5 5 6

Picture: Irina Ivaschenko, IMFs representative in Budapest More positively, export sectors are strong, generating revenues which enable the country to continue to pay down its external debt. In this context, softening external demand is also a risk. The possibility of a stand-by credit facility from the IMF being established has an important stabilizing effect on Hungarian markets. The chances of the country successfully negotiating such an arrangement have increased after the EU recently dropped its political pre-conditions for formal IMF negotiations to start. Another EU positive is its more optimistic view on the possibilities of Hungary improving its fiscal position. Negatively though, formal negotiations have yet to start. The IMF is also concerned about the structural growth impact stemming from the unpredictability of Hungarian fiscal policy. As we write, the question of whether or not the Hungarian central bank is independent has almost, but not entirely, been resolved.

3 Feb-12

3 May-12

Iceland: Recovering slowly but strongly

Despite continued liberalization of Icelandic capital controls, they have been strengthened in one important respect. The right to repatriate all cash-flows from instalment bonds, specifically HFF inflation linked bonds, has been cancelled. While latecomers to our HFF case may have lost as bond prices plummeted on the announcement, those who bought at the time of our recommendation have made attractive profits, which of course is the very reason why controls have been tightened. The countrys financial situation has improved slowly but strongly, with the unwinding of the huge Landsbanki estate proceeding better than expected. Potentially destabilising offshore ISK holdings have also been substantially rewound. HFF bond owners would not face excessive risks by retaining Icelandic assets. From a currency regulation perspective, a switch into high coupon government bonds, preferably the 8.75% 2019 would be best.

Hungary 5yr yield

360 yield, % p.a. 320 280 240 200 2007

13 11 9 7 5

South Africa, Indonesia and Brazil to benefit from low inflation environment
To secure a geographically diversified exposure to the improved inflation environment, we consider bonds in South Africa, Indonesia and Brazil.





From a portfolio perspective, the premium offered to compensate for carrying Hungarys own unique risks is attractive due to diversification benefits. However, the countrys heavy dependence on the Eurozone still ensures it remains a leveraged bet on risk sentiment in global markets. Overall, we recommend near term caution due to the countrys non-diversified investor


Emerging Markets Cross Assets

16 14 12 10 yield, % p.a. 8 6 4 2 0

South Africa 10yr yield


03 04 05 06 07 08 09 10 11 12

inflation developments have remained benign while growth has decreased. The currency war is going in reverse with authorities recently buying their own FX on the open market at just over USD/BRL 2.0 to prevent excessive weakness. While domestic capacity appears limited, demand seems to have softened while inflation rates are down, supported by international developments. We believe a couple of more short rate cuts remain likely, with authorities now considering the consequences of potentially easing IOF taxes to strengthen the currency and stimulate investment. It all appears a very conducive environment for lower yields.
40 35 30 25 yield, % p.a. 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Brazil 2yr yield inflation

The focal point for political risks in South Africa is Mr. Malema, the former leader of the governing ANC party youth league (ANCYL). After being removed from his post by the government who accused him of acting contrary to the national interest by threatening to nationalize the mining industry, his popular base has so far not revolted, as feared by many analysts. In this respect, risks are in the process of being unwound, with some way left to go. While lower food prices could help, at present inflation rates have not yet begun to decrease. As in the case of Hungary, local political risks weigh on asset prices. Consequently, to a diversified global portfolio South African bonds offer an additional return at little extra total risk. Inflation in Indonesia have proved very benign despite increasing to 4.5% over the past couple of months; as late as 2008 prices were rising at doubledigit rates. Recent action to support the depreciating rupee focuses on this issue. With a low GDP per capita, reduced food prices have an important effect on household economy. Domestic demand may thus support growth when external demand softens. Bond yields have been trending steadily lower with more likely to come.
20 18 16 14 12 10 8 6 4 2 0 2003 2004

Investment conclusions
With European risks continuing to increase, most strongly fuelled by Greek parliamentary uncertainty, and the negative outlook for banking and macroeconomic stability in Spain, recommending specific securities is difficult. We do however highlight our previous recommendation to buy Latvian bonds vs. Lithuanian. For the hard currency space, we see value in Latin American sovereign credits following recent spread developments. Despite ongoing concerns regarding the Eurozone, Latin American credits have underperformed vs. CEE securities, leaving spreads relatively attractive.

Bond basket
Over the past couple of years, we have used a table which has included a selection of our favourite bonds to express our fixed income recommendations, concentrating on unhedged local currency positions, and comprising those most easily investable by ourselves and our clients. In addition, we offer to wrap these baskets (or indeed any combination of EM bonds) in SEB certificates. Having already positioned our basket on the basis of an expected improvement in the global inflation environment in our last EMXA, we largely reiterate our earlier call to benefit from a continuation of this trend. Reflecting our previously issued (see below) recommendation to take profits on the Lithuanian hard currency bond, we switch
2009 2010 2011

yield, % p.a.

Indonesia 10yr yield inflation 2005 2006 2007 2008

Brazil has continued to switch from monetary to fiscal policy constraints. The monetary stance has softened significantly, on the fiscal front; at least official numbers show some tightening. Nevertheless,


Emerging Markets Cross Assets

out of it in favour of a corresponding Latvian bond consistent with our favourite trade (also below).
SEB EM Bond Portfolio February 13 2012 to January 1 2012
SEB weight Poland Hungary Lithuania S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average 5% 7.5% 10% 15% 5% 10% 15% 10% 15% 7.5% Rating S&P (LT-FC) ABB+ BBB BBB+ BB A BB+ ABBB BBB Yield 13-Feb 5.1% 8.5% 4.3% 6.6% 9.3% 3.6% 4.5% 3.2% 11.0% 5.0% 6.2% m~==cJNP= Yield 01-Jun `= i~=K rpa=K JNMKTB OKOB JUKTB 4.9% 8.9% JNMKPB MKVB JVKRB 4.0% MKMB OKOB OKOB 6.4% JNMKOB OKSB JTKVB 9.3% JRKMB OKVB JOKPB 3.4% JQKUB NKVB JPKMB 5.6% JQKMB JPKMB JSKVB 3.2% JRKPB MKTB JQKSB JNRKVB TKSB JVKQB 9.8% 4.9% JNNKNB NKVB JVKQB 6.1% JTKVB OKMB JSKNB

Favourite trade
We made a substantial profit from our favoured trade to buy Lithuania in USD with a European corporate CDS index as a hedge, as recommended in our previous EMXA. We thought EM hard-currency bonds should eventually catchup after the risk-rally in January, during which they did not participate. And they did. Our exit recommendation was published on April 4 in our publication EM Fixed Income Market Views. Entry and exit points are marked in the EMBI and VIX diagram earlier in this section. Currently, our favourite trade is based on our macroeconomic analysis of the Baltic region and was previously published as part of our Baltic Fixed Income research. Despite S&P having recognised the improvements achieved in Latvia, the market has still not responded by tightening the countrys spread vs. neighbours, especially the more internationally exposed Lithuania. From a 3-6 month perspective, we believe markets will eventually discover the relative value of Latvian credits and the problems Lithuania faces due to its economys heavy export dependence.

100% BBB

Our bond-basket this time outperformed the GBI-EM both on a currency hedged and fully exposed basis. Since the stop-date for the last EMXA on January 13, our basket has gained 2.0% currency hedged, and 6.1% fully exposed in USD. The corresponding number for the GBI-EM Global Diversified is -0.3% and -7.5% respectively. Our decision to avoid CEE assets but to invest in Lithuania in USD has been helpful, while our overweight in Brazil has been costly due to the softness of the real. We hope to recoup those losses as the Central Bank now has stepped in to defend its currency. Our position on high-inflation countries was gainful on a currency-hedged basis, but weighed down our returns when currency returns are included. Also, as an effect of our positive view on Latin American economies, we increase our exposure to Mexican bonds. This we finance by decreasing our Hungarian holdings. We already have enough of exposure to Eurozone developments indirectly as it will affect all and every risky asset, including those in our portfolio. Above that, we remain uncertain regarding the lack of heterogeneity of owners of Hungarian bonds.
New SEB EM Bond Basket June 1
SEB weight Poland Hungary Latvia S. Africa Turkey S. Korea Indonesia Malaysia Brazil Mexico Average 5% 5% 7.5% 15% 7.5% 10% 15% 10% 15% 10% Rating S&P (LT-FC) ABB+ BBBBBB+ BB A BB+ ABBB BBB Yield 01-Jun 4.9% 8.9% 5.4% 6.4% 9.3% 3.4% 5.6% 3.2% 9.8% 4.9% 6.2% Duration years 4.0 4.6 4.2 2.7 3.1 4.0 4.2 3.9 3.6 3.1 3.7

100% BBB


Emerging Markets Cross Assets

Equities: Cheap to become even cheaper

After rallying strongly at the beginning of the year, EM equities have been sold off over the past six weeks, as we forecast in our last edition of EMXA in February. In the current issue, we conclude that EM equities are cheap both on a stand alone basis and compared to DM and that they will cease to underperform soon. However, the technical outlook is weak, signaling further near-term losses. We therefore expect several attractive entry points to overweight EM which are set to outperform DM during the next 3-6 months. Within our EM universe we recommend overweighting Asia, remaining neutral in Latin America and underweighting EMEA. Despite anticipating short, exceptionally strong EMEA rallies if Eurozone debt crisis tensions ease even temporarily, we do not expect the region to outperform over the longer term. Individually, we recommend overweighting China and South Korea in Asia, Russia and Egypt in EMEA, and Peru and Colombia in Latin America. We also keep an eye on Brazil as we lean towards a change of direction when the aggressive policy measures start to bite. Historical data show EM equity returns are strongly correlated with overall risk sentiment. During periods of stress investors rush to buy safe assets with EM equities among the first to be sold. Similarly, on the FX market the USD tends to outperform whenever EM equities are weak. Currently, the USD Index is increasing, risky assets are being sold off, and EM equities are obviously underperforming (chart below). It is difficult to expect them to rebound until the USD stops appreciating against its principal counterparts. According to our main scenario, we are bullish on EM FX for the next 3-6 months, a situation which will in turn produce a lower USD index and positive EM equity returns. However, timing remains crucial. We believe the next quarter will provide opportunities to go long EM equities but just not yet.

Dollar index versus EM equities

MSCI EM (inverted) 400 500 600 700 800 900 1000 1100 1200 USD Index vs MSCI EM Index USD Index 90 USD Index MSCI EM Index 88 86 84 82 80 78 76 74 72 70

The MSCI EM Index performed spectacularly well in Q1. However, very much in line with our view as expressed in the previous edition of our EMXA report, EM equities failed to maintain their gains, being sold off in Q2. Currently, the MSCI EM index is almost unchanged YTD. Since the start of 2011, EM equities have underperformed DM as shown in the following chart, mainly due to an increased risk premium and general flight to safety. However, periods in which EM tend to underperform are often followed by significant outperformance.
EM Equities relative to the world
110 105 100 95 90 85 80 75 70
Ju n11 Au g11 Ap r-1 1 -1 2 Oc t-1 1 ar -1 2 b11 c11 De De Fe Ja n M ay -1 2 M c10

Se p0 Ja 8 nM 09 ay -0 Au 9 g0 De 9 c09 Ap r-1 0 Ju l-1 No 0 v10 M ar -1 1 Ju n11 Oc t- 1 Fe 1 bM 12 ay -1 2

Source: Bloomberg


EMXA Feb cut-off

105 100 95 90 85


80 75 70

Source: Reuters Ecowin

Regionally, Latin America has performed worst so far this year, losing 5.8%, mainly due to the 10.4% decrease in MSCI Brazil (in USD terms). Fully consistent with consensus expectations, EMEA equity performance has been weak. Its long and safe distance from Europe and superior growth prospects have caused investors to favour Asian markets, which remain higher (+1.6% in USD terms) compared to the end of last year.


Emerging Markets Cross Assets

EM Equities regional relative performance (vs. EM)

1.04 1.02 1 0.98 0.96 0.94 0.92 EMEA Latam Asia

Source: Bloomberg

We still believe there is a good chance that Asia will outperform other regions going forward. Despite reduced growth forecasts in several countries including China, earnings per share in EM Asia should still increase faster than in other EM. In our view this situation is also likely to be reflected in equity prices. In effect, Latin America stands between Asia and EMEA. Although market expectations concerning earnings growth have decreased, equities are more expensive based on either P/E or P/B ratios. Arguably, Latin American markets have already sold off aggressively with most of the negative news already discounted. However, recent regional underperformance is largely explained by negative currency contributions due to the simultaneously strong USD as local currency-based equity indices fell much less. As regards EMEA, we believe it will be very difficult for the region to outperform given very weak Eurozone growth. On the other hand, strong, short rallies are not unlikely if temporary relief measures to ease the Eurozone debt crisis are implemented. Although, while we believe the region is already underweighted by investors, we do not expect it to benefit from major regional rotation during the next 36 months.
MSCI AC World selected markets (local currency)

MSCI Germany MSCI Mexico MSCI Taiwan MSCI Malaysia MSCI Hong Kong MSCI Ireland MSCI China MSCI Chile MSCI Australia MSCI Sweden MSCI Japan MSCI Switzerland MSCI Poland MSCI Brazil MSCI France MSCI Hungary MSCI United Kingdom MSCI Czech Republic MSCI Indonesia MSCI Russia MSCI Morocco MSCI Portugal MSCI Greece MSCI Spain

3.2 3.1 2.7 2.0 1.5 0.8 0.8 0.1 0.0 -0.6 -1.1 -1.5 -2.1 -2.8 -3.6 -4.2 -4.4 -5.5 -5.8 -6.6 -8.6 -20.1 -22.2 -29.2

-16.4 9.4 -18.1 -0.6 -18.3 11.4 -22.8 -11.3 -14.2 -16.7 -15.5 -11.3 -27.6 -11.4 -23.6 -34.0 -11.1 -19.8 -5.6 -22.7 -22.3 -39.4 -67.4 -42.4

3.2 3.1 2.7 2.0 1.5 0.8 0.8 0.1 0.0 -0.6 -1.1 -1.5 -2.1 -2.8 -3.6 -4.2 -4.4 -5.5 -5.8 -6.6 -8.6 -20.1 -22.2 -29.2
Source: FactSet

-1 2

-1 2


ar -1 2

r-1 2

Ja n

Ja n



ay -1 2

From an MSCI AC World Index perspective, Spain and Greece have performed worst so far this year for several good reasons. The recovery in Egypt which began at the start of this year helped the market recoup most losses incurred in the sell-off that followed the Arab Spring. Asian markets particularly the Philippines and Thailand have also performed reasonably well. In addition, Indian equities posted solid gains at the beginning of the year, although the INR has been one of the worst EM FX performers since December 2011, with the result that foreign investors are receiving much lower unhedged returns than those included in the table above. Another market worth mentioning is Russia where equities increased almost 20% during the first quarter. However, the sell-off which occurred in Q2 produced negative YTD returns, making it one of the worst performing markets since the end of last year. On a GICS sector level performance between the various industry groups has varied widely. The difference between the best and worst performing sectors was 16 percentage points. Best performers have included the IT and Healthcare segments while Materials and Energy fell furthest. Outperformance by the Health Care industry may be explained by investors positioning themselves in defensive sectors less sensitive to demand shocks caused, for example, by a rapidly slowing economy or an unexpectedly negative outcome to the European debt crisis. Underperformance by the Energy and Materials sectors was caused by sharply lower oil and commodity prices. On the other hand, it is fairly difficult to explain the especially poor performance by Utilities, a sector so far regarded as safe. From a valuation perspective, it appears

Market MSCI AC World MSCI Egypt MSCI Philippines MSCI Thailand MSCI Colombia MSCI New Zealand MSCI India MSCI Singapore MSCI Peru MSCI Turkey MSCI USA MSCI South Africa MSCI Korea

YTD % 0.9 31.9 16.9 9.9 9.4 7.7 6.3 5.4 5.4 5.1 4.3 4.2 3.9

Feb EMXA 1 year, % cut- off, % -10.2 -6.3 -11.3 18.6 3.3 2.2 -1.4 -13.3 -13.7 -1.6 -12.3 -2.8 5.5 -11.7 31.9 16.9 9.9 9.4 7.7 6.3 5.4 5.4 5.1 4.3 4.2 3.9


Emerging Markets Cross Assets

attractive with a P/B ratio of 1.0x. Meanwhile, Healthcare and Consumer Staples have remained the most expensive in our EM universe.
Sector Performance and 12m fwd expectations

MSCI EM GICS Sectors YTD, % IT Health Care Industrials Consumer Staples Financials Consumer Discret. Utilities Telecom. Services Materials Energy 8.5 7.3 2.5 1.7 0.4 -0.8 -3.2 -3.5 -6.4 -9.7

1 year. P/E % -10.6 11.3 -15.5 17.5 -27.4 11.1 -2.0 18.9 -24.5 8.2 -19.1 9.6 -21.0 11.3 -12.5 11.6 -34.1 9.0 -31.2 6.1

P/B EPS, % 1.8 2.6 1.3 3.1 1.2 1.7 1.0 1.9 1.2 0.8 34.8 17.8 19.4 18.3 12.1 16.7 16.8 9.5 2.9 -0.1

Source: FactSet

EM equity flows At the beginning of this year, EM equity funds experienced large inflows of new money. Investors rushed to catch up with rapidly rising markets. Consequently, by the end of the first quarter, cumulative flows to EM equity funds totaled USD 22.6bn or 3.5% of AUM. However, the trend reversed immediately in Q2. Investors changed their minds and began withdrawing money from EM equity funds, with outflows totaling USD 7.8bn or one third of total cash received in Q1. Investors decided to favour global EM funds at the expense of regional counterparts. Latin America was worst hit by the outflow. According to EPFR data, it lost 4.2% of AUM YTD followed by EMEA with almost 1.5%. Wholly consistent with the consensus view that Asian markets are most resilient to slowing global growth and Eurozone debt problems, Asian funds have reported the smallest outflows so far this year.
Cumulative EM equity fund flows, 2012 YTD
7 Global EM Asia 5 EMEA Latam 3

1.5bn or 8.3% of AUM so far this year. Huge outflows have depressed equity prices producing much better local equity valuations. The downward revision of growth has also impacted returns negatively. Policy makers are doing what they can for the economy to regain momentum by lowering the SELIC interest rate by 400bps in less than a year and supporting the export sector by intervening in the currency market. With the Brazilian real having depreciated 8.4% against the US dollar since the beginning of the year, we think the market will become attractive over the coming months. Also, significantly, investor sentiment increasingly favours Chinese funds. Local equity funds have posted the second highest peer-relative inflows so far this year totaling USD 700mn, a major change compared to last year when investors withdrew USD 3.2bn. Apparently, money is being put back to work in Chinese equities despite recent warnings concerning the countrys slowing GDP growth.
Equity fund flows

4wk ma Brazil -171 Chile -15 China -125 Colombia 9 Czech 0 Egypt 0 India -59 Indonesia 1 Korea -42 Malaysia -1 Mexico -25 Peru -15 Philippines 3 Poland -1 Russia -86 Singapore -3 South Africa -15 Taiwan 76 Thailand 11 Turkey -24

YTD, USD YTD cum, 2011, USD M % AUM M -1552 -8.3 -2,167 64 7.6 -239 706 2.0 -3,235 67 6.1 39 0 0.3 -19 -44 -36.3 53 -205 -1.0 -3,841 274 13.4 -199 -1304 -10.6 -318 -64 -5.0 -267 -35 -1.8 -422 -68 -13.9 20 61 51.3 78 -6 -3.7 56 962 6.6 -166 -11 -0.5 -804 24 4.6 -255 -810 -9.1 1,726 273 19.3 -383 -23 -1.5 -547
Source: EPFR

r-1 2



Concerning individual country flows it is easy to conclude that Brazil is to blame for outflows from Latin America. They began as early as 2011 but accelerated only recently. Brazilian funds have already lost USD

r-1 2 M ay -1 2 M ay -1 2

Fe b

Fe b

Fe b

Ja n

Ja n

ar -1 2

ar -1 2


Source: EPFR

Also reporting strong inflows is Russia at USD 970mn, equivalent to 7% of AUM. The recent fall in oil price and subsequent Russian fund redemptions have driven equity prices much lower with valuations once again back at attractive levels. Overall, flow data shows a mixed picture. Clearly, investors generally favour global EM funds at the expense of their regional or national counterparts, a phenomenon likely to continue at least in the near-term. On a country basis current flow data support markets such as China and Russia, ranked first and fourth respectively in our EM equity markets assessment discussed in more detail in the following section.

-1 2

-1 2






Even better value for money now

Compared to our last EMXA published in February 2012, EM equities have become even cheaper, mainly due to the recent sell-off driven by concerns that the Eurozone may


Emerging Markets Cross Assets

break up and signs that the growth is losing momentum in both the US and Asia. Although EPS growth estimates have been revised lower in most EM markets during the last three months, equity prices declined much more, producing a substantial improvement in valuation measures. Currently market consensus forecasts 11.3% growth in MSCI EM Index EPS, compared with 11.5% expected in February this year. Significantly, the same market consensus expects higher MSCI World Index EPS growth (+11.5%) than for EM. With EPS recently increasing faster in EM and GDP forecasts tending to be higher for EM countries, DM earnings are unlikely to outstrip those in EM, at least in the longer term. Latin America remains the most expensive region in P/E, P/B and PEG terms. On the one hand, this is attributable to the inclusion of very expensive markets such as Mexico, Peru and Chile. However, Mexicos high P/E ratio is justified by strong EPS growth expectations. On the other hand, while Brazilian equities may appear cheap based on a P/E ratio of 9.0x compared with a 5 year average of 10.7x, its EPS growth expectations have been slashed more than any other EM country over the past three months. Currently, analysts expect EPS 14.8% lower than three months ago. Regionally, EM Europe remains cheapest in our EM universe. Certainly, it appears very inexpensive at a P/E ratio of 5.3x compared to 6.4x in our last EMXA and a 5 year average of 9.2x. Of course, there are two reasons for the low regional valuation. Firstly, most analysts agree that EM Europe is most vulnerable to Eurozone problems. Secondly, the Russian equity market is cheap. Russia has always been one of the least expensive EM with a P/E ratio rarely exceeding 7.0x. We do not expect this situation to change fundamentally in the foreseeable future such that P/E ratio to rise sharply in Russia However, while markets suggest a difficult outlook with valuations implying significantly slower earnings, we regard a P/E ratio of around 4.0x as attractive for longterm investors. Further, Hungary also appears cheap. Its equities recently lost all YTD gains as investors decided to flee local assets including currency, bonds and equities on concerns that its promised IMF deal would not materialize anytime soon. With a P/E ratio of 7.3x and PEG of 0.4x, Hungary is one of the cheapest markets in our EM universe. Obviously, if the Hungarian government is able to secure a stand-by agreement with the IMF in the near future the market is likely to outperform its peers even if the European debt crisis remains unresolved.

Key Figures, consensus estimates (12m fwd)

Market P/E MSCI EM 9.4 MSCI World 11.0 MSCI EM Asia 9.8 MSCI EM Europe 5.3 MSCI EM Latam 10.6 MSCI Brazil MSCI China MSCI Korea MSCI Russia MSCI Taiwan MSCI S Africa MSCI India MSCI Mexico MSCI Poland MSCI Turkey MSCI Malaysia MSCI Indonesia MSCI Chile MSCI Thailand MSCI Colombia MSCI Peru MSCI Egypt MSCI Philippines MSCI Hungary MSCI Czech R. MSCI Morocco

EPS% 11.3 11.5 16.4 -3.9 8.2

ROE Yield% P/B 14.4 3.4 1.3 13.3 3.2 1.5 14.4 2.9 1.4 13.8 4.6 0.7 13.8 3.8 1.5 13.3 15.7 13.2 14.1 11.9 17.7 16.0 16.0 11.1 15.2 14.0 23.2 13.8 18.5 13.1 24.8 14.3 15.9 10.4 15.7 30.7 4.6 3.8 1.4 4.2 4.0 4.3 1.8 2.0 5.8 3.7 3.4 3.3 3.0 4.2 3.1 3.4 4.4 2.5 5.0 7.3 5.4 1.2 1.3 1.1 0.6 1.6 1.9 2.0 2.5 1.0 1.3 1.9 2.8 2.1 1.9 1.9 2.6 1.2 2.5 0.7 1.6 3.6

PEG 0.8 1.0 0.6 -1.4 1.3 1.8 0.7 0.4 -1.1 0.6 0.6 0.9 0.7 -0.6 0.8 1.1 1.0 1.3 0.6 1.2 1.0 0.4 1.4 0.4 1.8 1.5

9.0 5.1 8.4 11.3 8.2 21.7 4.6 -4.2 13.4 22.2 10.6 16.9 12.5 14.0 15.5 22.2 9.3 -14.4 8.4 10.2 13.9 12.8 12.2 12.8 14.9 11.3 10.2 17.3 14.6 12.0 10.2 9.8 8.4 20.8 16.0 11.7 7.3 20.7 10.0 5.7 11.7 8.0

Source: FactSet

Despite increasing 32% YTD, the Egyptian stock market remains cheap based on key valuation metrics. Following last years sell-off due to the Arab Spring and overthrow of President Hosni Mubarak, Egypt has recovered strongly since the year end. With an elected parliament installed, presidential elections are scheduled to take place at the beginning of June. If political tensions continue to ease and the country decides to adopt even a limited form of democracy, equities will enjoy further upside potential. Currently, Egyptian equities trade approximately 25% cheaper than they were immediately prior to last years political upheaval. Furthermore, Asian markets are now also cheaper. While the effects on Asian economies of a possible blowout in Europe should be limited, markets have begun to discount slowing growth in the worlds second largest economy China. While EPS forecasts have been reduced slightly, lower PMI figures, slowing exports and weaker GDP projections have caused a sell-off, sending the MSCI China index down sharply to levels last seen at the beginning of this year. Currently, the market trades at a 2012 P/E ratio of 9.8x, equivalent to a 26% discount to its 5 year historic average. Similarly, the P/B ratio is now 21% below its 5 year average. Arguably of course, these metrics may be justified by expected significantly slower GDP growth. Overall, based on P/E and P/B ratios China and South Korea are currently Asias two cheapest markets. Conversely, the Philippines remains the regions most expensive market. Further, with local equity market prices having increased so far this year, it has become even more


Emerging Markets Cross Assets

so since the end of last year. All valuation metrics for the Philippines are well above their respective 5 year historic averages. Valuation ranking model Using most of the metrics in the table on the previous page, we have created a ranking model for the 21 countries included in the MSCI EM Index. We use fundamental valuation metrics on an index level to rank markets from cheapest to most expensive. We have taken into account ratios such as expected P/E, P/B, dividend yield and ROE, and compared them to their 5 year averages. To capture earnings momentum, we also include expected EPS growth for the next 12 months and incorporate EPS revisions made by analysts over the past three months. When ranking markets we attach different weights to our inputs. In our model we weight the difference between the current value of the metric and its 5 year average, and also EPS momentum data more heavily. Using fundamental valuation ratios and EPS momentum indicators allows us to divide the total score into two parts: valuation, which shows the score based on valuation ratios; and EPS momentum which shows the score attributable to the expected change in EPS and EPS revisions.
Index Ranking MSCI China MSCI Korea MSCI Egypt MSCI Russia MSCI Thailand MSCI Morocco MSCI Taiwan MSCI Hungary MSCI Peru MSCI Turkey MSCI India MSCI Colombia MSCI Malaysia -EM MSCI Poland MSCI Brazil MSCI Czech Republic MSCI Indonesia MSCI South Africa MSCI Chile MSCI Philippines MSCI Mexico Tot. Score 274 254 251 250 230 226 221 211 210 199 190 185 182 177 169 169 166 158 156 145 135 Value EPS mom. 196 78 138 116 135 116 216 34 132 98 180 46 107 114 169 42 120 90 127 72 154 36 71 114 96 86 167 10 161 8 149 20 104 62 118 40 112 44 65 80 55 80
Data Source: FactSet

materialises and the Chinese economy slows as some predict, EPS forecasts will be slashed going forward justifying the markets present cheap valuation. Moreover, while Russia posted the highest score in the last edition of our EMXA, its cheap valuation and relatively high EPS momentum did not help the market to outperform. As we discussed earlier, Russia is even cheaper today than it was at the beginning of the year. While EPS momentum is low, a very high score attributable to the value component has helped the country achieve its fourth ranking. While a leading recommendation in our previous edition of EMXA South Africa - has outperformed all other EM, currently the market score is among the lowest. We do not expect it to continue to outperform. Concerning the weakest scores, Chile and the Philippines are currently joined by Mexico. According to our model Mexicos value component is extremely low, despite the market enjoying sufficiently strong EPS momentum to indicate attractive growth going forward. EM vs. DM, P/E discount To better understand how EM equities are valued compared to their DM counterparts we usually compare MSCI EM and MSCI World P/E ratios. For a long time we have argued that a P/E discount of between 5-15% should be regard as normal. However, during periods of market stress and flight to quality investors tend to favour DM far more. Consequently, the P/E discount decreases below the aforementioned band. However, at least recently, investors have tended to overreact with price action unjustified by subsequent changes in earnings. Currently, the EM universe trades at a 15% P/E discount, equal to the lower band of the interval. In our opinion, while this does not immediately imply a strong overweight EM recommendation, investors should be looking to add EM to their portfolios if they become even cheaper in the shortterm.
Relative EM valuation and relative performance
1.3 1.2 1.1 1.00 1 0.9 0.8 0.7
7 t-0 Oc y-0 Ma 8 8 c-0 De 9 l-0 Ju 10 bFe 10 pSe 1 r-1 Ap v-1 No 1 12 nJu

EM/DM PE ratio EM/DM Index, normalized

1.20 1.10


0.80 0.70

Data Source: FactSet

According to our model the cheapest market currently is China. Obviously, this can be explained by increasing concerns regarding its slowing economy. However, EPS expectations remain high and analysts have not rushed to downgrade earnings forecasts sharply. Of course, if the worst case scenario


Emerging Markets Cross Assets

Technical Analysis MSCI EM Index (USD)


Russia IRTS (USD)


Price USD 1,500


USD 1,100


100.0% 835


100.0% 700

2009 2010 2011 2012

2000 2010

600 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4





All eyes remain focused at the B-wave low at 874, as a break will also confirm passing the 2011 low point, 824, setting the next likely target at the negatively sloped neckline, currently running in the 800-area (a secondary ideal wave target will however be found closer to the 700 handle). To ease downside pressure the market needs to recover above 1,005.
MSCI EM/MSCI World ratio

With only small upward corrections on a declining path, the big picture still clearly supports an imminent test (and breach) of the 2011 low point. As previously, the violation of the B-wave low has confirmed that the 2011 low point will be passed (minimum target = 1,200) and that a medium term ideal target is around 835.
Brazil Bovespa (BRL)
Price BRL 50,000

Value USD 1.05

40,000 29,676.44 30,000


100.0% 0.9119 2001 trend line

0.9 0.85






161.8% 0.8232
0.8 0.75



Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3






As previously, we believe the market will plunge through the Aug 2011 low point, 47,793, taking aim at long-term trend lines. In the short-term we may nevertheless see some further congestion in a probable bear triangle. Strategically, we would sell up tics to the 56,000-area.
Mexico IPC (MXN)
Price MXN 36,000 32,000

The break down from the recent bear flag and the successful passing of the 2011 support line clearly indicates further underperformance to come. The next potential target is the low 0.91s, the point at which the decrease roughly equals the two preceding declining phases (seen from the peak). Our advice is to further reduce emerging market exposure generally in the near term.


Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3




The market has properly corrected, erasing the oversold position occurring around the 233d moving average. Consequently, we seek a new short from the current area


Emerging Markets Cross Assets

and an upcoming test and break of the 233d ma. The next target remains 31-33.000.
Indonesia JKSE (IDR)
Monthly graph Price IDR



2,500 2009 2010 2011 2012



After having printed a new record high in early May the market subsequently collapsed, falling below the April low point to create a key month reversal, a very bearish price pattern emerging from a new all-time high. This implies further weakness going forward and a probable first hand target around the 2011 low point. We expect upside reactions to be capped by the 4,000 resistance.


Emerging Markets Cross Assets

Currencies: Potential for major recovery in Q3

EM FX fell out of bed in May. The correction we expected following the January rally has occurred leaving the currencies of that part of the world still enjoying healthy growth cheaper against the USD than at any time this year. So, is this the time to buy them? In our main scenario, the answer is Yes, soon. However, this scenario involves near term, binary and potentially explosive risks from the Eurozone. Consequently, risk reward does not yet favour outright long EM positions. Instead, we suggest buying options which we regard as attractively priced despite recently increased volatility. We recommend a 6 months butterfly for the downside in EUR/MXN. As a hedge we buy a 1 month USD/HUF call spread. If the Greek election results in a bail-out supportive government and Spains banks receive support, as we expect, we would recommend buying EM spot. Market drivers will switch from liquidity to positioning and technicals and, prospectively, fundamentals and carry. By then, the best opportunities will be found in Latin America where we favour MXN as well as BRL and CLP. In Asia we like KRW, SGD and IDR and also expect CNY appreciation to resume. Tail risks will remain largest in the CEE region though we recommend seeking exposure to TRY and RUB as part of a Carry basket with diversified funding. The rally in EM currencies in January came too far, too fast, as we argued in our previous report, simultaneously suggesting that a correction was imminent. Subsequently, 15 key EM currencies have fallen against the USD to below their low points late last year and in May 2010. So far this year, they have depreciated 2.1% against the USD.

Best and worst performers year-to-date

Worst performing currencies vs. USD this year are BRL, RON, ZAR and CZK, having depreciated 5-8%. During May, the largest losses (exceeding 10%) were incurred by HUF, PLN and RUB. Overall, Latin American currencies have fallen further than we had expected.
Source: Bloomberg

In retrospect, this comes as no surprise given the markets focus this spring on the vulnerability of Spanish banks and their substantial involvement in Latin America both through direct bank ownership and funding. The best performers since the beginning of the year are COP, TRY, TWD and PHP. Three are well removed from the epicentre of the Eurozone crisis, while in the case of the Turkish lira its strong performance more reflects last years severe depreciation and its central banks sharp, effective, hike in interest rates.

EM FX look cheap in trade weighted terms

In trade weighted (nominal effective exchange rate, NEER) terms, EM currencies look cheap. Once the BIS delivers data for May, we expect the graph below to indicate further depreciation to a low point similar to the end of last year. Consequently, from an historical perspective, EM currencies look cheap in trade weighted terms. Overall, the NEER graph below exaggerates the cheapness of EM currencies as inflation has been higher than in DM.


Emerging Markets Cross Assets

Furthermore, external deficits in some EM indicate that the currencies of these countries may be over-, rather than undervalued, at least in the near term, unless their respective deficits are the result of ongoing, heavy, investments in export oriented industries. Countries with external deficits that clearly become a liability for their currencies during periods of risk aversion include; Poland, Romania, South Africa, Turkey and Ukraine (all in Europe) and India and Vietnam in Emerging Asia. In Latin America, the Brazilian current account deficit is most in focus. While almost fully financed by FDI inflows, with external debt low and FX reserves substantially increased, the wider external deficit is a key factor behind the governments desire to prevent the real from excessive appreciation.

The institutional framework, incentives structure and predictability in decision making must all meet minimum standards for economic development to occur. Progress made in absolute and relative terms (i.e. vs. mature economies) have in some cases led to complacency among EM policymakers regarding the need to maintain momentum in the structural reform process. There has also been an element of reform fatigue among large parts of the electorate in these often young democracies. With much attention rightfully devoted to crisis management (especially in developed countries) in recent years, there is a slowly increasing need to drive the reform agenda forward. While unorthodox experiments in policymaking in some EM may deserve criticism, the general sense is, nonetheless, that the process is moving in the right rather than the wrong, direction.
REER, % change vs. 10Y avg.

In the following box, we examine EM currency valuations in more detailed.

COMPETITIVENESS, REER AND REFORMS Competitiveness is, as stated, not determined by the NEER but by the real effective exchange rate, REER, which also incorporates differences in inflation between countries. Although inflation has decreased from historically very high levels in EM, price and wage increases have been greater than in DM, eroding the competitive position of producers in EM. To varying degrees, this is offset (sometimes more than fully) by a generally more rapid improvement in productivity in developing countries. Essentially, the potential for faster productivity is the mirror image of the economic catchup process. The realisation of this potential is, however, not a given by any economic natural law, as the mismanagement of EM economies during the 1980s and 1990s testifies. It was not until economic stabilisation and structural reforms were implemented more thoroughly some 10-15 years ago that EM generally began to realize their growth potential.





Source: BIS



Emerging Markets Cross Assets

Measuring the most recent reading of the REER relative to its 10 year historical average shows that the most expensive EM currencies are the BRL, RUB, CNY and SGD. Overall, those characterised by a growth strategy involving a greater reliance on domestic demand are high on this list. In some countries, this also reflects the demographic situation. A young population is good for growth and pension system viability though young people typically save less. In aggregate terms, this results in low savings and a high current account deficit. Provided productive investments account for a reasonable share of domestic demand, and financing of the external deficit is stable, this is economically rational. In some countries, such as Turkey, Romania and Brazil, this has not been entirely the case with high external deficits therefore raising questions concerning the viability of maintaining a strong currency. As regards China and Singapore, it is hard to argue that their currencies would be overvalued given their very strong external balances, i.e. this proxy for capturing valuation mis-matches has some limitations. With relative productivity gains being a dynamic process through which we believe EM will retain superiority for many years, we see scope for EM REER to appreciate modestly without creating vulnerability. Indeed, many EM currencies should possess a current REER exceeding their respective 10-year averages. Consequently, as shown in the previous table, in our opinion, most EM currencies are also relatively cheap from an REER perspective, particularly KRW, MXN and TWD. From a fundamental point of view and taking the ongoing expansion of central bank balance sheets in major economies into account, one can argue that increasing exposure to EM currencies is a hedge against a potentially significant erosion of currency value in much of the G7 countries. For more on this and how to allocate within EM, see the special study by SEBs X-assets team on p. 1115.

to be followed by positioning and technicals

However, we expect a market friendly outcome to the Greek election and progress regarding a Spanish bank bailout package which we expect to trigger a relief rally with positioning (or rather re-positioning) and technicals the dominant factors. Conversely, if these assumptions prove incorrect, the flight to liquidity will continue and probably intensify to the detriment of EM currencies.

and eventually fundamentals and carry

Assuming our main scenario is correct, we expect fundamentals and carry to become steadily more significant drivers in Q3 with investors closely monitoring valuations to determine in which currencies they should go long and which short. This will, in our view, be a period in which EM FX perform well.

If carry will become a progressively more important driver moving into Q3, EM currencies are likely to become major beneficiaries. TRY, BRL, INR and HUF should be well positioned, having the highest effective policy rates. Indeed, based on carry actually received by investors, they are ranked high although current NDF pricing pushes INR to the top with TRY in second place followed by IDR, RUB and BRL. However, in some countries with a high policy rate conditions in the non-deliverable foreword (NDF) market imply that actual carry earned is significantly smaller. As shown in the following chart, China (through CNY NDFs) offers only low carry, although at least it is not negative for once.
Carry %, 3m vs USD, Annualized
10 9 8 7 Carry %

EM FX drivers ahead
To use a well-known quote: Prediction is very hard, especially about the future Yogi Berra This is certainly true today. In our General section we have tried to describe the most likely scenario given the assumptions we make as well as the biggest risks and their potential impact on EM macroeconomies and markets.


Flight to liquidity
Regarding the likely FX market drivers going forward, we conclude from this analysis that flight to liquidity will continue to dominate the market in the very near term as risk appetite continues falling and carry positions, for instance, fall further.

Also, taking into account uncertainty in carry positions resulting from spot market volatility, we derive a risk adjusted carry measure. Doing so shows that IDR ranks highest followed by INR and TRY, all of which offer Sharpe ratios close to or exceeding one based on the developments during the last three months. In turn, they are followed by RUB, CLP, BRL, ZAR and


Emerging Markets Cross Assets

CNY (surprise!). All EM currencies we have considered for the purposes of this study except PLN, provide a better risk adjusted carry than the prime (and only) carry alternative among G10 currencies, the AUD.
Risk adjusted 3m carry
2.0 1.8 1.6 Sharp ratio 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 ZAR CNY TRY KRW RUB AUD BRL HUF CLP IDR INR MXN PLN

External financing vulnerability

The key risk to our forecasts and recommendations is that our assumptions regarding the next leg of the Eurozone crisis are incorrect. This would, undoubtedly, cause additional problems for EM currencies. In the General section, on p. 8, we elaborate on possible contagion from a European credit crunch. As is well established by now, CEE markets are most vulnerable; however given the new focus on Spain, Latin Americas exposure has also been more closely scrutinized recently. Asia, with its high domestic savings, is better insulated. From a currency perspective we naturally focus on capital flows and have analysed potential FX effects in a worst case scenario by examining external financing vulnerability.
External financing need to FX reserves (% ) Turkey Ukraine Romania Poland South Africa Czech Republic Hungary Chile South Korea India Indonesia Mexico Brazil Thailand Russia China
0 50 100 150 200 250 300

Central banks active on both sides

Sharp fluctuations in the FX market since last August have kept EM central bankers on their toes. This is especially true given the unprecedented policy actions taken by counterparts in several DMs and as the socalled Currency War continues to develop. Interventions by EM central banks to prevent their currencies from appreciating too far or too fast in Q1 were followed in May by interventions on the other side to restrict their being sold off. Brazil is the clearest example of this behavior, buying dollars up to around 1.90 in USD/BRL and shortly afterwards attempting to stem the dollar rally with the real rising above the 2.00 handle. Market participants dislike such behavior which makes it even harder to interpret and predict the intentions of policymakers. While according to IMF aggregate readings, EM FX reserves have continued to increase based on SDR, they have tended to level off in in USD terms. We expect a slump once May data is reported, reflecting both valuation effects (stronger USD) and protective interventions in several countries.

External fin. need/FX reserves

Source: JEDH, IIF, IMF

This time again we rank Emerging economies by calculating the so called liquidity ratios, that indicate how big or small


Emerging Markets Cross Assets

external financing needs over the coming 12 months are in comparison to the FX reserves. Let us the reader remind that this measure shows the total amount of hard currency a country needs, which is the sum of C/A and FDI plus short term external debt and amortizations on long term external debt, in relation to available hard currency in the FX reserves. Compared to our previous update, few changes are notable in our ranking. Turkey remains on top of the list with the large short term debt burden and C/A deficit as well as relatively small FX reserves, thus being most vulnerable to a freeze in financial markets. Other economies in the not so favourable position from this standpoint are Ukraine, Romania and Poland, with the ratio exceeding 100%. China, Russia, Brazil, Thailand and Mexico are the safest ones with the aforementioned ratio being below 50%. Hungarys position has improved due to lowering amortizations to be paid, improved C/A balance and slightly higher FX reserves. Chile stands stronger as its international FX reserves soared during the last year. Ukraines position, on the other hand, deteriorated due to increased short term debt and amortizations paid on the long term debt.

Given such a negative environment, USD/HUF emerges a winner with a likelihood of imminently breaking 2009 & 2011 tops at 252/253 and extending towards 285/300 or even 311/>319. The first target is derived from the 2008/09 rally and an equality point measured from the 2010 low. The second objective is measured by the base of a previously violated contracting range and the 2000 high. A move back below the yearly low of 213 is needed to justify thinking otherwise from this broad perspective.

Insights provide by our team of technical analysts:

The EM community is suffering from a flight to safety, abandoning EM currencies in favor of USD. In addition, the EUR is also crippled by its own internal problems. Consequently, the USD is generally strong vs. EM currencies. Amongst EM, CEE currencies and those from Latin America (so far) are suffering more than their Asian counterparts. Since March, a basket of equally short BRL, KRW and HUF vs. USD has increased nearly 12% and gains appear to be accelerating rather than slowing. Consequently, we retain a general very cautious approach to EM longs, certainly from a technical perspective. Even more so when taking into account MSCI EM underperformance vs. MSCI DW from an equity perspective.

USD/BRL (1mt NDF) has rallied sharply into a medium-term stretch and in the process filled previous objectives and possibly completed a full medium-term 5-wave impulse. Still, this does not in itself promote shorts as the 5-wave sequence is part of a much larger picture most likely comprising A in a bigger A-B-C correction. Therefore, following a period of correction or consolidation (to neutralize the stretch), we expect another 5-wave sequence higher. Previous highs (resistance) at 1.97 & 1.93 probably act as a firm support zone going forward. A bearish move back under the rapidly rising 26week (year) average, now at 1.86, is needed to blunt a mediumterm bullish outlook for USD/BRL.

USD/KRW (1mt NDF) has also been pushed into a shortterm impulse which so far is incomplete (i.e. arguing for fresh highs) and therefore runs an increased risk of further distancing itself from the already violated high of 1183 from December 2011. An upper parallel suggests 1205, while a


Emerging Markets Cross Assets

medium-term 261.8% Fibo projection holds 1219 possible (not far from the 2011 high). Medium-term support at 1160/1150 needs to be taken out to reassess the bullish approach in this laggard USD/EM cross.

term investor could start accumulating EM FX risk during June.

Cautious near term trade it through options

However, the binary and potentially explosive nature of risks argues against doing so. We recommend remaining side-lined in the cash market and risk missing the first leg of the upturn likely if our main scenario begins to materialise. However, we do not suggest remaining unpositioned. In our view, while FX volatility increased from 9 to a bit over13 in May, this may not fully reflect all nearterm risks (either way). Volatilities are still below the highs from last autumn and way below the peaks in 2008 when VIX reached 80 and these EM currencies vol was at 28.

SEB EM FX forecasts
The analysis above boils down to the following forecasts for the EM currencies where we have our primary focus:
SEB EM FX forecasts for eop 01-Jun-12 2Q12 3Q12 4.20 3.33 295 234 25.0 4.40 220 40.1 35.5 31.8 8.03 1.78 8.20 1.95 13.50 490 6.28 6.26 1140 54.0 9200 1.26 1.26 82.0 4Q12 4.10 3.28 290 232 24.6 4.30 210 38.8 34.5 31.0 8.03 1.75 7.95 1.88 13.00 480 6.20 6.20 1100 52.0 9000 1.24 1.25 84.0 1Q13 4.05 3.27 290 234 24.4 4.25 200 38.1 34.0 30.7 8.03 1.73 7.80 1.85 12.80 475 6.16 6.16 1075 51.0 8800 1.22 1.24 87.0 2Q13 4.05 3.27 290 234 24.2 4.25 195 38.1 34.0 30.7 8.03 1.73 7.80 1.85 12.80 475 6.12 6.12 1065 51.0 8600 1.20 1.24 90.0

ISK offshore


4.40 3.55 305 246 25.7 4.46 240 41.8 37.3 33.7 8.08 1.86 8.58 2.03 14.38 518 6.37 6.37 1178 55.6 9380 1.29 1.2402 78.2

4.50 3.66 315 256 26.0 4.52 240 42.3 38.0 34.4 8.15 1.90 8.80 2.07 14.60 525 6.38 6.38 1200 57.0 9500 1.30 1.23 80.0


Our first forecast point is usually 1M which on this occasion coincides with end-Q2 (based on a cut-off date for this report of 1 June). As we have already discussed, we expect the factors that drove the sell-off in May to continue to destabilize markets in the nearterm. If the Greek election is market positive and a support package for Spain is made very likely already by mid-June, then, obviously, the relief rally would not wait until July 1. Instead, we would move along the chain of market drivers as described above. Conversely, if developments in Greece and Spain do not proceed as we expect, the sell-off of EM currencies will certainly not stop in line with our Q2 forecasts. An additional 5-10% upside in the USD/EM crosses would certainly be possible, implying a return to the March 2009 fire-sale rates.

We therefore recommend positioning for near term developments through options and by buying a 6 month butterfly in EUR/MXN for the down side and by buying a 1 month USD/HUF call spread.

EM FX value set to be released during Q3

Beyond this complicated first phase, the potential ensuing relief rally may derive support from four additional factors (see p. 7). This would encourage a more straight-forward long positioning spot in EM currencies, benefiting from a combination of being oversold, fundamentally sound and offering attractive risk adjusted carry. From a pure hedging perspective, this will be the time to reduce EM FX hedging ratios. In our previous report we expected a correction of the rally that drove EM currencies substantially higher at the beginning of the year, arguing that CEE hedges should be reduced from 100% to 50% while moving from full hedges to open FX risks in Emerging Asia and Latin America. The ensuing correction has taken longer than we expected and gone further than we anticipated. However we retain our strategy to reduce hedges if and as we turn the corner and move on to the next phase comprising bullish EM positions in our speculative trading recommendations which we expect will largely occur in Q3. We see various attractive opportunities including a couple of baskets.

Investment strategy
Our investment strategy is characterised by three stages. Firstly, in the very near-term, we recommend caution ahead of the Greek election on June 17, the G7 meeting on June 18 and EU summit at the end of the month. Once these are over and Spain has received a support package, FX drivers will become far more conducive for EM currencies. Consequently, a longer-


Emerging Markets Cross Assets

Still a bumpy road ahead

However, as we have emphasized, although current market pricing offers substantial upside potential for higher risk assets if current Eurozone problems are resolved, its fundamental difficulties will not be overcome so readily. New challenges will most likely arise and old instabilities resurface, implying that stoploss management will be challenging. It also suggests that hedges should be increased again as the relief rally begins getting mature. As we see things now, we envisage increasing the hedge ratio to 75% in Emerging Europe and to rebuild hedges to 50% in Emerging Asia and Latin America and towards the middle of the second half of the year unless a credible long term solution to the Eurozone crisis has been presented. One way to at least partly address this issue for investors is to position via baskets. Doing so provides diversification opportunities, especially when more than one funding currency is used. This strategy aims to ensure the possibility of remaining positioned for longer. It therefore benefits more from high interest rate differentials. In the following, we suggest two long EM baskets with different profiles. Another way to reduce the risk of sudden, sharp variations in general risk sentiment is by using relative trades. The zloty has suffered from the liquidity paradox (as have MXN, ZAR and KRW) and may continue to do so. Eventually, however, we expect other driving forces to take over and follow PLN/HUF developments for opportunities to buy.

EM currencies after the Lehman shock and is over 10% weaker than its 10 years average in REER) Strong fundamentals (prudent policies, low indebtedness) Reasonable carry Positioning now positive (speculators are short MXN, for once) More economically dependent on US than EU.

For these factors to start supporting the MXN, market drivers must move away from flight-to-liquidity. While this situation may include some relief for the EUR, we still regard the single currency as one of the weakest of the G10, also due to substantial event risk (see Currency Strategy, 23 May). Consequently, we prefer to express our bullish views on the MXN vs. EUR. However, while we regard MXN as currently cheap, near term risks favor further weakness. We do not therefore recommend buying spot just yet. At present, the technical outlook also indicates EUR/MXN upside risks. Indeed, in our opinion, it would require a move below 17.31 from currently 17.80 to alter the technical position, see box below. From a short- to medium-term perspective the EUR/MXN chart looks like a bearish 5-wave impulse followed by a "Double Zigzag" (correctional pattern). Currently the cross is in a near-term bullish drive and at the time of writing not confirmed as having passed its high.

How to trade it
Given the strategy discussed above, we regard the most appealing trading opportunities from a risk reward perspective to be as follows:

1. Buy a six months EUR/MXN butterfly for the downside

Recently, the Mexican peso has been amongst the hardest hit currencies, suffering from weak US economic data and the countrys ties to Spanish banks which account for a major portion of the Eurozones 35% share of total credit (Source: BIS). The MXN is also victim of what we call the liquidity paradox, i.e. during times of flight to liquidity it is one of several EM currencies (including the PLN, ZAR and KRW) that are often used by investors as a proxy for bearish bets on EM and/or a region. In addition, the peso was badly hurt by opinion polls in late May showing the PRD candidate (AMLO) trailing PRIs Pea Nieto by only 4%. Prospectively, we think a solid recovery is possible with several factors potentially positive for the MXN: Low valuation (The MXN recovered less than most

But a move back below 17.31, followed by confirmation below 16.93 would substantially increase the odds in favour of a later violation under the yearly low of 16.38 which would be our minimum objective. If the current high is the peak a better target could then be sought at 15.95 or even as low as 15.33.


Emerging Markets Cross Assets

Our preferred strategy is to trade this via a put butterfly where we buy the wings at 17.25 and 15.25 and sell the double amount in the belly at 16.25. The cost of this structure is 1.0% of the nominal amount with a maximum net profit of 5.2% if spot trades at 16.25 in six months: 16.25 just happens to be our endQ4 forecast.

2. Buy a 1 month USD/HUF call spread

In order to benefit from an expected continued near term flight to liquidity, and potential sharp market reaction to near term developments in the Eurozone, we recommend buying a 1 month call spread in USD/HUF. This will also works as a hedge against the MXN option. Regionally, Emerging Europe is most exposed to the Eurozone debacle and Hungary is one of those most deeply involved through both its trade and financial connections. Fundamentals are weak especially regarding the public sector and external indebtedness although the current account surplus provides some consolation. Good judgment is especially crucial if sailing in stormy waters. In our view, steps taken by the government imply that a fairly high political risk premium should apply to Hungarian assets, at least for now. We still expect a bail-out package to be agreed with the EU/IMF. Indeed, the EU has softened its position. We intend to follow closely market reactions to the expected Hungarian parliamentary vote on the Central Bank Act due on the date of publication of this report. Even if the EU were to provide authorization, we would expect tough negotiations with the IMF to follow. We therefore believe a deal is unlikely before late Q3 and only after further difficulties and challenges. The forint has obviously discounted much of this already, having depreciated considerably. However, if risk appetite remains depressed, we would expect it to remain one of the biggest losers again. Furthermore, the technical position is worse for the forint (vs. the USD) than for almost any other cross, see Insights provided by our technical analysts on p. 34.

Consistent with these arguments, we recommend buying a 1 month USD/HUF call spread with strikes at 250 and 275. This costs 2.1% and has a maximum net profit of almost 8%. The current strongly positive skew in the market also benefits our strategy of selling the lower delta call option. Below we present the skewness for the 1 month 10 delta risk reversal showing a positive call skew of 8.35% for the 10 delta USD call HUF put strike, also revealing the markets view on risk:
USD/HUF 1 month 10 delta skew
14 12 10 8 6 4 2 0 30/12/10 28/02/11 30/04/11 30/06/11 30/08/11 30/10/11 30/12/11 29/02/12 30/04/12 30/06/12

3. Look to sell USD/BRL

The real is richer in real effective terms compared to its 10 years average than any of the currencies we track, see the box on p. 31. This is partly because the reference period includes 2002 and 2003 when the real was heavily oversold during the period between Lula becoming president and his having proven himself to the market. Also, the current account deficit is modest at around 3% of GDP is almost fully financed by FDI. Meanwhile, external indebtedness has decreased very substantially while FX reserves have increased sevenfold to USD 363 bn. Nonetheless, Brazil has a competitiveness problem as shown by the ambiguity of economic progress in recent years during which domestic demand has flourished but production struggled. It is therefore understandable that authorities aim to prevent the BRL from appreciating too far and too fast. This rationale also supports the policy shift which has taken place since last August in which monetary policy has been eased by 400 bps to 8.5%. Given


Emerging Markets Cross Assets

disappointing Q1 GDP data, up just 0.8% y/y, we expect a further 100 bps in rate cuts. Consequently, the BRL no longer occupies the prime position in our rank of EM currencies based on carry. Still, it does remain respectable in most comparisons.
Inflation and policy rate
14 13 12 11 10 9 8 7 6 5 4 08 09 10 11 12
CPI (IPCA), % change y/y Policy rate (SELIC), %

14 13 12 11 10 9 8 7 6 5 4

During periods of high uncertainty, we have often used EM currency baskets to secure exposure with slightly less potential but with expected greater resistance to market volatility. An EM currency basket will provide several diversification benefits as currencies included are from different regions, and because their respective advantages and disadvantages are differently distributed along the lines of the drivers we expect will influence the market going forward. This effect should not however be exaggerated as the correlation during the last 2-3 quarters has been high, and because we do not expect any major changes in the near term. The use of several funding currencies probably provides more diversification benefits including reducing risk, while it also limits upside potential. This is preferable when positioning with a slightly longer term investment horizon. Based on the insights derived from our investigation of risk and return from investing in different groups of EM currencies over the last decade (see p. 11-15), we suggest two EM baskets; one offensive with Carry currencies and one defensive with fundamentally stronger Upside countries. In the carry basket we include currencies with strong potential according to our forecasts, together with high risk adjusted carry and reasonable event risk. We look to buy a basket comprising IDR, INR, TRY, RUB, ZAR and BRL equally weighted. On average, we expect these currencies to strengthen by over 9% vs. USD by the middle of next year. Consistent with this rationale, we diversify the funding leg and sell USD, EUR, JPY and CHF also equally weighted.

Source: Reuters EcoWin

However, the central bank is gambling with its hard earned credibility as inflation, despite decreasing from 7.3% last September to 5.1% in April this year, remains above the mid point of the 2.5-6.5% target. Rapid BRL depreciation in May therefore forced the central bank to switch sides concerning its intervention policy; it began offering USD to the market at around 2.09, shortly after having been on the other side buying USD up to around 1.90.

5. Look to buy a fundamentally strong Upside basket

A more defensive alternative is to buy a basket with fundamentally strong EM currencies largely belonging to the group of Upside countries in the study presented on p. 11-15. These currencies have also suffered rather badly during the recent period of flight to liquidity. Combining our forecasts with our views on fundamental strengths we recommend buying a heavily Asia tilted basket comprising CNY, KRW, SGD, CLP and CZK equally weighted, funded by USD, EUR, JPY and CHF also equally weighted.

To us, this latest action is a credible message that the BCB wants to see USD/BRL below current levels and that it is prepared to act to achieve its objective. And indeed, if risk appetite was to improve, old correlations provide room for a rather solid BRL come back. As outline above, however, we are not prepared to act due to fear of catching a falling knife. We would rather await clarification regarding the Eurozones near-term challenges while standing ready to jump onboard the train once it has started rolling.

6. Look to sell USD/CNH 12 months forward

Chinese growth has disappointed and in May we revised our GDP forecast down to 8.1% this year and 8.4% in 2013. Inflation risks have, however, also eased substantially which, in our view means that it is Time for China to shift policy priorities, the headline in our Strategy Focus-EM report from May 24. With inflation well below the 4% target and growth threatening the 7.5% limit, we expect the bank reserve

4. Look to buy a Carry basket


Emerging Markets Cross Assets

requirement ratio (RRR) to be cut by a further 150bps this year and 100bps next from currently 20.0%. We also forecast a 25bps cut in interest rates and fiscal policy easing. While the latter will not be on the same scale as occurred in 2008/09, it will be sufficient to support a recovery in economic activity in Q3.

With growth turning around, we would also expect the CNY to resume appreciation, consistent with the governments overriding objective to move the economy away from its dependence on exports and investment in favor of private consumption. Furthermore, we believe international pressure on surplus countries in general and China in particular will increase, requiring them to accept greater responsibility for global rebalancing. In particular, pressure from the US is likely to intensify in the run up to the November presidential elections. Still, we expect the CNY to appreciate less rapidly than last year. Chinese authorities have been arguing that the exchange rate is approaching it equilibrium. In support of this contention they refer to a smaller current account deficit. It is also true to say that the CNY has strengthened in both trade-weighted nominal and real terms, partly as a result of its close ties to the USD and the recent rise in the greenback. Finally, slower CNY appreciation is likely given Chinas lower inflation rate which reduces the need for a stronger currency to keep imported prices down. We have already raised our USD/CNY forecast in line with the arguments above, and now expect the cross at 6.20 by year end. Prospectively, we expect the NDF and the CNH market will to trade close to the onshore spot rate or slightly below.

USD/CNY has been on the rise since May, in line with other USD crosses. The market currently discounts continued CNY depreciation with the 12 months NDF trading 1.0% above spot and the 12 months CNH forward approximately 1.3% above the deliverable CNH spot (the CNH forward is unfortunately not in the graph above due to a data base problem). Although this situation may persist for a little while longer, if our assumption on global risk appetite is accurate a reversal is likely. We therefore look to sell USD/CNH 12 months forward when the time is ripe.


Emerging Markets Cross Assets



Emerging Markets Cross Assets



Emerging Markets Cross Assets



Emerging Markets Cross Assets

Emerging Markets Magnus Lilja Emerging Markets Research Mats Lind Mats Olausson Jurgis Rosickas Head of EM +46 8 506 23 169 Fixed Income Strategist FX Strategist Analyst +46 8 506 23 351 +46 8 506 23 262 +370 526 82 418

Emerging Markets Sales /Trading Stockholm Lars-Erik Kristensen FX, Fixed Income Sales Louise Valentin FX, Fixed Income Sales Julius Dukta Fixed Income Trading Christopher Flensborg Fixed Income Sales Gothenburg Magnus Green EM Sales Malm Tomas Anelli Helsinki Henrik Typpnen Sami Huttunen Heidi Alanko Oslo Silje Ingeberg Trond Solstad Copenhagen Peter Lauridsen London ChrisBennett Nick Dorman Frankfurt Detlef Joehnk Peter Friedman Alexander N. Maximilian New York Oskar Elmgart Marcus Jansson Moscow Ksenia Uralskaya Singapore Gustaf Ljungdahl Shanghai Fredrik Hhnel
Peter Knutzen

+46 8 506 23 110 +46 8 506 23 110 +46 8 506 23 094 +46 8 506 23 295 +46 8 506 23 138 +46 31 62 22 69 +46 40 667 6958 +358 9 6162 8624 +358 9 6162 8540 +358 9 6162 8540 +47 22 82 72 81 +47 22 82 72 84 +45 3317 7734 +44 208 246 4620 +44 207 246 4676 +4969 9727 1252 +49 69 9727 11 14 +49 69 9727 7743 +1 212 286 0608 +1 212 692 4793 +7 495 662 6310 +65 65 05 05 05 +86 21 539 666 81 +86 21 539 65789 +852 97207800 +852 97207800 +852 97207800 +852 97207800 +852 39192652

EM Sales Acting Head of EM Helsinki FX Sales Equity Sales Head of EM Oslo EM Sales EM Sales EM Sales EM Sales FX Sales Fixed Income Sales Equity Sales FX Sales Fixed Income Sales EM sales EM Sales Head
Head of Trading Capital Markets

Hong Kong Pablo Riddell Chloe Merdjanian Kazushige Koyama Per Nordstrm Carol Au-Yeung

FX Sales FX Sales Fixed Income Sales Fixed Income Sales Fixed Income Sales

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