-
Deutsche Bank Markets Research
Emerging Markets
Economics Foreign Exchange Rates Credit
Date 5 December 2013
Diverging Markets
Emerging Markets 2014 Outlook
Taimur Baig Marc Balston Robert Burgess Gustavo Cañonero Drausio
Giacomelli Michael Spencer
(+65) 64 23-8681 (+44) 20 754-71484 (+44) 20 754-71930 (+1) 212
250-7530 (+1) 212 250-7355 (+852 ) 2203-8305
________________________________________________________________________________________________________________
Deutsche Bank Securities Inc. Note to U.S. investors: US
regulators have not approved most foreign listed stock index
futures and options for USinvestors. Eligible investors may be able
to get exposure through over-the-counter products. DISCLOSURES
ANDANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P)
054/04/2013.
Special Reports Diverging Markets
Rates in 2014: Refocusing on EM Fundamentals
Sovereign Credit in 2014: Back in the Black
FX in 2014: Diverging Currencies
EM Performance: Too Much Ado About Technicals
Asia’s Frontier Economies: Plenty of Alpha
Brazil: Overview of 2014 Presidential Elections
US Manufacturing and Mexican Growth
Foreign Demand for EM Local Currency Debt
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5 December 2013
EM Monthly: Diverging Markets
Page 2 Deutsche Bank Securities Inc.
Key Economic Forecasts
2013F 2014F 2015F 2013F 2014F 2015F 2013F 2014F 2015F 2013F
2014F 2015F
Global 2.8 3.7 3.9 3.1 3.5 3.4 0.0 0.0 -0.2 -3.3 -2.9 -2.5
US 1.8 3.2 3.5 1.6 2.5 2.3 -3.0 -2.6 -2.7 -3.8 -3.1 -2.0
Japan 1.6 0.7 1.3 0.3 2.7 1.5 0.8 1.1 2.1 -9.5 -8.0 -6.6
Euroland -0.2 1.2 1.4 1.5 1.4 1.5 1.8 1.4 1.3 -2.9 -2.4
-2.0Germany 0.5 1.5 1.4 1.7 1.6 1.8 7.1 7.0 7.1 0.1 0.2 0.4France
0.2 1.3 1.9 1.1 1.5 1.3 -1.7 -1.5 -1.3 -4.1 -3.3 -2.9Italy -1.8 0.6
0.5 1.5 1.5 1.5 0.6 1.3 1.8 -3.1 -2.9 -2.9Spain -1.5 0.5 1.3 1.7
1.1 1.2 1.2 1.5 1.8 -6.5 -5.3 -4.0Netherlands -1.1 0.4 1.2 2.8 1.8
1.8 12.8 11.7 12.3 -3.9 -3.3 -3.0Belgium 0.1 1.2 1.6 1.2 1.4 1.6
-0.5 0.5 0.5 -3.0 -2.9 -2.7Austria 0.4 1.4 1.8 2.1 1.7 1.8 3.2 3.5
3.5 -2.1 -1.8 -1.6Finland -1.0 0.9 1.5 2.4 2.0 1.9 -0.8 -0.4 0.7
-2.7 -1.8 -0.7Greece -4.3 0.8 2.0 -0.6 -0.4 0.0 0.0 1.0 2.0 -4.5
-3.4 -2.5Portugal -1.7 0.8 1.3 0.6 0.9 1.1 0.5 1.5 2.0 -5.4 -4.4
-3.3Ireland 0.5 2.0 2.0 0.8 1.1 1.3 3.5 4.0 4.0 -7.4 -4.9 -2.8
Other Industrial CountriesUnited Kingdom 1.5 2.5 2.0 2.7 2.2 2.0
-3.5 -3.2 -2.8 -6.0 -4.8 -4.1Sweden 0.7 2.3 2.5 0.1 1.1 2.0 6.5 6.0
6.0 -1.5 -1.0 0.5Denmark 0.2 1.8 1.5 0.7 1.5 1.9 6.3 6.1 6.0 -2.0
-1.8 -1.5Norway 1.8 2.4 2.6 2.3 2.6 2.0 12.5 12.0 11.5 11.0 10.5
10.0Switzerland 1.9 2.0 2.0 -0.1 0.5 1.0 12.5 12.1 11.8 0.7 0.8
1.0Canada 1.7 2.8 2.8 1.1 1.9 2.4 -2.7 -2.5 -1.8 -1.4 -0.9
-0.3Australia 2.7 3.7 3.6 2.3 2.2 2.1 -2.4 -2.1 -1.7 -1.8 -1.7
-0.9New Zealand 2.7 3.2 2.4 1.1 1.9 2.3 -4.6 -3.9 -6.0 -1.7 -0.3
0.3
Emerging Europe, Middle East & Africa 2.2 2.9 3.5 4.8 4.5
4.7 0.7 0.2 -0.4 -1.1 -0.8 -1.6Czech Republic -1.2 1.7 2.2 1.4 0.9
2.0 -0.6 -1.1 -2.5 -3.1 -2.7 -2.6Egypt 2.1 3.0 4.2 6.9 8.6 10.5
-2.1 -0.4 -2.8 -14.7 -13.2 -14.3Hungary 0.7 1.8 2.0 1.8 1.7 2.8 1.2
1.0 0.6 -2.9 -2.9 -2.7Israel 3.6 3.7 4.2 1.6 2.0 2.2 1.6 1.9 2.1
-3.6 -3.0 -2.5Kazakhstan 5.3 4.8 5.2 6.0 5.6 6.3 1.3 2.0 1.5 5.3
4.8 3.3Poland 1.4 3.0 3.9 1.0 2.3 2.7 -1.4 -1.6 -2.5 -4.8 4.0
-3.1Romania 2.2 2.6 2.6 4.1 2.3 3.2 -1.6 -3.1 -3.0 -2.5 -2.2
-2.2Russia 1.5 2.4 2.8 6.7 5.2 4.7 1.7 1.7 1.0 -0.6 -1.1 -1.3Saudi
Arabia 3.7 4.3 4.3 3.8 3.6 3.5 16.4 9.8 8.0 11.9 7.7 7.4South
Africa 1.9 2.9 3.5 5.7 5.1 5.3 -6.6 -5.6 -5.0 -4.1 -4.0 -3.5Turkey
3.7 3.4 4.4 7.5 6.4 6.8 -7.5 -6.5 -6.0 -2.3 -2.3 -2.3Ukraine 0.3
1.5 2.0 -0.4 1.4 2.9 -10.2 -7.5 -7.0 -4.0 -4.5 -4.2United Arab
Emirates 5.1 3.1 3.4 1.5 2.5 2.5 17.9 14.1 13.0 9.7 7.1 7.4
Asia (ex-Japan) 5.9 6.9 6.8 3.5 3.9 4.0 1.5 1.5 1.1 -3.0 -2.8
-2.5China 7.7 8.6 8.2 2.6 3.5 3.2 2.4 2.2 1.9 -2.0 -1.8 -1.5Hong
Kong 3.2 5.0 4.5 4.1 3.5 3.2 -0.9 3.7 2.7 2.8 3.2 3.5India 4.3 5.5
6.0 6.3 5.5 6.3 -3.4 -3.0 -3.5 -7.5 -7.3 -7.0Indonesia 5.5 5.2 5.5
7.0 6.7 6.5 -3.9 -3.3 -2.8 -2.2 -2.4 -2.6Korea 2.8 3.9 3.6 1.1 1.8
2.8 5.7 4.5 3.6 -0.7 -0.1 0.1Malaysia 4.8 6.0 5.8 2.1 3.0 2.9 3.6
4.5 6.3 -4.2 -3.8 -3.3Philippines 7.0 6.8 7.0 2.9 4.1 3.3 4.0 4.1
4.4 -2.0 -2.4 -2.2Singapore 3.5 3.5 4.2 2.3 2.8 3.5 14.7 15.5 14.5
7.3 6.9 6.8Sri Lanka 7.2 7.5 7.5 7.0 7.0 7.4 -4.1 -3.1 -2.7 -5.8
-5.5 -5.0Taiwan 1.8 3.5 3.4 0.8 0.9 1.2 10.8 9.4 8.1 -3.0 -2.0
-1.1Thailand 3.0 4.2 5.0 2.2 3.2 2.4 -0.3 0.2 -0.6 -3.0 -3.2
-3.3Vietnam 5.3 5.8 6.3 6.6 7.3 9.8 3.2 2.0 -3.1 -6.0 -6.2 -5.5
Latin America 2.3 2.6 3.1 9.0 9.9 8.9 -2.4 -2.3 -2.5 -3.5 -3.8
-3.7Argentina 2.4 1.6 2.8 24.9 28.5 23.6 -1.2 -1.6 -2.0 -3.6 -3.8
-3.6Brazil 2.2 1.9 1.7 6.2 5.8 5.4 -3.6 -3.2 -3.5 -3.2 -3.8
-3.4Chile 4.3 4.2 4.5 1.7 2.8 3.0 -3.2 -3.8 -3.2 -0.9 -0.5
-0.4Colombia 4.0 4.3 4.5 2.6 3.1 3.6 -2.6 -2.7 -3.0 -2.4 -2.3
-2.2Mexico 1.2 3.2 3.6 3.7 3.8 3.7 -1.4 -2.0 -2.2 -2.9 -4.0
-3.6Peru 5.2 6.0 6.5 2.5 2.7 2.9 -5.0 -5.5 -4.5 1.0 0.6
0.5Venezuela 1.5 0.5 3.5 40.0 47.5 43.0 1.7 4.3 4.2 -14.3 -11.5
-13.5
Memorandum Lines: 1/
G7 1.3 2.3 2.5 1.4 2.3 2.0 -1.2 -0.9 -0.7 -4.3 -3.5
-2.6Industrial Countries 1.2 2.2 2.5 1.4 2.1 2.0 -0.7 -0.6 -0.5
-4.0 -3.3 -2.4Emerging Markets 4.5 5.3 5.4 4.7 5.1 5.0 0.7 0.6 0.1
-2.7 -2.5 -2.5BRICs 5.6 6.4 6.4 4.3 4.4 4.3 0.4 0.4 0.0 -3.2 -3.2
-2.9
Consumer prices (% pavg) Current account (% GDP) Fiscal balance
(% GDP)Real GDP (%)
1/ Aggregates are PPP-weighted within the aggregate indicated.
For instance, EM growth is calculated by taking the sum of each EM
country's individual growth rate multiplied it by its share in
global PPP divided by the sum of EM PPP weights.
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 3
Table of Contents Diverging Markets EM economies and asset
markets have disappointed, leading to a growing perception that
better opportunities lie elsewhere. This is too simplistic. Some
economies will continue to struggle but growth elsewhere will
remain relatively strong, albeit below past peaks. Investment
appetite for EM may also be lower than in recent years. This could
see some markets overshoot to the downside in the near term as
expectations adjust. But there is still sufficient value in EM to
justify a material allocation in global portfolios over the longer
term. Spotting the divergence within EM will be the key to
extracting it.
............................................................................................................................................................................
04
Rates in 2014: Refocusing on EM Fundamentals Closer to their
historical norm, we expect term premia in EM curves to track more
closely with growth potentials and inflation trends in 2014.
Accordingly, we expect country specifics to continue to play an
important role in performance. Overall, we find that the cushion to
absorb a potentially faster pace of global growth is more limited
in the short end and belly, expecting EM curves to bear-flatten as
normalization proceeds and volatility subsides.
........................................... 15
Sovereign Credit in 2014: Back in the Black While EM assets are
likely to face continued headwinds in 2014, we believe the dramatic
negative shift in the wider perception of EM debt cannot be
repeated in 2014 given the return of risk premium. With continued
taper risk, we start the year with a neutral overall exposure, but
believe EM sovereign spreads have potential for moderate
tightening, offsetting a rise in US yields, offering about 6%
return in 2014...........
................................................................................
20
FX in 2014: Diverging Currencies Despite still being exposed to
a tapering/guidance related hurdle we see a better potential for
EMFX as an asset class in the upcoming year. While EMFX will
probably continue to be a shock absorber to global risks, the
prospects of a more benign economic backdrop should not only help
EMFX but evidence the nuances between EM economies that are likely
to grow in 2014...........
...........................................................................................................................................................
34
EM Performance: Too Much Ado about Technicals We find little
evidence of technical bottlenecks determining EM performance – both
of domestic and external sources. Instead, this seems to originate
in cyclical – fundamentals-related – weakness in demand rather than
secular portfolio shifts.
......................................................................................................................................................................................
39
Asia’s Frontier Economies: Plenty of Alpha We focus on eight
selected frontier economies of Asia that hold promise for a better
tomorrow, not just for their population but for investors seeking
alpha in an increasingly correlated world. Most of these economies,
because of their early stages of development and lack of market
depth, are by and large uncorrelated to global markets, thus
offering a useful investment strategy
.....................................................................................................................................................
45
Brazil: Overview of 2014 Presidential Elections Barring a
significant deterioration in economic conditions, the most likely
scenario for next year’s elections is that President Dilma Rousseff
will be re-elected due to her high approval ratings, low
unemployment, extensive welfare policies, and her party’s powerful
political structure. While we believe some policy adjustments will
be inevitable (especially on the fiscal front), we expect Rousseff
to maintain strong government intervention in the economy, and do
not anticipate significant progress in structural economic reforms
during her second term...........
.................................... 49
US Manufacturing and Mexican Growth Manufacturing activity has
recovered more slowly in Mexico than in the US throughout late 2012
and 2013, partly explaining subpar GDP growth in Mexico recently.
Using manufacturing disaggregate data for both countries, we find
that those activities characterized by the highest correlation
between the two countries grew more slowly in the US in 2013.
Furthermore, we estimate that if the recovery of US manufacturing
had been generalized across activities this year, manufacturing
output south the border would have been approximately 4% larger.
Such broad base growth is expected for 2014, likely adding 70bps of
GDP growth to the Mexican economy.
.............................................................................
54
Foreign Demand for EM Local Currency Debt Foreign holdings of EM
local currency debt have increased 3-fold in the past 4 years,
adding USD500bn of additional investment. This increase has been
driven by the emergence of global local currency bond funds, but in
recent months appetite for such funds, as indicated by mutual fund
flows, appears to have reversed. In this report we look beyond the
EPFR flow data to understand the global dynamics of non-resident
demand. We examine the data which is available from each country on
non-resident bond holdings
........................................................................................................................
57
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5 December 2013
EM Monthly: Diverging Markets
Page 4 Deutsche Bank Securities Inc.
Diverging Markets
We have witnessed a dramatic shift in the perception of EM as an
investment destination. After many years during which EM was touted
as an outperformer, there is now a perception that better
opportunities lie elsewhere.
There are several, related, factors which have contributed to
this shift:
— Growth has weakened, especially in the larger economies, just
at the time when expectations of growth in DM have been
improving;
— Capital flows to EM slowed sharply on fears of Fed tapering,
exposing vulnerable external positions in a number of cases;
— Several countries have seen large scale protests as growth has
not kept pace with popular aspirations that were raised during
earlier phases of rapid expansion;
— EM asset markets have underperformed.
We believe that investors’ perceptions have been exacerbated by
cyclical factors, but structural bottlenecks should not be
discarded – especially in the larger economies. It is becoming
increasingly inappropriate, however, to base investment in the
asset class on sweeping judgments of economic outperformance or
excess risk premium. Differentiation has increased.
The differences relative to developed markets are no longer
large relative to the variation within the asset class. The future
of EM will be one of divergence within these markets rather than
one of collective outperformance or underperformance.
Key to such divergence will be the paths taken in adjusting to
rising global interest rates. With the possible exception of
Ukraine, this is highly unlikely to trigger a classic EM crisis. It
will, however, be a painful process for those countries with large
external financing needs, though India is now relatively better
positioned to weather this storm.
In the years to come, there will be a premium on reform as
tailwinds that favored EM over the last decade fade. Asia remains
best placed to deliver high growth, albeit not as rapid as in the
recent past. Chile, Colombia, Peru, and Turkey, should enjoy
relatively healthy expansions. Mexico and much of central Europe,
which have been among the poorest performers in recent years, are
set to see growth accelerate. A little further down the line, we
could also see brighter days in Argentina if elections in late-2015
lead to a change of policies.
Others, including Brazil, Russia, South Africa, and Venezuela,
will struggle to deliver tough reforms and their economic
performance will reflect this.
Given this outlook, we expect appetite for EM investment to be
lower going forward than in recent years, but offering sufficient
value to justify a material allocation in global portfolios. As the
shock waves from the crises in developed markets dissipate, and as
fund flows become less dominant, the correlation between EM (local
currency) fixed income and DM fixed income should decline,
increasing the value of EM as a diversifier once again.
In the near term, however, as investors re-calibrate their
expectations for the performance of the asset class valuations
could continue to overshoot to the downside. This is already taking
place in currencies, the natural shock absorbers that actually
render EM less fragile, and in sovereign credit.
Introduction: the past and present of EM
After many years during which EM was touted as an outperformer,
there is now a perception that better opportunities lie elsewhere.
Circumstances that led to a golden age for EM will not be repeated.
Economies are closer to maturity, most of the low hanging fruits of
reform have been picked, and the external backdrop has become more
challenging. Growth has slipped accordingly. Asset market
performance has disappointed. Does this simply represent the
difficult teenage years for EM or is it symptomatic of a deeper
malaise?
The Golden Age of Emerging Markets The decade leading up to the
2008 financial crisis were transformational years for emerging
markets, characterized by several unusually favorable
developments:
The great moderation and years of robust expansion in the US
provided a tremendously strong foundation for the global
economy.
The establishment of the single market and single currency in
Europe provided a second powerful engine for growth and reform,
especially for emerging European countries that joined an enlarged
European Union.
Within EM, the widespread adoption of macroeconomic
stabilization policies following the crises of the 1990s and early
2000s tamed inflation and brought public finances under control.
Fixed
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 5
exchange rate regimes were ditched. Ability to borrow in local
currency increased.
The emergence of China and, especially, its integration into the
global trading system was a hugely positive supply shock for the
world.
The associated super cycle in commodities provided a fillip for
previously struggling natural resource producers.
Favorable demographics further underscored EM’s advantage over
DM.
Lastly, and most recently, cheap and plentiful external
financing following unprecedented monetary expansion in core
markets has cushioned the slowdown in global activity.
The broadening appreciation of such factors helped to fuel an
unprecedented increase in investment into emerging asset markets.
Nowhere has this been more evident than the boom in EM fixed income
markets in recent years. Dedicated EM debt mutual funds, for
example, now manage well over USD 300bn of assets compared to a
pre-crisis peak of USD100bn. Foreign holdings of Mexican local
currency bonds have risen by USD 110bn over this period, a pattern
that has been replicated to varying degrees in Brazil, Malaysia,
Poland, Russia, South Africa, Turkey, and beyond.
The future will be more challenging These tailwinds have faded
and, in some cases, turned into headwinds. We see six key
challenges for EM in this regard:
Global growth will be stronger than it is today but below the
peaks seen from 2003-07.
The cost of external financing will increase as the Fed and
other major central banks slowly start to withdraw monetary
stimulus.
A possible multi-year dollar upswing will challenge the
competitiveness of some EMs.
Demographics will turn less favourable, more imminently for some
countries, such as Russia, than others.
Commodity prices may be well supported at current levels but are
past their peak.
Growth models within EM are past their sell by date in some
cases, with their excessive reliance on demand vs. supply.
Exiting demographic windows
1940
1960
1980
2000
2020
2040
2060
2080
FRA USA RUS CHN BRA TUR MEX IDN IND ZAF
Exit year
Exit year shows the point at which countries exit the "demographic window " when the working age population is most prominent, defined (by the UN) as the period when the proportion of children falls below 30 percent and proportion of people over 65 is still below 15 percent.
Source: UN, Deutsche Bank
Growth in EM is already fading, especially in the larger
economies. While growth reached 10% during the immediate
post-crisis rebound, it has decelerated to 5% over the last couple
of years. Against this backdrop, meeting the demands of newly
aspiring populations will be more difficult. Social tensions are to
be expected and the political environment will become noisier.
Public protests, such as those recently witnessed in Brazil,
Russia, South Africa, and Turkey, are likely to become a more
regular occurrence.
This more challenging environment is already weighing on the
performance of emerging asset markets. Relative to most other asset
classes, emerging FX and fixed income markets sold off more
aggressively during the summer when tapering fears were at their
most acute and rebounded less strongly as these fears dissipated.
Benchmark indices for both local currency and hard currency debt,
for example, remain down around 5.5-6% this year. This has left
many investors in
The inflows to EM debt funds have been disappointed
-10
0
10
20
30
Jan 10 Jan 11 Jan 12 Jan 13
Return on inflows of hard ccy funds%
-15
-10
-5
0
5
10
15
Jan 10 Jan 11 Jan 12 Jan 13
Return on inflows of local ccy funds%
Note: Each bubble represents a month of inflows to EMD funds,
with the size of the bubble being proportional to the amount of
inflow (in USD) and the y-axis indicating the cumulative average
fund performance since the inflow occurred.
Source: Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
Page 6 Deutsche Bank Securities Inc.
EM sitting on losses or only marginal gains. We estimate that
less than 40% of the mutual fund inflows to EM local currency
assets since the start of 2010 are in the money, with less than 20%
having cumulative gains in excess of 5%. For EM hard currency
investment, the picture is only a little better: 56% of inflows are
in-the-money, with 33% above 5% cumulative gains.
While portraying EM as a single asset class has always been
overly simplistic, it used to be broadly sufficient given the
powerful collective forces that drove performance during their
golden age. The distinction between EM and DM was significant
enough that the details could be ignored. This no longer applies:
the differences within EM and DM are now more significant than the
distinctions between the two groups.
The future of EM is thus likely to be one of diverging
performance. Higher US interest rates will raise the bar for some
and perhaps even trigger a crisis in the odd case. Others will sail
through largely unscathed. Some countries are emerging from
deleveraging and are poised to enjoy significant acceleration
activity. Others overly reliant on cheap credit or high commodity
prices need to undertake painful reforms to avoid further
deceleration in growth. Social discontent may be the catalyst they
need for change. These are the factors that will determine the
divergences in performance and to which we now turn, starting with
long-term growth prospects.
Diverging growth prospects
In aggregate, we estimate that the potential growth rate of EM
will decline from a peak of 6.5% prior to the crisis to about 5%
over the next five years, driven primarily by a deceleration in the
larger EM economies. This is disappointing and explains much of the
current pessimism towards EM. If we exclude the BRICS economies,
however, the drop in growth is much less dramatic, from a peak of
4.2% to around 3.6% over the next five years.
Within EM, however, the pattern will be far from uniform. Reform
priorities differ from country to country. In a few cases, there
are still lingering first generation macroeconomic stabilization
issues that need to be addressed. Russia, for example, needs to
complete its transition to inflation targeting. Others, such as
Brazil, Indonesia, and Turkey, have broadly the right frameworks in
place but have not always implemented them effectively, resulting
in episodes of high inflation. At the other end of the spectrum,
Argentina and Venezuela have not even hinted at fighting
inflation.
Among the larger EM economies, however, the priorities lie
mostly in the area of structural reforms. China, for example, has
relied on capital accumulation and the absorption of surplus rural
labor into more productive activities in urban areas. Very high
rates of investment have inevitably resulted in diminishing
returns. The labor force will also start declining within the next
few years. Maintaining high growth rates will therefore require
much greater efficiency in the use of capital and labor. This will
in turn require deregulation and a shift from state-owned to
private enterprise.
Commodity producers will no longer be able to ride the super
cycle in prices that made consumption-led growth an easy option.
Greater investment is needed to foster faster productivity growth
and diversification into other areas of economic activity. Some,
including Russia and South Africa, will also need to encourage more
investment in natural resources just to maintain their comparative
advantage in these areas. Few have made much progress. Among major
EM commodity
Mind the gap: trend growth in EM and DM
G7
EM
BRICS
Non-BRICS EM
0
1
2
3
4
5
6
7
8
9
1980 1985 1990 1995 2000 2005 2010 2015
Trend GDP growth %
Source: Haver Analytics, IMF, Deutsche Bank
EM commodity producers fail to diversify
BRA
CHL
IDN
RUS
ZAF
40
60
80
100
120
2000 2002 2004 2006 2008 2010 2012
Manufacturing
exports as % of total goods exports (2000=100)
Source: Haver Analytics, Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 7
producers, manufactured goods, for example, account for a lower
share of total exports today than they did a decade ago.
What of the prognosis for reforms? Asia remains best placed to
deliver high growth, albeit not as rapid as in the recent past.
Chile, Colombia, Peru, and Turkey, should enjoy relatively healthy
expansions. Mexico and much of central Europe, which have been
among the poorest performers in recent years, are set to see growth
accelerate. Others, including Brazil, Russia, South Africa, and
Venezuela have not signaled any sense of urgency in responding to
this new reality .
Potential growth rates in EM
0
2
4
6
8
10
12
CH
NU
KR IND
RU
SH
UN
PO
LA
RG
BR
AKO
RZA
FTU
RM
AL
CH
LC
OL
THA
PH
LM
EX IDN G7
EM
2003-07 2014-18
Potential growth (%)
Countries ranked by change in
change in potential growth (lowest to highest)
Source: Haver Analytics, IMF, Deutsche Bank
High or higher growth While China will not return to the
double-digit growth rates of the past, it should be able to sustain
growth rates in excess of 7% for the rest of this decade. The
deregulation of interest rates will raise the cost of capital and
weigh on growth. Allowing capital to be reallocated away from a
state sector to the private sector, on the other hand, should allow
productivity growth to be maintained. Financial deregulation and
the opening up of protected sectors to private investors, both
domestic and foreign, will be needed to deliver this. The reforms
announced last month go a long way in this direction. The improving
outlook in the US and Europe should also help the process of
adjustment to a somewhat lower but more durable growth
trajectory.
Recent reforms in India are also likely to pay dividends.
Despite an economic slowdown and a fairly unfavorable political
environment, the government has implemented an impressive range of
reforms, including: fuel price reform and fiscal consolidation;
energy sector reform, especially tariff liberalization; the
unlocking of numerous projects stuck at various stages of
regulatory and administrative approval; opening up
various sectors, especially retail, to more foreign investment;
and capital account liberalization. Additional reforms are
underway, including an ambitious deregulation of the banking
sector. Regardless of the nature of coalition that governs India
after elections next year, economic performance will likely be
better.
Outside the big two in Asia, the low hanging fruits of reform
appear most evident in Indonesia. The recent economic slowdown has
been mainly cyclical and a function of loose macroeconomic
policies, which led to overheating and worsening of external
balances. Recent steps to tighten policies are thus welcome.
Blessed with a large and young population, a rich commodity base,
stable democracy, a thriving civil society, improving governance,
and low leverage (the combined debt of public sector and households
is less than 50% of GDP), the economy is ripe for an acceleration
in growth provided the right policies are deployed to encourage
investment. Regardless of the outcome of next year’s election, it
is likely that reforms in the mining sector and labor market will
resume and should further support growth.
Elsewhere in Asia, Malaysia, with the recent conclusion of
elections, has a fairly unimpeded half-decade window to carry out
reforms to reduce its dependence on the commodity sector, embrace
high valued added manufacturing, reduce public sector intervention
in the corporate sector, and consolidate fiscally. The latest
budget offers some hope in this regard. The Philippines is keen to
boost its infrastructure for both manufacturing and tourism, and in
that respect the key reform would be to set up regulation and
operating mechanism for public-private partnerships. Thailand could
also offer good returns given its productive manufacturing and
labor base, thriving tourism and agriculture sectors, and a well
anchored macroeconomic policy framework. But it would first need to
deal with seemingly perennial political unrest and upgrade its
infrastructure where there has been a gap between announcements and
implementation.
In EMEA, we see the challenges in Turkey as mostly cyclical in
nature. Favorable demographics, a well-diversified export sector,
and relatively low levels of leverage should support growth over
the medium term, though participation in the labor market remains
low (especially among women) and excessive reliance on foreign
savings will leave the economy prone to boom and bust cycles. The
year ahead may be difficult given the twin challenges of Fed
tapering and important domestic elections. But thereafter the
economy should be able to sustain growth rates comfortably in
excess of 4%.
In central Europe, after years of underperformance, much of the
region (Hungary being an exception) is primed for a relatively
strong upswing. The drag from
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5 December 2013
EM Monthly: Diverging Markets
Page 8 Deutsche Bank Securities Inc.
years of fiscal consolidation and deleveraging in the private
sector is now starting to fade, confidence is returning, and
domestic demand should respond accordingly. Competitiveness has
improved as manufacturers have successfully plugged into the German
supply chain, leaving them well placed to take advantage of
strengthening global and European recoveries. Vulnerabilities have
also been reduced as balance sheets have been rebuilt and external
positions strengthened, leaving the region more resilient to rising
US rates.
Competitiveness gains in central Europe
CZE
HUN
POL
ROM
80
100
120
140
160
Sep-2007 Sep-2009 Sep-2011 Sep-2013
Share
of German export market (September 2007 = 100)
Source: Haver Analytics, Deutsche Bank
Mexico has been the market destination of choice in Latin
America over the last year. Despite strong fiscal and monetary
institutions, deep local pension markets, and a liberal trade
regime, performance in recent years has been lackluster, partly due
to US weakness. A new administration, however, has already
delivered labor market, financial, and fiscal reforms. Proposals to
allow greater private investment in the energy sector are set to be
passed by the end of the year and would be another step in the
right direction given Mexico’s abundant natural resources. Together
with a pick up in the US, this should support moderately stronger
growth in Mexico.
Elsewhere in the region, Chile, Colombia, and Peru have already
delivered significant reforms over the past decade or two. They
have seen some slowdown in growth recently and remain relatively
dependent on commodities but are still delivering solid
productivity gains and should remain the fastest growing economies
in the region.
Low or lower growth Brazil has relied for too long on
consumption-led growth. This was sustainable so long as commodity
prices were on an upward trend. Financial deepening, from a low
base, also helped. But these tail winds have faded. Potential
growth has probably already dipped
below 3% and will remain there if nothing changes. Low
investment, among the lowest in EM at less than 20% of GDP, is the
main constraint to higher growth. There are various reasons for
this. The lack of a proper regulatory framework for infrastructure
projects has also taken a heavy toll on long term investment.
Public investment in infrastructure has been squeezed by higher
spending on public wages and social transfers. The latter has
discouraged savings while high corporate tax rates to pay for this
spending have weighed on private investment. Public debt dynamics
are still favorable: little or no adjustment in the overall fiscal
position would be needed to keep debt on a sustainable path.
Reforming the tax regime or the social security system against this
backdrop should therefore be possible. In our view, however, the
likelihood of such changes, even after elections next year, is
still low – for ideological reasons.
Russia has made significant strides on macroeconomic reforms,
which have helped to reduce inflation to historically low levels
and maintained a buffer of oil savings. But experience elsewhere
shows that this will not be enough and indeed potential growth is
probably not much more than 3% right now. Like China, resource
allocation needs to become more efficient, which will necessitate a
reduction in the role of the state, including in the banking
sector. Investment also needs to increase, which will require a
better investment climate, better governance, and more
transparency. Russia must also deal with the challenges of an
ageing population, which will bite sooner than in all other major
EMs. Plans are in place in each of these areas, which have
delivered some results: Russia joined the WTO last year and this
year and reached the top 100 in the World Bank’s Doing Business
survey this year. But implementation has been hesitant and is
likely to remain so.
Strong and weak performers in Latin America
ARG
BRA
CHI
COL
MEX
PER
VEN
18
20
22
24
26
15 20 25 30 35 40 45
Gross investment (% GDP)
Government primary expenditure (% GDP)
Stronger performers
Source: Haver Analytics, Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
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Despite its strong institutions and first rate local capital
markets, structural impediments have also weighed on both growth
and the external accounts in South Africa. Public infrastructure
has suffered from years of lack of investment, resulting in power
shortages and a lack of capacity in the port and rail systems.
These are being addressed. Significant new power generating
capacity is set to come on stream late next year, for example. But
it will be some years before these bottlenecks are fully resolved.
There are few grounds for much optimism beyond this. Labor markets
are not functioning properly, resulting in strikes and high wage
settlements that are in turn limiting employment growth, eroding
competitiveness, and discouraging investment. Despite significant
public spending (higher than in the US), the education system is
delivering outcomes that are among the worst in the world.
Education outcomes in EM
1
2
3
4
5
6
7
SGP
KOR
UKR IDN
CH
N
RU
S
PO
L
THA
PH
LTU
R
CO
L
AR
G
MEX
BR
A
ZAF
Quality of maths and science education
Best
Worst
South Africa
Source: World Economic Forum – The Global Competitiveness Report
2013-14, Deutsche Bank
Hungary will likely see a moderate cyclical recovery but its
longer-term prospects remain constrained by the excesses of the
past. The stock of public and private debt has fallen but remains
onerous at over 230% of GDP. It is running small current account
surpluses and modest fiscal deficits. But without much faster
growth, which would in turn require a more supportive business
climate, it will require years of tight policies to reduce debt
levels to more comfortable levels.
Venezuela has spent most of its commodity windfall and emerged
with little to show for it. After years of increased state
intervention in the economy financed by high oil prices and debt,
the country now finds itself saddled with excessive regulation,
inefficient state companies, and a rigid exchange rate regime. With
President Maduro seemingly fully committed to maintaining this
“Bolivarian Revolution” of deceased President Chavez, this will
likely mean low growth, high inflation, and rationing of basic
goods. Debt service remains manageable, but on a clear
deteriorating path.
Argentina has followed a similarly myopic path over the last
decade, using commodity income to finance consumption while
deterring investment. Recent mid-term elections, however, confirm a
new social preference for more balanced policies. General elections
are still nearly two years away. But with vast relatively
unexploited natural resources and an economy that is basically
unleveraged, there are reasons to be optimistic about the
longer-term outlook if the electorate turns its back on the last
decade of failed policies.
Adjusting to the end of easy money
If the factors discussed above will play out over the next
several years, the near-term economic performance of EM will be
determined as much by how its economies adjust to rising US rates
and the end of easy money. The impact on global liquidity
conditions may be partially offset by continued aggressive monetary
expansion by the Bank of Japan and, potentially, the ECB if it
feels the need for another long-term refinancing operation.
Nevertheless, past and recent experience suggests that adjusting to
higher US rates will be a bumpy ride for many – emerging and
developed.
There are two main features of EM economies that make them
potentially sensitive to rising global interest rates: first,
reliance on external financing flows, which are likely to become
both less abundant and more costly; and second, high leverage
levels in some cases, in either the public or the private sectors,
which will see debt service costs rise as interest rates
increase.
We had a fire drill over the summer when fears of Fed tapering
first surfaced. After an initial wave of selling that largely
reflected market positioning, attention quickly shifted towards
fundamentals. The so-called fragile five EM economies (Brazil,
India, Indonesia, South Africa, and Turkey) that were characterized
by
EM Basic Balances
-8
-6
-4
-2
0
2
4
6
8
10
TAI
KOR
HU
N
PH
L
CZE
RU
S
CH
N
RO
M
CO
L
CH
L
BR
A
MEX
THA
PO
L
IDR
ISR
IND
UKR
TUR
ZAF
% GDP
Basic balances are the sum of the current account balance and
foreign direct investment. Source: Haver Analytics, Deutsche
Bank
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5 December 2013
EM Monthly: Diverging Markets
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large external imbalances and high inflation generally saw the
biggest corrections in their currencies and local rate markets.
Should we expect the same pattern repeat itself as and when the
Fed finally does begin to taper its asset purchases? We have
already seen a significant adjustment in asset prices. Currencies
in the fragile five, for example, have recovered a little in recent
weeks but still look moderately cheap relative to our measures of
longer-term fair value.
Currency valuation in the fragile five
-15
-10
-5
0
5
10
15
BRL TRY IDR INR ZAR
Apr
End Nov
Misalignment (vs. productivity‐adjusted PPPs)
Overvalue
dUnd
ervalued
Source: Haver Analytics, Deutsche Bank
On the other hand, we have seen relatively little reduction in
foreign exposure to local currency EM debt markets. EM debt mutual
funds have experienced significant and ongoing outflows, but these
investors represent a relatively small part of the overall foreign
investment. Institutional funds meanwhile began adding exposure
once again as soon as July. The share of foreign ownership of
Brazilian local currency debt
markets has actually hit new peaks in recent weeks. Even in
Turkey, which has been in the eye of the taper storm, the share of
foreign holdings of domestic debt securities is barely 2ppts below
its May peak.
The fragilities that led to underperformance in the first place
have also not changed all that much in the last few months although
we would expect to see some more differentiation within the fragile
five.
The change of governor at the Reserve Bank of India and a
greater emphasis on tackling inflation has gained some credibility.
The external accounts are also improving and we expect the current
account deficit to dip to 3% of GDP next year.
Monetary policies in Brazil, Indonesia, and Turkey, have also
been tightened. Real policy rates are still very low in Indonesia
and Turkey, however, despite relatively robust domestic demand and
credit extension. Fiscal policy has been loosened further in Brazil
ahead of elections.
South Africa’s vulnerabilities reflect structural weaknesses
rather than loose macroeconomic policies. As such, they are less
amenable to a quick fix. Public infrastructure investment will
continue to boost imports for the next year or two but is necessary
to support long-term growth. More worrisome is the performance of
exports, where high wage settlements, strikes, and low investment,
have undermined any competitiveness gains from the weaker rand.
Currencies will likely come under further pressure if capital
flows remain soft or weaken further. This is highly unlikely to
trigger a payments or solvency crisis of the kind that once
characterized EM. Currency mismatches are generally small and
certainly much lower than in the past. Even in Turkey, where the
short FX position of companies has increased in recent years to
about 20% of GDP, this is offset by the long FX position of
households. Weaker exchange rates will not therefore blow up
balance sheets in the way that we have seen in past major EM
crises.
The process of adjustment may nevertheless be painful in terms
of growth, especially if domestic liquidity conditions need to be
tightened further to keep inflation in check. The large stock of
foreign holdings of local currency debt in these markets is another
source of potential risk. While foreign investors proved relatively
“sticky” during the summer, a further round of selling could put
upward pressure on yields and squeeze growth.
Only Ukraine today has the features of a classic EM crisis with
a fixed and overvalued exchange rate, a current account deficit
that exceeds any in the fragile five, currency mismatches, and very
limited reserves to defend the currency. The reduced availability
and rising
Foreign ownership of local currency debt is not far
from the peak
0
100
200
300
400
500
600
700
800
Mar 09 Mar 10 Mar 11 Mar 12 Mar 13
Sum of all foreign holdings
AUM of EMD LC mutual funds
USD bn
Source: Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 11
cost of financing will likely require substantial domestic
adjustment and significant external financial assistance. But
Ukraine will be viewed as an exception and a crisis there will not
lead to a reappraisal of the rest of EM.
Overall, EM sovereigns appear least vulnerable. As is well
known, EM sovereign credit metrics are generally healthy,
especially when stacked up against most developed markets.
Government debt levels in EM are still only about 40% of GDP on
average, barely one-third of the level in G7 countries, and not
much higher than before the global financial crisis. There are just
a handful of EM countries that have seen their debt ratios increase
by more than 10% of GDP (Ukraine, Malaysia, South Africa, Hungary,
Poland, and Venezuela) in the last five years. But only in Hungary
has this taken government debt to levels that might be deemed
obviously excessive.
Government debt in EM
0
20
40
60
80
100
120
140
UKR
MYS
ZAF
HU
NP
OL
CH
LTH
AC
HN
MEX
KOR
RU
SB
RZ
CO
LP
HL
TUR
IND
IDN
AR
G
EM G7
2007 2012
% GDP
Countries ranked by the change in government debt (highest
to lowest)
Source: Haver Analytics, IMF, Deutsche Bank
At the same time, most countries have also been able to take
advantage of favorable financing conditions to lengthen the average
maturity of their debt. Once more, only a handful of countries saw
the average maturity of their debt shorten over the last few years
and in these cases maturities were either already long and/or debt
levels low. Again, Hungary stands out as having seen its debt level
rise significantly from an already elevated level while the
maturity of that debt has shortened further to less than four
years.
Government debt maturities in EM
0
2
4
6
8
10
12
14
16
CH
L
RU
S
HU
N
AR
G
IDN
MYS
PO
L
BR
Z
KOR
CO
L
TUR
IND
THA
MEX ZA
F
PH
L
2007 2012
Average remaining maturity (years)
Countries ranked by the change in average maturites
(shorter to longer)
Source: Haver Analytics, IMF, Deutsche Bank
Private debt levels, however, have increased more rapidly over
this period. Total credit to the non-financial sector, from both
bank and non-bank sources, increased from 72% of GDP on average in
2007 to over 90% by early 2013. Our view, therefore, is that it
will likely be at the level of corporate and household debt that
the normalization of interest rates will probably be most
problematic. Across the three EM regions, the risks appear greatest
in Asia. Not only are debt levels there much higher, averaging 130%
of GDP versus about 80% in EMEA and 40% in Latin America, but also
they have generally risen much more in Asia than in the other
regions, especially in China and Korea (and more so for companies
than for households).
Private debt levels in EM
0
20
40
60
80
100
120
140
160
180
200
220
CH
N
HU
N
KOR
BR
Z
TUR
THA
PO
L
MYS IND
RU
S
IDN
MEX
AR
G
ZAF
2007
2013
Credit
to non‐financial private sector (% GDP)
Source: BIS, Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
Page 12 Deutsche Bank Securities Inc.
Implications for EM investment performance
Since late May, mutual fund investors have steadily and
consistently withdrawn money from EM fixed income. Strategic
institutional investors have thus far held firm, but there is
evidently a re-assessment of EM excess return potential taking
place. The outcome of this could have a profound impact on the
performance of the asset class for over the medium term. So, how
should we look at the excess return potential of EM fixed
income?
Structural drivers of excess returns In simplistic terms, we can
think of the investment case for EM relying upon structural
macroeconomic drivers that deliver trend outperformance (versus
DM), and short-term cyclical factors (macro, technicals, and
valuation) which result in oscillations around this underlying
trend, with frequent overshoots to the upside and downside. At
present there is a great deal of focus on near-term factors, such
as the timing of a Fed tapering, and the impact that it has on
capital flows and currencies. We would view these as part of the
short-term cyclical factors. Nevertheless, as discussed, there is
also a re-assessment of the trend potential of EM that is ongoing
and impacting performance of the asset class.
In terms of the macro-economic drivers, over the medium-term,
three factors ultimately dominate: productivity growth relative to
the trade partners, the real interest rate premium over developed
markets and improving sovereign balance sheets. Economic growth
is obviously a key factor underpinning all three, but it is
useful to split the three up given their specific impact on the
various ways of investing in EM.
First, the more rapid growth of productivity supports the real
appreciation of currencies. This obviously impacts any investment
in local currency assets. Higher real rates lead to a direct
outperformance of local currency fixed income assuming constant
real exchange rates. Finally, improving sovereign balance sheets
lead to stronger credit ratings and tighter spreads for sovereigns
(and often also for corporate borrowers as the country risk premium
declines) and hence outperformance of hard currency debt. The
charts below illustrate the evolution of these three variables in
recent years.
Note that when we consider ‘EM’ in aggregate in our analysis, we
weight the component countries/markets according to the main
benchmarks against which most global fixed income investment is
managed.
In all three cases the recent dynamics of these drivers are not
as powerful as they were in the 2002-07 period. In the past couple
of years, annual relative productivity growth has slowed to just
0.8% from an average of 3.0% in 2005-07. Sovereign ratings
migration has also slowed, with effectively no improvement in
average credit quality, compared to an average pace of improvement
of 0.25 rating notches per year in 2003-07. The one aspect that
remains robust is aggregate real rates. While real rates are not as
high as they were at the start of the 2002-07 period, relative to
US real rates they remain at the high end of the range of the past
decade.
The structural drivers of EM outperformance are not as powerful
as during the 2002-07 period
95
100
105
110
115
120
125
2005 2007 2009 2011 2013
Per-capita PPP GDP vs US
As a proxy for productivity, we construct indices
of relative per-capita PPP GDP between
individual EM countries and the US. These are
then aggregated to provide a global EM index
using the weights of the GBI-EM Global
Diversified.
-2
0
2
4
6
8
2004 2006 2008 2010 2012 2014
Real rate differential vs US
Individual country real rates are constructed on
the basis of DB’s EMLIN sub-index yields minus
ex-post y/y inflation. From this we subtract 5Y
TIIPS yield. Country real rates are aggregates
using the weights of the GBI-EM Global
Diversified.
9
10
11
12
'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13
Average credit rating of EM sovereign USD debt
We take the average sovereign ratings from
Moody’s S&P and Fitch and then construct an
aggregate based on the weights of DB’s EM USD
Sovereign index. On the scale above 9
corresponds to BBB/Baa2, 10 to BBB-/Baa3, etc.
Source: Deutsche Bank
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 13
The decline in the pace of relative productivity growth is at
the heart of the shift in attitude towards EM. However, it is not
universal. Latin America has slowed to 0.3% from 3.8%, EMEA to 0.2%
from 1.5%, but in Asia the slow-down has been more modest, falling
to 2.4% from 3.0%. This pattern can also be seen in the
differential behavior of real exchange rates, with the trend in
both Latin America and EMEA stalling after 2007, but continuing to
appreciate until more recently in Asia.
Regional real exchange rates and productivity
differentials
Latin America
90
100
110
120
130
140
2005 2007 2009 2011 2013
Productivity (proxy) differential
Real exchange rate
EMEA
90
100
110
120
130
140
2005 2007 2009 2011 2013
Asia
90
100
110
120
130
140
2005 2007 2009 2011 2013* Real exchange rates are re-based such
that Dec-2004 = 100
Productivity differentials are re-based so that there is no
average misaligment between the two series over the entire
period.
Source: Deutsche Bank
The likelihood of broad acceleration in relative productivity
growth across EM seems low. As such,
and with real yields hovering at around 2% above the US, there
seems little justification to assume significant outperformance by
EM in the coming few years. Absent a benign economic shock at the
core, which seems highly unlikely, reforms will likely be the key
to changing this picture, by reinvigorating growth. As discussed
above, the outlook is mixed with growth set to remain relatively
high in some cases, to recover from low levels in others, but to
remain low or fall further elsewhere. These divergences should be
reflected in the long-term performance of asset markets within
EM.
What does this mean for the medium-term performance potential of
EM fixed income? Can we derive an expectation for returns using as
a basis our sober assessment of macroeconomic prospects?
Local currency fixed income: In simple terms, over the
medium-term, an investment in local currency fixed income should
deliver a USD return from two sources: (i) real appreciation of the
currency relative to the dollar, fueled by productivity gains and
(ii) an excess return from the relative real rate differential.
The chart below illustrates the trade-off between these two
variables: excess real rates (current 5Y) on the y-axis and growth
differential (DB forecast for next 2-years as a proxy of
productivity) on the x-axis for a range of EM local markets.
Drivers of long term value in local markets
BR
CL
CO
CZ
HU
ID
IL
MX
MY
PE
PH
PL
RU TR
ZA
KR
TH
NG
RO
GBI
-1
0
1
2
3
4
-2 -1 0 1 2 3 4
Real rate differential vs US, %
2014-15 growth differential vs US, %
Dark blue points represent major local markets (GBI-EM Global
Diversified weights > 5%) Diagonal lines represent constant
values (0, +1.5%, +3.0%) of real rate differential + 0.4 x growth
differential. Source: Deutsche Bank
Empirically we find that a coefficient of 0.4 for the
relationship between real exchange rates and per-capita PPP GDP
(our proxy for productivity). We can use this coefficient to see
the trade-off between growth and real rates. For instance, we
estimate the trend
-
5 December 2013
EM Monthly: Diverging Markets
Page 14 Deutsche Bank Securities Inc.
excess return for an investment in domestic currency fixed
income to be approximately RealRateDiff + 0.4 x GDPDiff. This
relationship is shown by the diagonal lines on the chart,
illustrating excess returns of 0%, +1.5% and +3.0%.
While there is a fairly wide dispersion of expected returns in
the sample, it is interesting that all but two of the major markets
have excess returns between 1.1% and 2.0%. For the GBI-EM (the most
widely followed benchmark) we obtain an excess return of +2.0%.
Given that this is a USD return in excess of US nominal rates, it
can be thought of as somewhat analogous to a credit spread.
Despite a wide range of forecasts, excess returns for
many major EM markets lie in the 1.5-2.0% range
0
+0.5
+1.0
+1.5
+2.0
+2.5
+3.0
+3.5
+4.0
+4.5
+5.0
Nig
eria
Bra
zil
Per
u
Co
lom
bia
Turk
ey
Ind
on
esia
Chile
Mex
ico
GB
I-E
M
Ru
ssia
Po
lan
d
Hu
ng
ary
So
uth
…
Mal
aysi
a
Thai
lan
d
Rom
ania
Ph
ilip
pin
es
Sou
th K
ore
a
Isra
el
Cze
ch …
Expected excess return, %
Source: Deutsche Bank
Is this sufficient to persuade the USD500+bn of strategic
institutional money currently invested in the market to remain put?
We think it should be. Considered in the context of other fixed
income opportunities an excess return of 200bp over US nominal
rates is material (basically double where real US rates are priced
to settle in five years!). Furthermore, considering the substantial
uncertainty that remains regarding the future prospects for the
global economy, retaining a degree of diversification, and a
foothold in what still represents approximately 50% of the global
economy, is surely prudent. Lastly, USD 500bn remains a very small
proportion of the global fixed income investment set.
Sovereign Credit Assessing the excess return potential of
sovereign credit is somewhat more straightforward than for local
currency fixed income. The competing asset class(es) are more
obvious: developed market corporate credit. The extent to which EM
sovereign credit has underperformed DM corporate credit during 2013
is quite remarkable and, as far as we are concerned, not
justified by fundamentals. Historically EM sovereigns traded
tighter than equivalently rated DM corporate credits. This was
arguably justified during the time in which EM sovereigns were on a
strong, secular upgrade path. However, in recent years, with the
pace of upgrades slowing substantially, such a premium was no
longer justified. However, the pendulum has now swung in the
opposite direction; EM sovereigns are trading cheaper than
similarly rated DM corporate credits. This discount is not
justified by fundamentals. There is admittedly a risk of a rating
downgrade for some high profile sovereigns, but fundamentally,
balance sheets of EM sovereigns remain extremely healthy.
Furthermore, with the market becoming increasingly diverse (the
EMBI Global now consists of 60 different sovereign credits), the
performance of idiosyncratic high yielders (such as Venezuela and
Argentina) is having a much-reduced impact on the performance of
the rest of the market.
EM sovereign spreads imply a rating 1 notch below the
actual
A
A-
BBB+
BBB
BBB-
BB+
BB
BB-2003 2005 2007 2009 2011 2013
Average credit quality of EM sovereign USD debt
As implied by the spread at which it
trades
Actual rating
Source: Deutsche Bank
The premium offered by EM over DM corporate credits provides a
cushion, while EM rating migration pauses. However, if EM countries
seize the nettle of reform as we discussed earlier, then it could
trigger a renewed re-rating of the asset-class. In this sense,
persistently positive growth differentials, albeit lower than in
the recent past, should also help. Given the underlying strong
balance sheets, this could happen relatively abruptly, albeit not
in the immediate future.
While external risks remain high and currencies the shock
absorber, we see credit (sovereigns and also selected corporates)
as the safest entry point (cyclically). Structurally, the upside
local markets offer remains quite attractive – even if
diminished.
Marc Balston, London, 44 20 754 71484 Robert Burgess, London, 44
20 754 71930
Drausio Giacomelli, New York, 1 212 250 7355 Gustavo Cañonero,
New York, 1 212 250 7355
Taimur Baig, Singapore, 65 64 23 8681
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5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 15
Rates: Refocusing on EM Fundamentals
The re-establishment of term premium that started in 2013 is
advanced and is now more comparable to historical norms. It is
obviously insufficient to absorb possible bouts of volatility that
could accompany tapering and potential testing of forward
guidance.
With more premia embedded in longer tenors across both EM and
DM, we expect term premia to track more closely with growth
potentials and inflation trends in 2014. Accordingly, we expect
country specifics to continue to play an important role in
performance.
We find that the cushion to absorb a potentially faster pace of
global growth is more limited in the short end and belly of most EM
curves. We favour payers in Turkey and Israel but favour receivers
in Poland. We see residual value in receiving in Hungary, while in
South Africa the value in the front end is now sizeable. In Asia we
like paying the front end of the Malay curve versus Thai, as well
as paying the front end of Korea and Taiwan (maintaining a
steepening bias).
There is a significant gap between current and ‘neutral’ policy
rates, yet only a modest growth upturn in the years ahead is priced
by the mid-sector of EM curves. On account of attractive valuation,
low carry burden and high beta to US rates, we find paying the
‘belly’ of the 2s5s10s butterfly attractive in Mexico, Czech
Republic and (less so) Hungary.
As normalization proceeds and volatility subsides, we expect EM
curves to bear-flatten in 2014. The Turkish curve stands out as a
good candidate for bear flattening. We also like flatteners in
South Africa and Israel, while favouring (bull)-steepeners in
Russia. In LatAm, we favour flatteners in Mexico and Brazil and,
less so now, steepeners in Chile. In Asia we recommend buying bonds
in India, receiving in the long end of Singapore vs. US, but paying
Hibor-Libor spread. Still in Asia we like paying spreads in China,
Malay vs. Thai rates, 2Y/5Y Korea IRS outright and 2Y/5Y Taiwan
spreads.
Inflation premium also seems subdued. We find the inflation
premium too low in Turkey and favour linkers vs. nominal bonds in
Brazil and Chile.
Re-pricing: Part II
EM local markets started 2013 under booming inflows and at very
tight valuations despite prospects of acceleration in global growth
throughout the year. In several “high-yield” markets, long-dated
tenors barely offered enough compensation for inflation. In
some
cases, long-dated real yields turned negative as inflows built.
As we end the year, valuation and flows are still on opposite
sides, while the outlook for the US economy is brighter again.
However, now real yields are back firmly in positive territory –
even if still low by historical standards in most cases. Despite
better valuations, however, outflows from local markets persist,
although at a much slower pace than in the summer months.
Interest rate differentials vs. the US have recovered as USTs
sold off. The chart below presents the spread between the
market-weighted average of EM and similar-duration US real yields
(5Y sector). The two charts cover not only “traded” real yields,
but also a more comprehensive sample of nominal bonds deflated by
inflation expectations in countries where linkers are non-existent.
The yield differential in favour of EM ranges from 200-400bp and it
is now hovering around almost 350bp in the broader sample.
Interest rate differentials recover despite UST sell-off
100
150
200
250
300
350
400
Dec 08 Nov 09 Oct 10 Sep 11 Aug 12 Jul 13
Spread of EM 5Y (deflated) real yields vs.US 5Y TIIPS, bp
0
2
4
6
8
2005 2007 2009 2011 2013
LatAm vs. TIPS EMEA vs. TIPS
LatAm and EMEA 5Y linkers' yield index vs. US 5Y TIPS (%)
Source: Deutsche Bank, Bloomberg Finance LP
-
5 December 2013
EM Monthly: Diverging Markets
Page 16 Deutsche Bank Securities Inc.
This suggests that concerns about persistent outflows and the
absence of EM premium over developed markets may be exaggerated –
especially in LatAm. Under DB’s baseline scenario for policy rates
and US rates (3.25% for UST10Y), we expect the EMLIN index to
return 4% this year vs. -8.7% so far in 2013. This compares with
-2% we forecast for UST in 2014.
In our view, the re-establishment of term premium that started
in 2013 is advanced.1 From the negative levels of early 2013, term
premia are now more comparable to historical averages (or higher).
They are obviously insufficient to absorb possible bouts of
volatility that could accompany tapering and potential testing of
forward guidance. However, with more cushion priced in longer
tenors across both EM and developed markets, we expect them to
track more closely growth potentials and inflation trends in 2014.
Accordingly, we expect country-specifics to continue to play an
important role in performance.
Although the global economy is improving, growth risks remain
two-sided, as 2013 reminded us repeatedly. This will likely
translate into range trading for longer tenors. However, we find
that the cushion to absorb a potentially faster pace of global
growth is more limited in the short end and belly of most EM
curves, as we discuss in the following sections. There is still a
substantial gap between current and “neutral” policy rates, while
the mid-sector of EM curves prices in modest growth upturns in the
years ahead. Inflation premium – though positive across EM – also
seems subdued.
These may prove adequate should global growth continue to
recover gradually, but limited monetary policy premium and the
possibility that forward guidance is tested (especially if the US
accelerates as we expect) suggest that local yield risks remain
exposed to further re-pricing in the year ahead – possibly not as
sharply as in 2013 at current valuations, however. We expect EM
curves to bear-flatten in 2014 once the dust settles.
EM specifics: Assessing curve premium The short end: Testing
“forward guidance” The ability of EM central banks to commit to
keeping policy rates low for a prolonged period of time is limited,
in our view. Not only are output gaps lower, but also inflation
risks are higher. In only a few cases (including Chile, Russia,
Israel, and CE3) are inflation expectations hovering below (by only
a small margin) or at the target.
1 US 10Y5Y is trading above 4.5%, which is consistent with
growth and inflation prospects of 2%. The re-pricing in 2013 has
amounted to about 150bp and the bulk of it stemmed from the
re-pricing in term premium. In our view, UST pricing should follow
more closely steady-state inflation and growth.
In most emerging economies, labour markets are not far from full
employment and we have found no (structural) systemic change in
these economies’ linkages to developed markets. As we discuss in a
separate piece2, we believe that most EMs are on the cusp of
acceleration in growth. Several important countries such as Brazil,
South Africa, Turkey, Russia, and India will likely lag for
structural reasons, but they already face persistently high
inflation nevertheless.
Under this backdrop, is “monetary policy premium” adequate? We
find it to be low under our baseline scenario of return to trend
growth – even if gradually so. In the charts below, we compare
market pricing, our estimates of “neutral” policy rates and the
basic elements of a Taylor rule to assess “monetary policy
premium”. In the first two charts, the horizontal axis gauges the
time it takes for yields as implied by the forwards to meet our
estimates of neutral policy rates. We note that since these curves
price some term premium, this probably underestimates the implied
time to achieve neutrality. The charts compare this “time to
convergence” with our estimates of output gaps and the differential
between inflation expectations and targets.
Assessing “monetary policy premium”
USD
ZAR
ILS
BRL
CLP
COP
MXN
EUR
CZKHUFPLN
RUB
TRY
KRW
INR
‐2.0
‐1.5
‐1.0
‐0.5
0.0
0.5
1.0
1.5
2.0
0 12 24 36 48 60 72
Expected inflation in excess of target (%)
Convergence time to "neutral" priced in (months)
receivers
payers
USD
ZAR
ILSBRL
CLP
COP
MXN EUR
CZK
HUF
PLN RUB
TRY
KRWINR
‐6
‐5
‐4
‐3
‐2
‐1
0
1
2
0 12 24 36 48 60 72
Output gap (%)
Convergence time to "neutral" priced in (months)
receivers
payers
Note: 1. We include India for completeness, even though the
current policy rate is higher than our estimated neutral rate.
Convergence time is plotted as 0 months. 2. In Turkey, Korea and
the Czech Republic, forwards do not converge to our estimated
neutral policy rates within 72 months. Source: Deutsche Bank
2 See “Diverging markets, in this publication.
-
5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 17
India, Russia, CE3, and Chile lead in terms of monetary policy
“cushion”, with inflation hovering below target and negative output
gaps. These are followed by Israel and Colombia. Among those,
receivers in Poland seem to stand out on lower inflation risks per
carry.
In contrast, there is less “central bank premium” in Brazil,
Turkey, and – to a lesser extent – South Africa. In these
countries, there is less room to manoeuvre given higher inflation
and smaller gaps. The signals are more mixed in Mexico, where
inflation and output gaps have opposite signs. The same is true in
Korea, but in this case the time to convergence to neutral is quite
long, suggesting upside risks to yields. Turkey stands out as the
most mispriced of these markets, in our view: Not only is inflation
too high and the output gap too low, but also the curve prices too
slow a normalization path.
Among the high-inflation countries, while temporary easing in
inflation pressures may bring small cuts in Russia, shorten the
cycle in Brazil and extend the SARB’s pause – thus attracting
short-term receivers – we caution that inflation in these countries
has an important inertial component – especially in Brazil. With
underlying inflation running well above headline in Brazil,
achieving neutrality requires overshooting neutral rates.
Looking beyond the intra-EM differences, the overall time to
convergence seems excessive. Even where premium is highest, it
would still take about 40 months to convergence. Historically,
business cycle upturns have closed these gaps in shorter time
frames. “Low for long” may be credible in countries such as Israel,
Chile, and the Czech Republic, which do not show any imminent
pressure points on inflation and capacity utilization, but the time
priced to “neutrality” (more than four years) still suggests that
risks are biased to higher rates even in these cases.
We favour payers in the short end of Turkey and Israel,
receivers in Poland, and tactical receivers in Hungary, Russia, and
South Africa. In LatAm, Brazil stands out as the best front-end
receiver (amid high volatility, however) followed by Colombia and
Chile. As disinflation runs its course in Asia, we like paying the
front end of the Malay curve versus Thai as a trade on divergent
inflation/policy outlooks. Long time to convergence contrasts with
more growth-sensitive markets in North Asia; we thus favour paying
the front end of Korea and Taiwan (maintaining a steepening
bias).
The belly: A mild business cycle priced in Forward guidance and
scepticism surrounding global growth may extend the life of
short-end receivers. Even under this dovish scenario, however, the
value proposition in mid sector of EM curves is questionable, in
our opinion. The delayed normalization priced may
be adequate for developed countries that still face the
leftovers of debt overhang. Arguably, a subdued upturn is likely in
the case of the BRICS, where credit cycles and policy expansion
post-crisis were also severe – yet not as deep as in developed
markets. For most emerging economies, however, growth normalization
appears within reach over the next year or two. The chart below
plots the gap between 2Y, 3Y ahead and 2Y spot vs. the neutral rate
– the current policy rate gap.
Only a few EM curves offer positive premium for receivers
(notably Brazil, India, Russia, and Mexico). In contrast, we see
value in payers across several countries such as Turkey, Korea,
Europe, the Czech Republic and the US. Not surprisingly, Turkey
again stands out.
Pricing a subdued cycle in the years ahead
USDZAR
ILSBRL
CLP
COPMXN
EURCZK
HUF
PLN
RUB
TRY KRW
INR0
50
100
150
200
250
300
350
400
‐200 ‐100 0 100 200 300 400
2Y3YF ‐2Y (bp)
receivers
payers
Policy rate gap
Source: Deutsche Bank
Where do we find the best protection trades against possibly
stronger business cycles? As we have highlighted 3 , despite their
negative carry, 2s5s10s butterflies are rather depressed across
several EMs, trading through pre-May levels in some cases, while
displaying a high correlation with global risk proxies (namely the
slope of the US volume curve). This suggests that butterfly payers
can be used as proxy hedges for a potential surge in front-end
rates volatility, whether predicated on stronger-than-expected
pick-up in activity or risks regarding the unbundling of tapering
and forward guidance.
We look for butterfly payers that combine attractive valuation,
lower carry burden, and the highest beta to US rates front end
volatility (DGX index) as a proxy of the perceived strength of the
global cycle. We favour the highest “payout” in the sense of the
highest potential upside vs. lowest carry and drawdown.
The chart below indicates that paying the belly in 1:2:1 2s5s10s
butterflies in Mexico, Czech Republic, and
3 See “Trading Pre-Taper Anxiety”.
-
5 December 2013
EM Monthly: Diverging Markets
Page 18 Deutsche Bank Securities Inc.
(less so) in the US combines potential upside (y-axis) and
significant exposure to a stronger cycle (x-axis), while having
relatively low carry burden (r-squares and 3M carry in bp are
expressed as the first and second numbers in the brackets).
Butterflies: Where to pay
(USD 88%,‐15)
(EUR 72%,‐4)
(MXN 84%,‐8)
(CLP 49%,‐4)
(HUF 76%,‐11)
(PLN 69%,‐2)
(CZK 80%,‐6)
(ILS 47%,‐9)
(ZAR 44%,7)
(TRY ‐33%,3)0
10
20
30
40
50
60
‐0.4 ‐0.2 0 0.2 0.4 0.6 0.8 1 1.2
Upside Potential (bp)
Beta do DGX
favored defensive trades
Source: Deutsche Bank
In EM, we favour paying the belly in Mexico, Czech Republic and
less so in Hungary as defensive trades. In Asia we favour paying 5Y
outright in China and also the belly in Korea and Taiwan.
The long end: Looking beyond tapering Extending the analysis of
the previous sections, we now look at premium in longer tenors. To
do so, we again compare “neutral” vs. forwards4. The vertical axis
in the chart below shows this “excess term premium” embedded in the
forwards. The horizontal axis presents the “monetary policy
premium” (the difference between what is priced in 2Y, 3Y forward
vs. 2Y spot and the “policy rate gap” – the distance from
“neutral”). The chart segments EMs into four quadrants, according
to these premia.
Comparing term premium and monetary premium to gauge the
relative value between the longer and shorter tenors of EM curves,
the chart below suggests that EM value is concentrated in
bear-flatteners. This is consistent with our view that premium is
higher in the longer end of EM curves with little cushion for a
faster pace of economic recovery in the shorter tenors. This is
also in line with tapering being the most imminent risk, while
forward guidance is yet to be tested.
Again, Turkey stands out as the best candidate for
bear-flattening. Korea appears as a clear short-end payer, but with
no clear curve trade. Mexico and Russia show value in receiving,
but while Russia bodes well
4 We use 3Y forwards as our starting date as we believe that
this time frame reduces potential mis-pricings related to
differences in monetary policy paths. We use the average 2s10s
slope during 2004-08 (before the crisis) as a proxy of “neutral”,
comparing it with the slope 3Yforwards.
for bull-steepening (which could be triggered by possible
easing), Mexico shows more value in the longer end
(bull-flattening). Hungary, South Africa, and Israel seem too
steep, with value concentrated in longer tenors.
Pricing long-term growth, after term premium
USD ZAR
ILS
INR
CLP
COP
MXN
EUR
CZK
HUF
PLN
RUB
TRY
KRW
BRL
‐150
‐100
‐50
0
50
100
150
200
250
300
‐220 ‐180 ‐140 ‐100 ‐60 ‐20 20 60 100 140 180 220
(pay 2s, long 2s10s flattener)
Excess term premium (bp)
Monetary policy premium (bp)
(rec 2s, long 2s10s flattener)
(pay 2s, long 2s10s steepener)
(rec 2s, long 2s10s steepener)
Source: Deutsche Bank
Brazil also stands out as too steep. Fiscal risks and a central
bank that prefers to chase inflation risks combined with election
uncertainty that could mount into 2Q/3Q bodes for caution, but at
over 13% (and 14%+ in forwards) we find nominal rates in Brazil
outright too high and the curve too steep. We expect the central
bank to continue to tighten – cornered by high inflation – even if
gradually so. Fiscal slippage seems to be peaking. However, rates
and FX will likely be most volatile in Brazil as elections (not
market stability) look to be an absolute priority for this
government.
In EMEA we favour flatteners in Turkey, South Africa and Israel,
while favouring steepeners in Russia. In LatAm we like flatteners
in Mexico, Brazil and see residual value in steepeners in Chile. We
also continue to favour receiving the long end in Mexico versus the
US. In Asia we recommend buying 5-7Y bonds in India, receiving in
the long end of Singapore vs. US, but paying Hibor-Libor spread.
Still in Asia we like paying 2Y/5Y IRS spreads in China, Malay vs.
Thai rates, 2Y/5Y Korea IRS outright and 2Y/5Y Taiwan spreads
Nominal bonds or linkers? Inflation across EMs has been low
except in cases where central banks have been negligent. However,
the benefits of lower food prices and lacklustre global growth will
likely start to fade during 2014 under our baseline scenario.
Subdued oil prices could provide a reprieve, but these prices have
been subsidized (and lagging) in many important emerging markets.
Also, as discussed above, output gaps are not nearly as high as
-
5 December 2013
EM Monthly: Diverging Markets
Deutsche Bank Securities Inc. Page 19
in developed countries. In addition, central banks will likely
err on the side of higher inflation than lower growth. Moreover, in
many important markets such as Brazil, Turkey, and South Africa,
inertia seems to have pushed the baseline level up.
Inflation premium (defined as breakevens – consensus inflation)
is negative in Chile, Colombia, and Israel (see chart below). This
is in line with inflation risks, which we deem low especially in
Chile if oil prices recede in 2014 as we expect. Liquidity may be
binding in Israel and Colombia, but – in Chile – linkers are most
liquid and – at negative premium – they seem an attractive
defensive trade. We also favour long breakevens in CLP.
In South Africa, premium seems adequate, given our view of
persistent economic slack and some currency appreciation. Yet, in
Brazil, it just looks too high. Underlying inflation is running
near 8% so that sub-100bp of premium seems low – especially given
the risk of additional BRL weakness. In Turkey, liquidity is also a
hurdle for linkers. Besides, food prices are running a little above
trend and will probably correct downwards; domestic liquidity
conditions are now finally being tightened, which should also help.
In both cases, however, there are risks to the upside, primarily
from the potential for further exchange rate weakness. Thus, we
find the premium to be too low.
Assessing inflation premium
-150
-100
-50
0
50
100
150
BRL CLP COP MXN ILS TRY ZAR BRL CLP COP MXN ILS TRY ZAR
2Y 5Y
Inflation Premia (bp)
Source: Deutsche Bank
We favour linkers vs. nominal bonds in Brazil, Chile, and Turkey
– liquidity permitting.
Final remarks: Technicals and other idiosyncratic risks
Technicals remain mostly an external risk, in our view. Although in
some cases amortization increases substantially in 2014, the
outlook for net supply (supply in excess of redemptions) seems
manageable – and actually benign in several countries. The chart
below shows the net financing picture in 2014 (y axis) vs. the net
financing picture in 2013 (x axis), both expressed relative to GDP
(%). Except for CZK and MXN, the outlook for net supply seems
benign.
The external technical risk remains potentially quite high. As
the last chart shows, foreign holding of local debt has increased
despite the outflows from local markets over the past year. In
Hungary, Poland, South Africa, Mexico, and Malaysia, foreign
holdings remain substantial and in excess of 30%. Historically,
foreign investors (a source of long-term savings via insurance and
pension funds) have been important anchors for the extension of
local curves. They have been quite resilient to several monetary
policy shocks, but it would be premature to discard the risk of a
more substantial rotation away from fixed income.
Our baseline view is that the global economy simply cannot
afford such a marked reallocation, as it is still quite leveraged.
The Fed’s own reluctance to validate more aggressive re-pricings of
US fixed income seems to concur with our baseline view. However,
these are unusual times. Even if significant outflows do not
materialize, investors should remain prepared for bouts of hedging
– either via paying swaps or buying USD – as was the case
throughout 2013.
Supply risk contained
CNY
HKD
INR
IDR
KRW
MYRPHP
SGP
TWDTHB
BRL
CLPCOP
MXN
PEN
CZKHUF
ILS
PLN
RUB
ZAR
TRY
‐2%
‐1%
0%
1%
2%
3%
4%
5%
‐2% ‐1% 0% 1% 2% 3% 4% 5%
Net Supply 2014 (% GDP)
Net Supply 2013 (% GDP)
Source: Deutsche Bank
Foreign holding: Resilient, but still the wild card
0%
10%
20%
30%
40%
50%
CZ HU PL RU ZA TR BR MX IN ID KR MY TH
Sep‐12 Highest Sep‐13% of outstanding
Source: Deutsche Bank
Drausio Giacomelli, New York, +1 212 250 7355 Guilherme Marone,
New York, +1 212 250 8640
Siddharth Kapoor, London, +44 20 7547 4241
-
5 December 2013
EM Monthly: Diverging Markets
Page 20 Deutsche Bank Securities Inc.
Sovereign Credit in 2014: Back in the Black
While EM assets are likely to face continued headwinds in 2014,
we believe the dramatic negative shift in the wider perception of
EM debt cannot be repeated in 2014 given the return of EM risk
premium.
With continued taper risk, we start the New Year with a neutral
overall exposure. However, as rate uncertainty recedes after the
initial taper shock and Fed continues with its dovish guidance as
we foresee, we believe EM sovereign spreads have potential of some
moderate tightening, offsetting the rise in US yields and offering
about 6% return in 2014.
We expect some moderate improvement in EM credit fundamentals
overall in 2014, especially in the ‘fragile’ countries, but foresee
continued negative ratings drift as in 2013.
We are not optimistic on the short-term outlook for funds flows,
but we believe supply/demand balance is likely to be more
supportive, as for the first time since 2007 we project principal
and interest repayments to be slightly more than gross
issuances.
In terms of credit differentiation, we apply our valuation model
based on country-specific macro factors and adjust the results with
impacts of current account balances – a main driver for credit’s
rate sensitivity in 2013.
We recommend an overweight exposure to Colombia, Russia, Poland,
and Hungary, underweight exposure to Brazil, Indonesia, and
Ukraine, while maintaining a neutral exposure to the rest, notably
Argentina, Venezuela, Turkey, and South Africa.
In relative value, we retain a cash curve steepening bias in the
near term given rate uncertainty. The CDS/bond basis is settling in
a tighter range currently but we look to trade a potential bounce
in the basis as rate volatility recedes later in 2014.
Introduction
2013 has been a very significant year for emerging market
sovereign credit. A perfect storm of factors transpired to push EM
spreads to their cheapest levels in over a decade, relative to
developed market corporate debt. The most important question facing
us as we look forward to 2014 is whether this past year was a
discrete adjustment, or whether appetite for EM sovereign debt has
been so damaged that we face an extended period of
underperformance.
With declining QE from the Fed and relatively lackluster
aggregate economic growth, emerging markets assets are likely to
face continued headwinds in 2014. However, these headwinds should
not brew into a storm like in 2013. We expect a further rise in US
10 year yields, but for this to be constrained with 5Y-5Y forward
around 4.5%. Furthermore, we believe the dramatic negative shift in
the wider perception of EM debt cannot be repeated in 2014.
Sentiment is already poor and expectations have adjusted downwards.
These factors should put a limit on further underperformance of EM
sovereign credit relative to developed market corporate. However,
given the shock of 2013, we believe EM sovereign debt is not cheap
enough to motivate the sharp reversal in fund flows which would be
a necessary condition for a substantial spread compression relative
to DM corporate.
As a result, while the major theme of 2013 was of the systematic
underperformance of EM sovereign credit, we expect diversity within
the asset class and divergent performance of individual EM credits
to be the dominant theme of 2014.
2013 in perspective: a revelation of fading tailwinds
It has been a year to forget for EM sovereign credit In 2013, EM
credit has been one of the worst performers among all asset
classes, suffering a major re-pricing on the deterioration in EM’s
relative fundamentals vs. the developed world and a dramatic shift
in the perception of EM as an investment opportunity, triggered by
the prospect of QE taper. Portfolio rebalancing due to rising
interest rates, a topic that has been talked about throughout the
year, has not materialized to the same extent (or in the same form)
as expected for the general credit market, as inflows to both
global investment grade and high yields have returned and both
asset classes are seeing credit spreads at the tightest levels
since 2007. Instead, rebalancing has been more pronounced in the
form of unwinding of inflows into EM debt funds accumulated during
previous years.
Year to date, EM sovereign credit, measured by the EMBI-Global
benchmark, returned -7.5%, significantly underperforming Global IG
(-1.3%) and in stark contrast with Global HY (+7%). Within E