The recovery in developed economies: a mixed blessing for ......The framework Trade flows The final frontier This time is different Making waves ... Valuation opportunities less and

FOR PROFESSIONAL INVESTORS ONLY AND NOT FOR PUBLIC DISTRIBUTION

The recovery in developed economies: a mixed blessing for Latin America?

William De Vijlder, Vice - Chairman of BNP Paribas Investment Partners

Cartagena, Colombia, 3 April 2014

I 03/04/2014 I 2 For professional investors only and not for public distribution

Overview

● Introduction

● The framework

● Trade flows

● The final frontier

● This time is different

● Making waves

● Preferred habitat

● The exchange rate

● Domestic fundamentals and policy reaction

● Conclusion and lessons learned


INTRODUCTION


● Developed economies are doing better

● Emerging economies are addressing structural issues

● Monetary policy divergence on the rise

● From liquidity driven to earnings driven markets

● Valuation opportunities less and less numerous

● Use active management to boost returns

The „new normal‟ has grown old and we‟re entering a new era


THE FRAMEWORK


Faster DM growth

EM exports

EM exchange rate vàv USD

EM inflation

Faster EM growth

Source: BNPP IP DM: developed economies EM: emerging economies


Faster DM growth Gradual US monetary policy normalisation

EM exports


EM inflation

Faster EM growth

EM interest

rates, bond

yields, equity

markets

Required risk

premium

stable

Rise DM yields




EM exports


DM market volatility VIX, MOVE

EM inflation

Faster EM growth

Required risk

premium

up

EM interest

rates, bond

yields, equity

markets

Required risk

premium

stable

Rise DM yields




EM exports


DM market volatility VIX, MOVE

EM inflation

Faster EM growth

Required risk

premium

up

EM interest

rates, bond

yields, equity

markets

Required risk

premium

stable

Rise DM yields



TRADE FLOWS


Significant differences. Degree of openness on average not that high Export structure in % of GDP. Source: IMF, United Nations


Country exposure sees considerable differences Export structure in % of GDP. Source: IMF, United Nations

Source: Consensus Economics forecasts as of 10 Feb 2014

2014 2015

USA 2.9 3

Eurozone 1 1.4

UK 2.7 2.4

Japan 1.6 1.3

China 7.5 7.3

Real GDP growth forecasts in %


Big differences in terms of export composition by sector Source: Uncomtrade database


THE FINAL FRONTIER


Emerging equities trade well below their long term average on a CAPE basis


… and, based on CAPE, emerging equities also look cheap against developed markets

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1999200020012002200320042005200620072008200920102011201220132014

In local currency In US dollars

Emerging/Developed Shiller

Source: Datastream, Shiller, BNPP IP


However, sustained outperformance will require confidence on the outlook for earnings growth vis à vis developed markets

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

07 08 09 10 11 12 13

EM Earnings Growth (YoY) - nominalterms

DM Eanrings Growth (YoY) - nominalterms

Earnings Growth gap improved for EM

Source: Datastream, IBES, BNPP IP


LATAM is slightly more expensive than Asia and EMEA

Country MSCI PB

weight 14E (X) 15E (X) 14E (X) 15E (X) 14E (X) 15E (X) 14E (X)

Brazil 10.0% 12.8 11.3 18.3 12.0 8.5 8.6 2.9

Chile 1.5% 15.9 13.3 16.7 12.7 6.2 7.7 2.0

Colombia 1.1% 12.9 14.5 -2.7 20.3 -2.4 11.7 2.0

Mexico 5.0% 17.3 17.4 10.7 18.0 8.8 11.1 2.9

Peru 0.4% 11.4 9.8 15.3 16.4 10.6 14.4 2.0

ASIA 64.3% 13.6 11.8 12.6 14.9 11.3 11.3 2.4

EMEA 17.5% 12.8 11.8 6.7 8.5 5.9 7.1 2.4

LATAM 18.1% 14.1 13.1 13.8 13.8 7.5 9.4 2.7

GEMS 13.4 12.0 11.3 13.2 9.4 10.0 2.4

US 16.1 14.5 8.2 11.4

EUROPE 14.1 12.6 9.9 11.9

JAPAN 13.4 12.2 8.2 10.2

Source:Deutsche Bank,IBES, Bloomberg

PE EPS Growth Rev Grth


Emerging debt valuation is attractive compared to DM corporate debt of equivalent rating. Spread volatility is also lower

100

300

500

700

900

1100

1300

1500

01/00 02/01 03/02 04/03 05/04 06/05 07/06 08/07 09/08 10/09 11/10 12/11 01/13

EM sovereign vs. US & EU corporate debt

Rating adj. US corp. spread Rating adj. EU corp. spread EMBI spread

in bps

Source: Datastream, Moody’s, Bloomberg, BNPP IP


THIS TIME IS DIFFERENT


The emerging markets fundamentals today look far better than in 1997-98

“This reflects the fundamental reforms these EMEs have put in place over the past 15

years, as well as the hard lessons learned from past periods of market stress. Among

the positives are:

– The absence of the type of fixed exchange rate peg regimes that often were

undermined violently in the past during periods of stress;

– Improved debt service ratios and generally moderate external debt levels;

– Larger foreign exchange reserve liquidity cushions;

– Clearer and more coherent monetary policy frameworks, supporting what are now

generally low to moderate inflation rates;

– Generally improved fiscal discipline;

– Better capitalized banking systems, supported by strengthened regulatory and

supervisory frameworks.”

Source: William Dudley, Remarks at the Roundtable Discussion in Honor of Terrence Checki: Three Decades of Crises: What Have

We Learned?, Federal Reserve Bank of New York, March 2014


MAKING WAVES


“Flow”: the mechanics of Quantitative Easing

Quantity

Price of

risky

assets

Waves of QE

supply demand

Source: BNPP IP

In an integrated world economy,

the price of risky assets can/will

rise globally, albeit to varying

degrees


“Ebb”: tapering and moving from data-contingent forward guidance to qualitative guidance

The success of data-

contingent forward

guidance


US monetary policy normalisation volatility structurally higher

The normalisation of volatility


Risk aversion, global asset prices and Fed tightening signals, Jan Groen & Richard Peck, Liberty Street Economics, Federal Reserve of New York

● The global sell-off last May of emerging market equities and currencies of

countries with high interest rates (“carry-trade” currencies) has been attributed to

changes in the outlook for U.S. monetary policy

● We conjecture that shifts in risk aversion coincide with exceptionally large changes

in implied volatility measures. An “exceptionally large” change in this case is

defined as when overall implied volatility is at least two standard deviations

above or below its mean over the previous sixty days.



“These currencies (carry trade) are those

among the sample of forty-five dollar

exchange rates that have the largest interest

rate differential with one-month U.S. rates.

The non-carry currencies are those with

interest rates that are similar to or lower than

U.S. rates. The carry-trade return is how

much the basket of carry currencies

appreciated relative to non-carry currencies

over a month on a given day. The model

results show that the drop in carry

currencies has been accentuated by the

increase in global risk aversion since

May. Nearly half of the depreciation of

carry currencies relative to non-carry

currencies that occurred between the

May 22 testimonial and early July was

due to increased risk aversion, according

to the model’s estimates



Source: Risk aversion, global asset prices and Fed tightening signals, Jan Groen & Richard Peck, Liberty

Street Economics, Federal Reserve of New York, March 2014

“the next chart …

attributes essentially all

of the percentage

changes in June and

July to increases in

global risk aversion. By

late August, risk-aversion

shocks from May no

longer affected prices

according to the model”

So once investors have

learned to live with

prospect of policy

normalisation, risk of

turmoil and disruption

is lower


PREFERRED HABITAT


“In my view, the fact that our large scale asset purchase

programs affect the size of term risk premia globally is

important.

This set of monetary policies affects financial asset prices in a

different way compared to changes in short-term interest rates,

and we should be humble about what we claim about

understanding the importance of this distinction.”

William Dudley, Remarks at the Roundtable Discussion in Honor of Terrence Checki: Three Decades of Crises: What Have We

Learned?, Federal Reserve Bank of New York, March 2014


Climbing the risk ladder

Risk

Expected

return

Target

return

A B C

Source: BNPP IP

For illustrative purpose

Preferred habitat


A post QE world: a feeling of unease, having climbed the risk ladder

Risk

High « Feeling of

unease »

Increased sensitivity to bad news especially when

valuations and prices have moved up a lot

Expected

return

Target

return

A B C

Preferred habitat

Source: BNPP IP

For illustrative purpose

Low « Feeling of

unease »


On the international spillovers of US Quantitative Easing ECB Working Paper 1557 June 2013, Marcel Fratzscher, Marco Lo Duca and Roland Straub

● QE1 policies during the first phase in 2008-2009 have triggered a substantial

rebalancing in global portfolios, with investors shifting out of EMEs and

other AEs and into US equity and bond funds.

● By contrast, Fed policies during the second phase in 2010 (QE2) induced a

portfolio rebalancing in the opposite direction, pushing capital into EMEs.

● Equally importantly, we find that Fed operations, such as the purchases of

Treasuries and MBS through its two LSAP programs, exerted substantially

larger effects on portfolio decisions and asset prices, than Fed

announcements of these programs.



● In addition, our findings indicate that Fed policies exerted larger effects on asset prices than on

capital flows.

● However, these Fed policy measures have significantly exacerbated the pro-cyclicality of

capital flows to EMEs – raising outflows even further in periods when capital flees EMEs, and

magnifying inflows when these are already large. By contrast, Fed policies have functioned in a

counter-cyclical fashion for investment flows into US equity and bonds funds.

● Finally, we do not find evidence that policy-makers succeeded in insulating their

countries from spillovers of QE policies by limiting exchange rate flexibility or imposing

controls on capital account openness. These policies might have amplified the pro-cyclical

impact of Fed interventions.

● Instead, an important determinant of the sensitivity of capital flows to Fed policy during

the crisis has been the institutional quality of countries, suggesting that the impact of

QE policies are partly linked to pull factors in recipient countries, and specifically to risk

and a flight-to-safety phenomenon.



● The findings of the paper have a number of implications for policy.

● First, some of the results may be interpreted as lending support to concerns expressed by

policymakers in EMEs. In particular, EMEs have been adversely affected by pro-cyclical effects

of QE policies, inducing capital outflows from EMEs when capital is scarce and pushing capital

into EMEs, driving up asset prices and exchange rates, when they already experience high

capital inflows through other sources.

● Yet, the findings also indicate that foreign policy-makers are not innocent bystanders. The

empirical results show that part of the effect of QE policies on foreign economies is related to

risk, and that sound domestic policies and strong domestic institutions help insulate

countries from US monetary policy spillovers. Thus there may indeed be a case both for

domestic policy reforms as well as for more coordination at the global level in order to deal with

policy spillovers and externalities.


THE EXCHANGE RATE


The Behavior of Currencies during Risk-off Episodes Reinout De Bock and Irineu de Carvalho Filho, IMF WP, January 2013

● Right after the onset of the risk-off episode, high yield currencies and those

whose returns have a higher beta with respect to the VIX or the AUDJPY

exchange rate tend to have larger depreciations relative to the U.S. dollar.

● Stronger current account balances and net foreign asset positions are factors

related to smaller risk-off depreciations or larger appreciations.

● Overvaluation in two out of three CGER (= IMF Consultative Group on

Exchange Rates) models is a factor related to larger risk-off depreciations.

● Country-specific factors remain essential in determining currency movements

within a risk-off episode.


The Behavior of Currencies during Risk-off Episodes Reinout De Bock and Irineu de Carvalho Filho, IMF WP, January 2013

● Looking at individual currencies, the Swiss franc and the Japanese yen tend to

appreciate relative to the U.S. dollar during risk-off episodes

● Because most other currencies depreciate relative to the U.S. dollar during

risk-off episodes, the Swiss franc and the Japanese yen appreciate even more

on a trade-weighted basis

● On the other hand, a wide range of currencies, including those of

Australia, Brazil, Canada, Chile, Colombia, India, Indonesia, Korea,

Malaysia, Mexico, New Zealand, Peru, Philippines, Singapore, South

Africa, Sweden, Turkey, Ukraine, and United Kingdom, tend to depreciate

during risk-off episodes, for at least some horizon window.

This provides guidance for investors (“where to hunt, what to avoid?”) and policy

makers (what to do to improve the domestic fundamentals?)


DOMESTIC FUNDAMENTALS AND POLICY REACTION


How Sovereign Is Sovereign Credit Risk? Francis A. Longstaff, Jun Pan, Lasse H. Pedersen, Kenneth J. Singleton, American Economic Journal, April, 2011

● We study the nature of sovereign credit risk using credit default swap data for an extensive

cross-section of developed and emerging-market countries.

● We show that sovereign credit risk tends to be much more correlated across countries than are

equity index returns for the same countries.

● Our results suggest that the source of these higher correlations is the dependence of

sovereign credit spreads on a common set of global market factors, risk premiums, and

liquidity patterns.

● Specifically, we find that the sovereign spreads are driven primarily by US equity and high-

yield factors. Also, sovereign spreads are significantly related to the volatility risk

premium embedded in the VIX index.



● Turning now to the principal components analysis … for the 2000–2010 sample period …The

results show that there is strong commonality in the behavior of sovereign CDS spreads.

In particular, the first PC explains 64 percent of the variation in sovereign CDS spreads during

the entire sample period.

● To explore further the interpretation of the first PC, we compute a time series for the first PC.

The correlation of this first PC index with US stock market returns is −74 percent, and the

correlation with changes in the VIX index is 61 percent. The correlation between stock market

returns and changes in the VIX index is −75 percent. Thus, the principal source of variation

across almost all sovereign credit spreads appears to be very highly correlated with the

US market as measured by US stock market returns or by US equity market volatility.



● Finally, there are strong interrelationships between sovereign credit spreads even after

including the local economic, and global financial market, risk premium, and

investment-flow variables in the regression. The coefficient for the regional credit spread is

significant for 16 of the countries. Of these significant coefficients, 14 are positive in sign.

Similarly, the coefficient for the global credit spread is significant for 18 of the countries, and 15

of these significant coefficients are positive in sign.

● These results are consistent with the presence of regional or global factors that affect all

sovereign credit spreads, but are not captured by the other explanatory variables.


Modelling the time varying determinants of portfolio flows to emerging markets ECB working paper 1468, September 2012, Marco Lo Duca

● The analysis shows that the regression coefficients display substantial time

variation.

● Major changes in the importance of the drivers of the flows coincide with

important market events/shocks.

● Overall, investors pay more attention to regional developments in

emerging markets in periods when market tensions are elevated.

● However, extreme tensions generate panics, i.e. periods when changes in

uncertainty and risk aversion drive flows, while regional developments

play only a marginal role.


The risk of negative feedback loops

● At some point over the next few years, central banks in the advanced economies will both increase short-

term interest rates and reduce their holdings of government and other bonds. How this policy shift will

unfold is not known, and uncertainty about the policy path could unsettle global bond markets.

● Downward pressures on some EM currencies could be accentuated, increasing the local currency cost of

servicing dollar debt. Higher long-term rates, currency depreciation and more volatile markets could make

even more difficult the choices that EM central banks face on their policy rate, on the exchange rate, on

the long-term interest rate and on the best use of their balance sheet.

● The present paper argues that a large rise in borrowing by EM non-financial corporations on

international capital markets over the past three to four years has also indirectly eased local bank

lending conditions for other borrowers at home. This link merits close attention.

Source: BIS Working Papers No 441 The global long-term interest rate, financial risks and policy choices in EMEs

by Philip Turner February 2014


The risk of negative feedback loops

● As they have borrowed more, EME corporations have also acquired assets on a large scale. The value of

assets of EM corporations is often harder to measure than liabilities, and off-balance-sheet exposures

escape detection.

● Issuance by EM non-bank corporations on such a scale, and a possible “stop” at some point in the future,

could affect the domestic banking systems in EMEs through at least three channels:

– EM corporations have typically borrowed from local banks. When extremely easy external financing

conditions allow such firms to borrow cheaply from abroad, local banks have to look for other customers – so that

domestic lending conditions facing most local borrowers actually ease more than the expansion in total domestic

bank credit aggregates suggest. A tightening in external financing conditions would reverse this … small firms

might then find it harder to get finance even if total domestic bank credit continues to rise.

– wholesale funding markets for banks. When EM corporations are awash with cash thanks to easy external

financing conditions, they will increase their wholesale deposits with local banks. This is also reversible.

– hedging of their forex or maturity exposures, often via derivative contracts with local banks. Even if the local

banks hedge their forex exposures with banks overseas, they still face the risk that local corporations will not be

able to meet their side of the contract.

Source: BIS Working Papers No 441 The global long-term interest rate, financial risks and policy choices in EMEs

by Philip Turner February 2014


Sudden stops and early warning signals

● “First, the early indicators used to detect crises ahead of time seem to perform relatively well if the

purpose is to predict crises in a given time window; however, they are much less efficient in predicting the

exact starting date of the crisis.

● Overall, the main economic variables that are found to predict crises are the ratio of short-term

debt to international reserves, the growth rate of credit to the private sector, the over-appreciation

of the nominal effective exchange rate (with respect to trend) and contagion from other countries.

● Different indicators signal crises at different lags, some being very short-term (e.g. the short-term debt to

reserves ratio or financial contagion), others with a longer lag (e.g. the lending boom variable or the

degree of exchange rate over-appreciation). This suggests that when a country faces liquidity

problems or financial contagion from crises in other emerging markets, policy reaction must be

particularly quick (a few months at most).

Source: ECB Working Paper 713, January 2007, Balance of payment crises in emerging markets – how early were the „early‟

warning signals?, Matthieu Bussière


CONCLUSION AND LESSONS LEARNED


Lessons learned

1. Risk aversion, global asset prices and Fed tightening signals

– Once investors have learned to live with prospect of policy normalisation, risk of turmoil and disruption is lower

2. On the international spillovers of US Quantitative Easing

– Sound domestic policies and strong domestic institutions help insulate countries from US monetary policy

spillovers

3. The Behavior of Currencies during Risk-off Episodes

– Country-specific factors remain essential in determining currency movements

4. How Sovereign Is Sovereign Credit Risk?

– Sovereign spreads driven primarily by US equity, high-yield and VIX

5. Time varying determinants of portfolio flows

– When tension is elevated, regional drivers become more important, but extreme tensions generate panics

6. The risk of negative feedback loops

– Need for clarity on corporate FX mismatch and impact on domestic banking system

7. Sudden stops and early warning signals

– Role of debt build-up, credit growth, currency overvaluation, contagion


The transition process triggered by US monetary policy normalisation appears inherently unstable

● Positive impact on trade balance

● Attractive valuation of emerging equities, bonds and currencies

But

● Will the Fed end up being behind the curve?

● Quality of Fed communication?

● How much will US rates and yields increase?

● Will there be a flight back towards the preferred habitat?

● Need to conduct sound domestic economic policies


You can‟t stop the waves, but you can influence how they impact you


Blog ● NL http://williamdevijlder.bnpparibas-ip.com/nederlands

● EN http://williamdevijlder.bnpparibas-ip.com/english

● FR http://williamdevijlder.bnpparibas-ip.com/francais

Twitter ● Follow William De Vijlder onTwitter: @DeVijlder

Recent videos (access via blog) ● The seven drivers of the Great Rotation

● Why the price of gold concerns everybody

● What are the limits to quantitative easing?

● Increasing monetary policy divergence creates opportunities

● Will US treasury yields reach 4% by the end of 2014?

● How does disinflation impact the market outlook?

● Let me be your guide - Is forward guidance making investing more easy?

● What makes the US dollar attractive in 2014?

● When inflation expectations become unanchored it will be too late

http://williamdevijlder.bnpparibas-ip.com/nederlands



http://williamdevijlder.bnpparibas-ip.com/english



http://williamdevijlder.bnpparibas-ip.com/francais



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The recovery in developed economies: a mixed blessing for ......The framework Trade flows The final frontier This time is different Making waves ... Valuation opportunities less and

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