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Please see important disclaimer and disclosures at the end of the document
EMERGING MARKETS28 November 2013
Important Notice: The circumstances in which this publication has been produced are such that it is not appropriate to characterise it as independentinvestment research as referred to in MiFID and that it should be treated as a marketing communication even if it contains a research recommendation.This publication is also not subject to any prohibition on dealing ahead of the dissemination of investment research. However, SG is required to havepolicies to manage the conflicts which may arise in the production of its research, including preventing dealing ahead of investment research.
OutlookGEM in 2014: Doom and Bloom
Many investors talk about EM in terms of doom and gloom for next year. We oppose this view
and instead propose our Doom and Bloom. We believe that after a short-livedalbeit potentially
severecorrection around the beginning of Fed tapering projected for March, GEM will burgeon
forth in a strong spring rally that will extend until later in the year. Part of that will reflect the impact
of the considerably more dovish forward guidance that we anticipate from the Fed. But it will also
be driven by attractive GEM valuations and improving growth fundamentals. However, GEM
investors will have to be more discerning next year, as differentiation between both asset classes
and regions will be a major consideration. To help investors differentiate between markets, we
produce an analysis of macro vulnerability across EM , as well as an assessment of EM authorities
policy room. We also guide EM investors in navigating the heavy political calendar next year.
Downgrading our short-term call: We turn neutral on GEM for the coming weeks. EM growth picking up: EM growth should gather pace early next year, helped by the USeconomy driving the global recovery.
EM vulnerability ranking: Ukraine, Venezuela and South Africa appear to be the mostvulnerable while China, the Philippines, and Peru are the least.
Policy room in EM: There is significant differentiation across EM in terms of policy room. Peru,Korea and Chile have the most, while India, the Czech Republic and Venezuela have the least.
EM FX: LatAm will outperform its peers, and EMEA will underperform. Our top picks are theliquidity currencies from late April onwards, including the IDR, the INR, the ZAR and the MXN.
EM local debt: We favour EMEA debt in the risk-on phase, especially Hungary and Poland. InLatAm, our top pick is Mexico.
EM credit: The Philippines, Chile, Poland, Colombia and Peru should be fairly resilient againstthe downside in Q1; high beta names from EMEA should outperform in the rally.
EM politics: We see a negative balance of risks for policies in Brazil, but a positive one inHungary, India and in Indonesia.
EM still growing faster than DM in coming years (GDP, ) Expected spot returns by region, by quarter
Source: SG Cross Asset Research/EM
3.8
2.3
-6
-4
-2
0
2
4
6
8
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
EM
DM-5
-4
-3
-2
-1
0
1
2
3
Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014
EMEA LatAm Asia
Global EM FX performance, %
Head of Emerging Markets StrategyBenot Anne(44) 20 7676 7622
benoit.anne@sgcib.com
Rgis Chatellier(44) 20 7676 7354
regis.chatellier@sgcib.com
Phoenix Kalen(44) 20 7676 7305
phoenix.kalen@sgcib.com
Eamon Aghdasi(1) 212 278 7939
eamon.aghdasi@sgcib.com
Amit Agrawal(91) 80 6758 4096
amit.agrawal@sgcib.com
CONTENTSDoom and Bloom................................... 2
EM Growth Showing Signs of
Recovery............................................... 13
Differentiated Vulnerability Risks..........15
The Haves and The Have Nots: An
Assessment of Policy Room in EM......18
EM Sovereign Credit: The Pain Before the
Gain.......................................................24
How to Trade EM Politics in 2014........28
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GEM in 2014: Doom and Bloom
The global risk backdrop for GEM: a tough start to the year,followed by some major relief
We expect the global risk environment to be challenging for GEM over the next few
months, with EM investors remaining concerned about the threat of Fed tapering.SGs
official call is for the Feds QE tapering to be initiated in March. Against this backdrop, we
choose to turn neutral on GEM from now on up to February. Overall, we have been
frustrated by the lack of appetite on the part of EM investors to put cash to work over the past
few weeks, and we now think that the chance of a strong rally in December is relatively slim,
especially given the seasonality that is turning negative reflecting the year-end portfolio
squaring. Moving on to February, the market nervousness will likely intensify as the decision
over QE tapering will be looming, ahead of the much-awaited March Fed meeting (19 March).
The renewed fear of QE tapering will likely trigger another round of correction in GEM.
As highlighted recently, the fear of QE tapering remains the primary risk factor for global
emerging market investors. Our informal survey conducted in late October showed that the
Fed fear was mentioned as the key reason for the GEMs disappointing performance by 33%
of the participants, followed by concerns over EM fundamentals. This overall means that we
stand ready to turn outright bearish on GEM by February, expecting local rates to sell off, EM
currencies to weaken, local curves to steepen, and credit spreads to widen.
The key reason behind the GEMs disappointing performance what EM investors are saying
Notes: based on a survey of 78 accounts.
Source: SG Cross Asset Research
At that time, it will make sense to favour defensive EM currencies relative to riskier ones, while
favouring rates payers and curve steepeners in EM fixed income. Our carry-to-vol indicator for
EM FX gives an excellent overview of which particular currencies produce the strongest
defensive characteristics. The TWD, CZK, SGD or ILS are the lowest beta in EM, and are
therefore likely to outperform their peers during the sell-off. In contrast, the yield-yielders,
especially those that are supported by poor fundamentals, are likely to come under significant
pressure. These include the INR, the TRY, the BRL, the ZAR and the HUF. During the phase ofcorrection starting in February, we anticipate that the so-called growth currenciesthose
that are leveraged to global growth expectationswill outperform the liquidity currencies,
0
5
10
15
20
25
30
35
Fed fear fundamentals outflows valuation positioning China seasonality
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which tend to be more sensitive to risk aversion shocks, but this will be predicated on EM
growth continuing to show signs of recovery (see full classification below).
Fair value of EM rates based on the volatility Carry-to-vol. rankings for EM currencies
Source: SG Cross Asset Research/Cross-Asset Quant team Note: PLN, CZK, HUF, RON and RUB are computed vs EUR, the others vs USD. Rates refers to the
rates differential as implied from 3M forward, annualized; Vol to the 3M implied volatility; Fair value
to the model-value of the regression of aforementioned rates vs vols for different currency pairs.
EM currencies: a simple classification
Growth currencies Liquidity currencies Safe-haven currencies
RUB
CLP
KRW
PHP
MYR
THB
COP
ZAR*
TRY
HUF
PLN
BRL
MXN
INR
IDR
RON
ZAR*
TWD
CZK
SGD
ILS
CNY
Notes: *The ZAR is a hybrid currency, sitting in both categories. Source: SG Cross Asset Research
Calling for a major GEM rally in the spring
The QE-related correction may be severe, but we also believe that it will be short-lived.
By late April, we expect to stand ready to turn bullish on GEM, as global investors will have
fully priced in the completion of QE tapering. This process will pave the way for a major rally in
GEM, in our view, supported by the Feds strengthening of forward guidance and a much
more dovish bias expressed through the lowering of the unemployment threshold. We believe
that GEM will return to goldilocks market conditions given that the prospect of a future Fed
rate hike will be quite far away. Meanwhile, we would argue that EM valuations will beattractive, reflecting the impact of the February-April correction. This will involve a radical
change of strategy approach, of course, focusing on going long high beta EM FX, buying EM
bonds, positioning for flatter EM curves, and going long high beta credit.
PLN
CZK
HUF
TRY
ZAR
ILS
TWD
KRW
INR
IDR
SGD
MXN
BRL
CLP
RON
RUB
y = 0.5273x
-4
-2
0
2
4
6
8
10
12
3 8 13
Yearlyrate(%)
Volatility (%)
Vols (%) Rates (%) Fair value CTV Rank
INR 11.7 10.5 6.2 0.9 1
RUB 7.7 6.3 4.0 0.8 2
TRY 9.6 7.5 5.1 0.8 3
BRL 12.9 8.9 6.8 0.7 4
IDR 14.3 9.2 7.5 0.6 5
CLP 9.8 4.5 5.1 0.5 6
ZAR 13.2 5.7 6.9 0.4 7
PLN 6.2 2.4 3.3 0.4 8
HUF 7.3 2.3 3.8 0.3 9
KRW 6.8 2.1 3.6 0.3 10
RON 6.5 1.9 3.4 0.3 11
MXN 10.6 3.0 5.6 0.3 12
ILS 6.5 0.6 3.4 0.1 13
SGD 4.6 0.0 2.4 0.0 14
CZK 4.4 -0.4 2.3 -0.1 15
TWD 3.4 -1.9 1.8 -0.6 16
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The past episodes of sharp UST curve steepening (2s10s)
Source: SG Cross Asset Research/EM
The impact of UST 2s10s steepening on selected EM assets: a look at the recent history
UST
2s10s
(bp)
MXN
(%)
ZAR
(%)
TRY
(%)
10y
MXN
(bp)
10yr
SAF
(bp)
10yr
Turkey
(bp)
Sept. 2007/Jan.2008 110 1.87 -2.36 10.41 -13 8 -13
Sept./Oct. 2008 102 -20.13 -13.15 -16.39 54 -31 13
March/May 2009 104 5.06 17.91 7.73 10 20 -20
Aug. 2010/Feb. 2011 93 9.04 0.86 -3.92 123 115 -2
Average 102 -1.06 0.82 -0.54 44 28 -5
Source: SG Cross Asset Research/EM; Bloomberg
The key lesson that we are drawing from this look back at history is that what matters to
EM investors is not the UST curve move itself, but rather the key driver behind it.To be
precise, what we are facing next year is a UST correction not triggered by the fear of Fed
tightening, but rather by a much stronger growth performance in the US in the absence of
imminent tightening threat. Under this scenario, the risk appetite backdrop will not be dented,
and we would even argue that this could turn out to produce a risk-positive signal. We
recognise that higher US rates render EM rates less attractive on a relative value basis, but
this does not negate the risk-positive environment. It is also important to note that the front-
end rates in the US will be well anchoredhelped by a strongly dovish forward guidance,
which means that the USD will not necessarily gain strong support relative to its G10 peers.
Ultimately, higher US rates are supposed to signify that growth and macro conditions are
improving globally, which should be supportive of EM FX appreciation and narrowing EM risk
premia. The summer sell-off was completely different in nature than all the other ones we have
-50
0
50
100
150
200
250
300
350
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
bp
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seen in recent years. USD-EM was negatively correlated with UST yields, but recently this
correlation has reversed.
Historical correlation between EM FX and UST: this summer was different
Source: SG Cross Asset Research/EM
Our outlook for capital flows to EM is fairly constructive
There is no denying that 2013 has been a pretty poor year for capital flows into EM. In fact,the short-term dynamics still show that outflows are ongoing, especially in EM fixed income,
where EM funds continue to register large exits week after week. Against this backdrop, we
believe that 2014 will show signs of stabilization, albeit from a lower base. The risk of further
outflows will remain present in the first few months of the new year but we expect some
upturn later on. It is interesting to note that the Institute of International Finance (IIF) does not
foresee a major decline in capital flows to EM for 2014 in its latest forecast. While the IIF
forecasts capital flows to drop significantly during the 3r quarter of 2013for which final
aggregated data are not yet availablethe path of inflows improves afterwards, with a marked
pick-up in the latter part of 2014. On an annual basis, the IIF actually forecasts a moderate
increase in total flows to EMboth private and officialin 2014 as a whole over 2013.
EM bond fund flows - cumulative EM equity fund flows - cumulative
Source: SG Cross Asset Research/EM; EPFR
-1.
-0.
0.
0.
1.
1.
0.95
1.00
1.05
1.10
1.15
1.20
1.25
1.30
'09 '10 '11 '12 '13
EM FX index vs USD (GDP-weighted, Jan'01 = 1)
Correlation, EM FX with UST 10y yield (180d)
60,000
65,000
70,000
75,000
80,000
85,000
90,000
95,000
100,000
105,000
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
140,000
150,000
160,000
170,000
180,000
190,000
200,000
210,000
Dec-12
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
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Total capital flows to EM gradually recover next year according to the IIF
Source: SG Cross Asset Research/EM; The Institute of International Finance
An uninspiring year ahead for GEM FX as a whole
Our market-size weighted index for global EM FX shows very modest appreciationless
than 1%from now to end-2014. Using a quarterly profile for FX forecasts, we expect the
trough to be registered in Q1, reflecting our top-down call on risk, followed by a risk-on phase.
This however masks some significant differentiation between the various types of currencies,
as discussed earlier, and between regions.
Global EM FX trajectory
Notes: based on our FX-market size-weighted global EM FX index. The market size weights are derived from the BIS (average daily turnover data).
Our Global EM FX index is expressed against the USD.
Source: SG Cross Asset Research/EM
LatAm FX will outperform its peers next year
We project LatAm FX to appreciate as a whole by 2.8% from now until end-2014, thereby
beating the other two regions by a large margin. This outperformance is driven by our
bullish view on the MXN, our top pick in the region. The strengthening fundamentals in
Mexico, together with the completion of key reforms should help the MXN appreciate all the
way to 12.25 by December 2014, in our view. Meanwhile, the BRL will remain a drag on the
regions performance, with macro risks still weighing on Brazil in the period ahead.
-200
-100
0
100
200
300
400
20
07Q1
20
07Q2
20
07Q3
20
07Q4
20
08Q1
20
08Q2
20
08Q3
20
08Q4
20
09Q1
20
09Q2
20
09Q3
20
09Q4
20
10Q1
20
10Q2
20
10Q3
20
10Q4
20
11Q1
20
11Q2
20
11Q3
20
11Q4
20
12Q1
20
12Q2
20
12Q3
20
12Q4
20
13Q1
201
3Q2e
2013Q3f
2013Q4f
2014Q1f
2014Q2f
2014Q3f
2014Q4f
USDbn
91
93
95
97
99
101
103
Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14
actual fcsts
Jan 2007 = 100
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In contrast to LatAm, EMEA will be the underperformer in the year ahead. There are two
main factors that will undermine EMEA FX performance. First, our in-house bearish view on
the EUR means that CEE FX is set to fare poorly against the USD, even though we would be
positive on CEE FX against the EUR. On top of that, we retain a bearish view on the RUB,
mainly reflecting adverse domestic factors.
Expected spot returns by region for the period up-to Dec. 2014 Our CEE FX forecasted spot moves up to December 2014
Notes: based on our FX-market size-weighted global EM FX index. The weights are derived from
the BIS (average daily turnover data). Our Global EM FX index is expressed vs. USD.
Source: SG Cross Asset Research/EM
Source: SG Cross Asset Research/EM
Within Central Europe, we are the most bullish on the PLN, as the macro fundamentals
improve throughout the period and the National Bank of Poland ultimately engages in some
policy normalisation in the latter part of next year. At the same time, we are only modestly
bullish on the HUF, as we think that excessive monetary policy easing may undermine the
attractiveness of HUF assets.
Our EM FX forecasts by region Expected spot returns by region, by quarter
Notes: based on our FX-market size-weighted global EM FX index, with the base 100 set for 25
Nov. 2013. The market size weights are derived from the BIS (average daily turnover data). Our
Global EM FX index is expressed against the USD.
Source: SG Cross Asset Research/EM
Source: SG Cross Asset Research/EM
The seasonality of EM FX performance will be a key factor
We expect the strongest quarter to be Q2 in terms of EM FX performance, as the risk-on
signals start flashing by late April, once EM investors come to the realisation that QE tapering
is now fully in the price. This will follow a first quarter that will likely produce negative returns
for EM FX across all regions.
-3%
-2%
-1%
0%
1%
2%
3%
4%
EMEA Asia LatAm 0.00
0.50
1.00
1.50
2.00
2.50
3.00
HUF RON CZK PLN
%
95
96
97
98
99
100
101
102
103
104
105
Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14
EMEALatAm
Asia
Inde x (25 Nov 2013 = 100) forecasts
-5
-4
-3
-2
-1
0
1
2
3
Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014
EMEA LatAm Asia
Global EM FX performance, %
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Risk off, risk on in GEM local debt
We stand ready to turn bullish on EM local debt from April onwards, but only after a phase of
correction associated with the initiation of QE tapering by the Fed. Once the risk backdropimproves, we believe that EM investors will be drawn back into EM fixed income, owing to its
attractive valuation. Valuations in a number of EM local debt market are indeed quite
attractive, in our view.
Real 10yr local bond yields in Poland Real 10yr local bond yields in Hungary
Notes: estimated as nominal 10yr yields minus inflation (using daily
interpolation)
Source: SG Cross Asset Research/EM
However you look at it, there is significant value in EM rates
We adopt a multi-pronged approach to EM rates valuation but the conclusion is that some
markets are quite attractive at current levels. This means that EM debt valuation should
actually improve further after the early-2014 correction if our scenario materialises. A number
of local debt markets are still quite attractive when measured in terms of 10yr bond yields
adjusted for inflation. In that category, Colombia, Hungary, Brazil, and Poland come out as the
most attractive markets, while Taiwan, Turkey and the Czech Republic do not feature well. It is
interesting to note that Turkey, while being a nominal high-yielding market, does not produce
a high real rate, suggesting that investors are currently not appropriately compensated for the
macro risks. Looking at the nominal spreads over UST, the most attractive local markets at
this point include Brazil, Turkey and South Africa, but we attach less significance to this
valuation approach, given the problem with domestic fundamentals.
Real 15yr local bond yields in South Africa Real 10yr swap rates in Mexico
Notes: estimated as nominal 10yr yields minus inflation (using daily
interpolation)
Source: SG Cross Asset Research/EM
In EMEA, our top picks are Hungary, Poland and, to a lesser extent, Russia for the year
ahead.In Hungary, it will be important to wait until after the elections scheduled in the spring.
One important consideration in favour of Hungary is the high real rate, together with the policy
0
1
2
3
4
5
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
10yr yield - CPI yoy inflation
-4
-2
0
2
4
6
8
10
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
10yr yield - CPI yoy inflation
-4
-2
0
2
4
6
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
0
1
2
3
4
5
6
7
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
10yr swap - CPI yoy inflation
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supportive environment. In Russia, we believe that the domestic fundamentals remain
supportive of exposure to fixed income, and positioning is rather light, especially after the
recent outflows. From an historical perspective, it is interesting to note that the real yields
are trading at attractive levels both in Hungary and Poland.
In LatAm, our top pick in EM rates is Mexico, by default.We still want to stay away from
Brazil, given the uncertainty surrounding the policy framework and the macro environment,
though there could be value in the front-end of the curve if the Copom decides not to meet the
market's hawkish expectations. Meanwhile, we are bullish on Mexico from a top-down
perspective, and believe that the country is well positioned to take advantage of next years
spring rally.
There is value in EM bonds: 10y bond yields minus current inflation
Notes: Based on Bloomberg generic 10y quotes.
Source: SG Cross Asset Research/EM
Value in EM bonds: 10y local bond yields minus current USTyields EM ratescarry in the front end: 1y1y fwd over 1y rates
Notes: Based on Bloomberg generic 10y quotes.
Source: SG Cross Asset Research/EM
EM curves to steepen first, and flatten from the spring onward, in a correlation break
with UST dynamics. From April onwards, we anticipate that EM curves will flatten, reflectingthe favourable risk environment, despite the pressure coming from the UST steepening. This
means that compression trades, namely EM receivers against US payers, will be particularly
0
1
2
3
4
5
6
Taiwan
T
urkey
Czech
Rep.
China
R
ussia
Israel
S.Africa
M
exico
K
orea
Rom
ania
Chile
Poland
Brazil
Hungary
Colo
mbia
%
-2
0
2
4
6
8
10
Taiwan
CzechRep.
Israel
Korea
Poland
China
Chile
Romania
Hungary
Mexico
Colombia
Russia
S.Africa
Turkey
Brazil
%
0
20
40
60
80
100
120
140
Chile
Russia
Hungary
CzechRep.
Korea
Israel
Turkey
Mexico
Poland
Brazil
S.Africa
bp
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attractive, in our view. One obvious candidate for this type of strategy is Mexico, where we
think investors will come back in force to gain exposure to the local bond market.
EM Sovereign Credit: The Pain before the Gain
The debate on the timing and the extent of the Tapering is likely to drive the EM credit market,
once again. In line with our global view, we think that EM hard currency-denominated bonds
will be affected by a risk-off environment which should materialise in February 2014. However,
we believe that the sell-off will be more contained than that of last summer (at least in relative
terms), essentially due to the ongoing improvement in fundamentals and the fact that spreads
are factoring in a much higher probability that tapering measures will be implemented. At the
peak of the sell-off (April), we see the EM spread index widening to 370bp.
EM Sovereign spread index forecast (bp)
Source: SG Cross Asset Research
Favouring the low-beta names, for now. As the EM credit market is likely to be under
pressure during the four to five months of next year, the high beta names may underperform
over the period. This should be particularly the case for Venezuela, Serbia, Croatia, Indonesia,
South Africa and, to a minor degree, Turkey. In the low beta space, we believe that Brazil is
also likely to underperform the index due to deteriorating fundamentals. The strong low beta
credits should be fairly resilient to the downside, especially the Philippines, Chile, Poland,
Colombia and Peru.
During the phase of rally (May/December 2014), high beta names should logically
outperform the index, including Ukraine, Serbia, Hungary and Croatia. We also see
Indonesian and Turkish dollar bonds performing well in such scenario. Although Venezuelan
assets should remain under pressure due to the sharp deterioration of the economic situation,
the very high carry should partially protect the absolute return.
In terms of positioning, we favour short duration exposures during the first part of the
year, the steepness of the curves remaining very directional. More specifically in the high beta
space, we favour the short end of Ukraine as the curve is likely to des-invert, we believe. In
Venezuela, we favour low-dollar priced bonds, overall, and would move away from the belly to
favour the wings for the curve. In Hungary, short-dated assets should also perform relativelywell. Lastly regarding Brazil, we tend to favour short- to mid-dated bonds over the long end,
as we expect the credit curve to bear-steepen.
200
250
300
350
400
Jan-13 M ar-13 May-13 Jul-13 Sep-13 Nov-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14
Historical Spread
Forecast
Upper and Lower Range
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EM remaining strongly anchored in the IG category. Over the course of next year, we
expect several important rating actions, including the downgrade of India, Brazil, Venezuela
and South Africa, while the Philippines, Colombia, Mexico (S&P) and Peru should be
upgraded. Overall, the EM asset class should benefit from a slight upgrade from, and remain
strongly anchored in the BBB- category.
An asset allocation view of Global Emerging Markets: Some
differentiation between asset classes and regions
Given the high market significance of US rates, hard-currency debt appears to be the
safest EM asset class. Both the local currency debt and EM FX tend to be more vulnerable
to swings in investor sentiment. Meanwhile, EM equities are usually high-risk but they may
continue to be well supported if we continue to see signs of strengthening EM growth. In our
latest EM investor survey, EM investors signalled that EM Equities were the preferred asset
class for both RM and HF investors, followed by external debt (EXD) and local debt (LCD).Meanwhile, EMFX was the least preferred asset class in November, reflecting the poor score
registered for real-money investors.
EM Asset preference: Equities the preferred asset class amongst EM investors
Notes: from our November EM investor survey Bullish sentiment signal, but EM investors dont want to invest, 21 November 2013.
Source: SG Cross Asset Research
We will favour defensive strategies in the first few months of the year. This means that
investors that have some EM asset allocation flexibility should prefer EM hard-currency
creditwith a strong focus on the low-beta creditsover FX and rates. In local fixed income,
we will focus on shorter duration and more defensive rates markets, such as Israel, the Czech
Republic or Chile. In principle, payer positions in some of the higher-beta markets would make
sense, although timing and valuation will be two key considerations. In EM FX, we will favour
the safe-haven currencies, followed by the growth currencies, while the liquidity currencies will
outperform. Relative value strategies with a defensive bias will also be appropriate.
Adding the regional exposure, we would initially favour exposure to Asia FX, given the
high proportion of low-beta growth safe-haven currencies in the region. Once the spring
rally kicks off, our favourite asset class will be EMEA fixed income, reflecting the attractive
valuation of both FX and rates in the region. In hard-currency debt, we stand ready to build up
exposure to high beta names.
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-4
-3
-2
-1
0
1
2
3
4
5
EXD EMFX LCD EM Equities
Investors asset preference (HF+RM)
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EM Growth Showing Signs of Recovery
EM growth prospects remain attractive
EM growth is picking up.Between Q2 and Q3 2013, the majority of EM countries have seen
a jump in their economic activity with the notable exception of Israel, Lithuania and Peru.
The rebound is particularly tangible in Eastern Europe, more specifically in Serbia, Romania,
Hungary and Poland (see table of growth momentum below). This comes as a confirmation of
Q2 data, which were already flagging some improvement relative to Q1 (seeEM Weekly: EM
Growth is Back,4 October 2013). Note that GDP growth numbers are not available yet for
Turkey and Brazil, but judging by the change in industrial production (+2.2% in Q3 vs. Q2 for
Turkey, and +1% for Brazil), the momentum seems to be also positive in these two countries.
On aggregate, we estimate that EM growth went from 4.5% to 4.7% y/y between Q1 and Q2
2013, and reached 4.9% in Q3.Excluding China, EM growth was 3.1% in Q3, up from 3.0% in
Q2.
EM Growth momentum: Changes in real GDP from Q2 to Q3 2013*
Source: SG Cross Asset Research * Q2 vs. Q1 2013 for Brazil, Colombia, India, Philippines and Turkey
The positive move can also be perceived through PMI numbers, the latter showing a
continuous improvement in the EM economic environment since July (see graph next page).
Based on IMF forecasts, EM growth should gather pace early next year, the US economy
driving the global recovery. China should continue to play an important role in that respect;
our economic team see the Chinese economy to decelerate a bit next year, but the country
should still grow at a sustained pace (7.4% y/y expected in 2014, vs. 7.6% for 2013).
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
SERB
ROM
TURK*
COL*
BRZ*
HUN
POL
KOR
CHILE
MAL
CHINA
RUS
THAI
UKR
PHI*
INDO
CZH
MEX
INDIA*
SOAF
PER
LITH
ISR
Changein
GDPgrowth(%)
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PMI on the rise since JulyGDP-weighted average EM PMI
EM growing faster than DM in coming yearsEM and DM growth, GDP weighted (excl. China)
Source: SG Cross Asset Research/EM Source: SG Cross Asset Research, based on IMF data
EM should continue to grow faster than developed economies. Growth in Asia should
outpace that of other regions in the coming years. In Latin America, the Andean countries
(Peru, Chile and Colombia) should continue to show strong economic performance (in part
due to the high volumes of exports to Asia), while growth in Mexico and Brazil is likely to
remain more modest. Turkey stands out as the leading country in terms of growth
performance in the EMEA region.
2014 real GDP growth forecast ( , y/y)
Source: IMF WEO
Overall, EM countries are expected to grow well above developed markets: based on IMF
forecasts, EM aggregate growth should be around 4.6% in 2013, rising to 4.9% in 2014 and
reach 5.1% in 2015 (excluding China, EM growth should be 2.7% in 2013, 3.3% in 2014 and
3.8%, which is still substantially above DM).
Expected GDP growth for Emerging and Developed MarketsPercentage, based on IMF data
2012 2013 (F) 2014 (F) 2015 (F)Emerging Markets 4.8 4.6 4.9 5.1
EM ex China 3.0 2.7 3.3 3.8
Developed Markets 1.5 1.1 1.9 2.3
Source: IMF WEO, SG Cross Asset Research
49.0
49.5
50.0
50.5
51.0
51.5
52.0
52.5
53.0
Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13
3.8
2.3
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
EM DM
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
PHI
PER
INDO
THAI
INDIA
MAL
CHILE
COL
KOR
TURK
LTU
ISR
RUS
MEX
SOAF
BRZ
POL
ROM
VEN
UKR
CRO
CZE
HUN
ExpectedGDPgrowth(%)
Asia
Latam
EMEA
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Differentiated Vulnerability Risks
Indebtedness in EM is considerably lower than in developed markets.Following the sell-
off of last summer, crossover investors have become worried about EM fundamentals, the
latter being considered as vulnerable to global liquidity conditions. At the initial stage of the
sell-off, investors made very little differentiation among EM, all countries being adversely
affected in relatively similar proportions. As far as we are concerned, we argue that the
fundamental backdrop in EM is relatively sound (especially compared to DM) and that a great
deal of differentiation must be operated, EM countries showing very different level of
vulnerability to external shocks.
Higher growth...As a starting point, we would say that EM fundamentals remain attractive,
especially versus developed markets. As mentioned earlier, the economic growth in EM is
likely to stay much higher than in DM: based on IMF forecasts, EM GDP growth should be
around 5% on average in the next two years (+3% ex China), well above the 2.1% average
expected for DM countries.
... and less debt.Moreover, the level of indebtedness in EM is still considerably less than in
DM: in fact, we calculate that the average public debt to GDP is 44% in EM, which is nearly
twice as less than in DM. As far as the level of external debt is concerned, it has remained
quite stable in the last ten years at around 50% of GDP for EM, when it has jumped from
120% to 170% over the same period see graphs below.
Half the Public Debt of DMPublic Debt/GDP for EM and DM countries (%)
One third the external debt* of DMExternal Debt/GDP for EM and DM countries (%)
Source: World Bank, SG Cross Asset Research/EM Source: World Bank, SG Cross Asset Research *Defined as the public
and private debt held by non-domestic investors
Foreign direct investments covering current account deficits.Many have argued that the
majority of EM countries are showing current accounts deficits, and this has become the main
weakness for the asset class. Indeed, EM countries show an average C/A deficit of 1.2% of
GDP, in sharp contrast with the average surplus of 1.9% for DM. But we would highlight two
points in that respect: 1.) A current account deficit of 1.2% is still a manageable level in our
view, especially considering that most of the external deficits are funded via FDI (which by
nature are less volatile than portfolio investments), and 2.) EM countries have built a
considerable cushion of FX reserves, in such a way than they cover an average of 7 months of
imports for EM, versus only 4 months for DM countries.
A great deal of differentiation among EM countries is necessary. Considering other
fundamentals, it is also necessary to look at individual situations as they considerably vary
from one country to another. For our purpose, we have computed scorecards based on
44.3
83.9
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10
20
30
40
50
60
70
80
90
'99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
EM DM
51.4
169.3
0
20
40
60
80
100
120
140
160
180
200
'99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
EM DM
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eleven macroeconomic critieria, including GDP growth, inflation, vulnerability to external
shocks and sustainability of fiscal dynamics. We present below the results of each
scorecards:
Vulnerability Indicators*See grey box next page to see criteria included in the vulnerability indicator
Source: SG Cross Asset Research/EM
The results of this scorecard are quite compelling and highlight the high disparity among EM
countries, in our view. Notably, EMEA countries are the most vulnerable, with an average
score of 14.4, due to a combination of slower growth, high external and public debt burdens,
low levels of foreign reserves. LatAm countries, with an average score of 12.7, are moderately
vulnerable, while Asian countries, with an average score of 9.6, are the least vulnerable amongemerging markets.
Ukraine, Venezuela and South Africa the most vulnerable.At the top of the vulnerability
ranking, we logically find Ukraine and Venezuela. For these two countries, pretty much all
indicators are showing distressed situations apart from the current account surplus for
Venezuela (although sharply declining in the last few years), and the low level of inflation for
Ukraine (which also reflects an economy on the verge of deflation). Surprisingly (or not), South
Africa shows one of the worst fundamentals in EM, due to particularly slow growth and its twin
deficit. Then follows India, Hungary, Turkey and Poland (the external and public debt levels are
indeed relatively high for the latter).
Asian economies the strongest. At the other hand of the spectrum, we find the Asian
countries which clearly appear as the strongest economies overall, starting with China.
Second to China comes the Philippines: despite its BBB- rating, the country shows very
0 5 10 15 20
China
Philippines
Peru
Korea
Thailand
Russia
Israel
Malaysia
Colombia
Romania
Mexico
Brazil
Lithuania
Indonesia
ChileCroatia
Czech Rep.
Poland
Turkey
Hungary
India
South Africa
Venezuela
Ukraine
Vulnerability indicator
Latam
EMEA
Asia
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strong fundamentals and is very likely to be upgraded during the course of next year, we
believe. In Latin America, we highlight the strength of the Peruvian economy, which has been
able to sustain high growth performance while keeping inflation at relatively low level. We note
also that Russia also compares relatively well in this ranking (due to its very high level of FX
reserves, as well as its very low level of public debt relative to GDP).
In view of this analysis, it is therefore necessary to differentiate among EM countries
when the market experiences higher volatility than usual, the fundamental risk being
considerably different depending on the credit profile.
Note that the market risk associated to each country (as measured in the present case by the
FX volatility) is strongly correlated to our indicator (correlation is around 86%), which
reinforces the relevance of the Vulnerability indicator.
FX volatility vs. Vulnerability Indicator
Source: SG Cross Asset Research/EM
VULNERABILITY INDICATOR: METHODOLOGY
We compute the Vulnerability Indicator using 11 macroeconomic criteria, including:
* Growth performance:We assess growth performance and changes in GDP.
* Inflation:We gauge inflation pressure as well as the change in inflation dynamics.
* FX vulnerability:Valuation of the real effective exchange rates.
* External vulnerability:Current account, foreign direct investment, gross international reserves (relative
to imports and relative to short-term liabilities) and level of external debt.
* Fiscal Position: Overall fiscal position, the primary balance and the level of public debt relative to GDP.
PLN HUF
CZK
RON
RUB
TRY
ZAR
ILS
BRL
MXN
CLP
COP
PEN
INR
IDR
MYR
PHP
KRW
THB
CNY
R = 0.7452
0
2
4
6
8
10
12
14
16
18
20
0 2 4 6 8 10 12 14 16
FXv
olatility
Vulnerability Indicator
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The Haves and the Have Nots: An Assessment ofPolicy Room in EM
Extent of policy space likely to determine economic resilience
Across global emerging markets, policy makers are facing the daunting reality of declining
policy space, amidst a global financial environment sensitive to the readjustment and
normalization of monetary policy led foremost by the US Federal Reserve and still sluggish
growth prospects. Against this backdrop, a gradually declining inflation trajectory in emerging
markets has helped to create much-needed policy space. Nonetheless, investors remain
skittish. Indeed, the lack of conviction may linger over the coming months until there is clarity
on Fed policy and on the liquidity available to emerging markets once tapering commences. In
this tentative environment, investors will likely differentiate between countries that have the
policy room to respond to external shocks, versus those that face difficult trade-offs betweenpromoting growth and protecting financial stability.
Declining inflation in GEM creates much-needed policy space (headline CPI, )
Notes: Based on GDP-weighted indices
Source: SG Cross Asset Research/EM.
We think that a key determinant of a countrys economic resilience to the potentially violent
period of financial markets readjustment ahead is the extent of its policy space. Some
countries notably Turkey, India, and Indonesia have had to resort to rate hikes, in many
instances to support their currencies. We would argue that in the case of Turkey, Indonesia,
and India, lack of monetary policy room forced the hands of the central banks to hike,
accepting the concomitant adverse impact on growth.
0%
5%
10%
15%
20%
25%
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13
EM
Asia
CEEMEA
Latam
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Real policy rates reflect the extent of remaining monetary policy space
Source: SG Cross Asset Research/EM
POLICY ROOM INDICATOR: METHODOLOGY
To gauge differences between countries remaining monetary and fiscal policy space, we have created a
rough measure called the Policy Room Indicator. It assesses the remaining policy space among our major
emerging market countries, and considers the following factors:
* The level of real interest rate: high real policy rates enable more scope for monetary policy
accommodation to support domestic growth
* Primary balance, as a percentage of GDP: high primary surpluses enable more fiscal flexibility to spend
on priorities
* Public debt, as a percentage of GDP: high general government debt may constrain the countrys
borrowing capacity, raise borrowing costs, and destabilize the financial markets in times of stress
* Official FX reserves, as a percentage of GDP: high levels of reserves can be deployed to support the
currency
We note that this rough gauge does not capture all relevant considerations, such as the varying amounts
of policy credibility across our markets, or the momentum of inflation pressures.
The results of our Policy Room Indicator suggest that Peru, Korea, Chile, and Hungary may
have among the most flexibility to steer their economies in the coming year. These countries
benefit from a combination of high real interest rates, strong primary balances, and with the
exception of Hungary low public debt. Regionally, LatAm countries, with an average score of
14.3, have the most policy room, thanks to high real interest rates, strong primary balances,
and low public debt. Asian countries, with an average score of 12.2, have moderate policy
space, while EMEA countries, scoring 11.7 on average, have the least policy flexibility. We
discuss below our key thoughts on the available policy space by region.
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12
Croatia
Ukraine
Brazil
Chile
China
Hungary
Romania
Korea
Poland
Colombia
Thailand
Peru
Philippines
Lithuania
Malaysia
Mexico
Turkey
SouthAfrica
Russia
Israel
Indonesia
Cze
chRepublic
India
Policy rate (%) Latest CPI (YoY %) Real policy rate (%)
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EM Policy Room Indicator a gauge of countries remaining fiscal and monetary flexibility
Source: SG Cross Asset Research/EM
EMEA
Czech Republic: Lack of policy room prompts the authorities to be creativeThe country is recovering slowly out of a recession, with growth remaining fragile. Monetary
policy space remains low, with nominal policy rates essentially at zero. Disinflationary
pressures have prompted the central bank to intervene directly in the FX markets and avoid
the deflationary trap. We expect the CNB to defend the desired 27.00 level of EURCZK with
unlimited sales of CZK, and to postpone interest rate hikes until 2016. Early elections held in
October have removed some tail risks, and the coalition government is likely to embark on a
pro-growth fiscal policy, while still maintaining the budget deficit within the 3% of GDP
threshold.
Hungary: Largest policy room in the region
Fiscal space is constrained by the governments commitment to meet its fiscal deficit target of3% of GDP, having so recently escaped the shackles of the EUs excessive deficit procedure.
However, real interest rates are still among the highest in the region, while inflation is on the
decline. Against a backdrop of weak growth, this combination creates the space for Hungary
to provide more monetary policy accommodation, which is what we foresee the central bank
continuing to do ahead of general elections in the spring.
Israel: Some difficult choices in the context of constrained policy roomNegative real interest rates, a weak primary balance, and high levels of public debt restrict
policy space in Israel. Fiscal space is hampered by a large budget deficit and an ambitious
target to keep the deficit within 3% of GDP next year, which will require extensive policy
measures. ILSs appreciation continues to adversely impact exports. The countrys growth is
slowing, while inflation expectations remain benign. Notably, concerns regarding the rapid
growth of the housing market and the risk to the banking system weigh on central bank policy
0 2 4 6 8 10 12 14 16 18 20
India
Czech Republic
Venezuela
South Africa
Indonesia
Israel
Malaysia
Lithuania
Mexico
Turkey
Poland
Russia
Ukraine
Colombia
Croatia
Philippines
Romania
China
Thailand
Hungary
Brazil
Chile
Korea
Peru
EMEA
Latam
Asia
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making. One consideration in favour of Israel is the strong credibility that the Bank of Israel
has enjoyed over recent years.
Poland: Committed to preserving monetary ammunition at a cost
The countrys fiscal spaceis constrained by a large fiscal deficit and ongoing efforts to exit the
EUs excessive deficit procedure. Space remains on monetary policy side, in light of relatively
high real yields. However, the central bank has completed its easing cycle earlier this year,
and is committed to maintaining the current level of policy rates at 2.5% until mid-2014 at the
earliest. In the absence of fiscal space, Poland has embarked on pension reforms, which are
likely to significantly improve the near-term fiscal balance, but entail long-term costs for the
government.
Romania: A strengthening policy frameworkThe country has higher than average policy room, benefiting from its positive real interest rate,
lower than average public debt, and adequate FX reserves. The central bank remains in easing
mode, helped by declining inflation. Romania is continuing to make progress in fiscal
consolidation, in restructuring its economy toward external demand, and in strengthening its
financial sector stability. As a result, fiscal policy space remains low. Improved absorption of
EU structural and cohesion funds from the current low capacity may help to boost investment
activity, as well as increase budgetary flexibility.
Russia: Assessment helped by its low debtDespite negative real interest rates, Russias primary surplus and low public debt profile
contribute to Russias moderate level of policy room. As a result of the countrys continued
reliance on commodity exports, declining oil prices are exerting budgetary pressures and
eroding the current account surplus. Reforms by the central bank and the ministry of finance
are slow-moving, and as yet ineffective at reviving the stagnant economy. The business
climate remains poor, while industry faces declining competitiveness.
South Africa: Serious policy challengesA worsening primary balance, negative real interest rates, and an elevated stock of
government debt conspire to restrict policy makers ability to revive the slowing economy.
Internal resistance from powerful labour unions and entrenched politics impede the pace of
reforms. We expect that the SARB will maintain an accommodative policy stance, with policy
rates on hold at 5%, and that fiscal loosening will be limited. But with relatively little in the way
of FX reserves to defend the currency, the SARB lacks adequate policy tools to respond in a
stress scenario.
Turkey: Fiscal outperformance, monetary underperformanceThe central bank has limited policy room, and is becoming more vigilant in protecting financialstability. It has recently tightened local liquidity conditions and raised the interest rate corridor,
although more tightening in monetary policy may still be needed to restore market confidence
and tame inflation. Positively, the country is showing signs of fiscal outperformance, with the
budget deficit likely to be substantially smaller this year than the government previously
projected.
LatAm
Brazil: A false positive of our Policy Room IndicatorThe country faces high amounts of policy constraints, despite its appearance near the top of
our Policy Room rankings (consequence of its high real interest rate and primary surplus).
Headline inflation is running well above the Copom's 4.5% target even after 275bp in Selic
hikes in 2013, and core inflation is now above 7%. Fiscal stimulus does not seem to be an
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option, either, with markets showing increasing concern over Brazil's long-term debt
trajectory. Policy makers could aim to ease conditions ahead of the October elections, but not
without risking more damage to the inflation outlook.
Chile: Plenty of policy ammunitionAlthough the Chilean Central Bank cut rates by 50bp in Q4, we still see ample room for further
monetary easing. Chile's economy and the central bank are highly sensitive to external
conditions, rendering policy responsive to global pressures. Inflation levels and expectations
remain extremely mild. Meanwhile, both nominal and real rates are much higher than in most
EM economies a fact which has bolstered the rationale for the recent easing cycle.
Colombia: Policy status quoWe view further policy stimulus in the country as unlikely, as with Mexico. Policy makers have
provided both monetary and fiscal stimulus earlier this year, and expects a gradual recovery
through next year.
Mexico: Focus shifting to reformsAfter 100bp of rate cuts in 2013 and plans for a slightly looser fiscal balance next year, further
stimulus appears unlikely. Growth is expected to accelerate next year, amid signs of recovery
in manufacturing and an expected increase in public spending. Meanwhile, inflation
expectations for 2014 have risen well above target, perhaps reflecting the uncertainty
regarding the impact of reforms on prices.
Peru: A solid policy frameworkThe country may be a candidate for looser policies next year, thanks to relatively high real
rates and solid fiscal accounts. However, the central banks tight inflation target (2%),
combined with the upward trajectory of core inflation, may constrain policy makers from
further easing.
Asia
India: Facing enormous policy challengesThe country is running tight on the fiscal policy front. Meanwhile, higher inflation is posing
constraints on monetary policy, as evident from Indias lowest rank in our EM Policy Room
Indicator. The fiscal deficit for FY2012-13 stood at 5.2% of GDP. The government aims to
improve it to 4.8% of GDP for FY2013-14, while the medium term goal for fiscal deficit
reduction remains at 3% for FY2016-17. The Reserve Bank of India (RBI) is facing a growth-
inflation dilemma. GDP growth slumped below 5%, well below the RBI sestimated potential
GDP growth of 7%, while WPI inflation has remained persistently higher. Near term inflation
risks are present from second round effects and diesel price pass-through effects. We expect
the RBI to reduce repo rates to 7.25% by the end of 2014, as inflation is expected to soften
starting the next fiscal year on demand slowdown.
Indonesia: Policy pressures are mountingOil subsidies are putting pressure on the budget balance, with 3-4.5% of GDP in oil subsidies.
The Bank of Indonesia (BI) has hiked the benchmark rate by 25bp to 7.5% as the CPI has
remained above 8%, much higher than the target level of 4.51%. We believe that the BI will
remain hawkish during 1H 2014 on higher inflation and a weak IDR, while some base effects
can ease inflation in 2H 2014.
Korea: A lot of breathing room
We believe that South Korea has the most policy room of the countries in the region. We
anticipate a gradual recovery, despite a considerable period of a negative output gap. Inflation
is likely to remain below the Bank of Korea's target range of 2.5%-3.5% throughout 2014.
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Hence, a pick-up in inflation is unlikely to be a major trigger for rate hikes. Upside surprises in
economic growth and downside surprises in inflation continued over recent months. In our
view, this development justifies a neutral, wait-and-see stance towards monetary policy until
the end of 2014.
Malaysia: Below averageThe Bank Negara Malaysia (BNM) has maintained an overnight policy rate at 3% since May
2011, while inflation has remained stable in a range of 1.3%-3.5% YoY, with the latest
October print at 2.8%. Amid a slower pace of government spending, improving export
dynamics are supporting GDP growth. According to the BNM, inflation is expected to pick up
on domestic cost factors. Risks to the inflation outlook are present from the external price
environment and domestic demand pressures. The BNM continues to see uncertainties in the
balance of risks surrounding the outlook for domestic growth and inflation. We anticipate that
the BNM will remain on hold, with a hawkish bias.
Philippines: Well positioned on the policy frontThe Bangko Sentral ng Pilipinas (BSP) targets inflation in the range of 41% for 2012-2014
and 31% for 2015. Although inflation expectations have been in line with the forecast, with
the latest print at 2.9% YoY for October, damage due to typhoon Haiyan from earlier this
month is likely to push inflation higher as commodity prices rise. We believe that
developments will stay within the BSPs tolerance band.
Thailand: Some room to manoeuvreThe Bank of Thailand (BoT) targets core inflation between 0.5-3%. This past year, core
inflation has ranged between 0.7%-1.7% YoY this year, with last month's inflation at 0.71%
YoY. Ongoing political uncertainty in the country puts further pressure on the growth outlook,
consumer confidence, and demand. With core inflation hovering near the lower end of the
range, the BoT has reduced policy rate to 2.25% on weaker Q3 growth and downside risks.
We expect growth to improve next year and for inflation to trend higher, placing the BoT in
neutral mode for 2014.
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Sovereign Credit: The Pain before the Gain
US Treasuries to drive the market
In the short term, we think EM dollar-denominated bonds will tend to outperform US
Treasuries, although to a limited extent. For now, downward pressure should ease a bit: SG
expects the 10Y UST yield to be around 2.70% by year end, which is in line with the current
level. In this context, EM sovereign bonds may be supported by relatively attractive valuations
(especially vs. US high yield and high grade bonds) and benign technicals (EM funds remain
underweight risk vs. their benchmark). We believe the EMBI spread index could tighten by
around 25bp to trade in the 310bp area by the end of January 2014.
The pain before the gain.Considering the outlook for 2014, the debate on the timing and the
extent of the Tapering is likely to drive the market, once again. We believe the gradual rise in
UST yields may prompt another correction in EM, possibly by February as the Fed scales
down its USD85 billion monthly bond-buying program as expected by our US Economics
team. In this scenario, concerns that EM assets will be affected by another wave of outflows
should resurface, resulting in higher sovereign spreads across the board. At the peak of the
sell-off (April), we see the EM spread index widening to 370bp.
Later in the spring of next year, as most of the risk may be priced in, EM spreads should tend
to compress until year end, following the improvement in fundamentals (see graph below).
EM Sovereign spread index forecast (bp)
Source: SG Cross Asset Research
EM dollar bonds more resilient to the downside. We believe the next sell-off could last two
to three months (from February until April/May), but the correction in the EM credit space is
likely to be more contained than that of last summer. We see four reasons why the EM credit
market should be more resilient against the downside:
Interest rate risk better reflected in EM valuations.As opposed to six months ago, EMspreads are now incorporating a much higher probability that tapering measures will be
implemented, which is reflected into cheaper valuations. In fact, even assuming that the EMBIspread index would trade at 310bp by early next year (our base case scenario), it would still
200
250
300
350
400
Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14
Historical Spread
Forecast
Upper and Lower Range
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be 35bp wider than prior to the sell-off of last summer. In yield terms, EM bonds are currently
trading 140bp wider than a year ago.
EM fundamentals still strong. The last episode of EM sell-off may have been
disproportionate in light of fundamentals. In many aspects, the EM backdrop remains more
attractive than in developed markets, especially in terms of growth prospects and debt levels
(see EM vulnerability section).
Growth picking up, stronger exports.By the time the Fed implements the Tapering, EMgrowth may have strengthened further; at current pace, we would expect GDP growth in EM
to be around 5%yoy by Q1 2014. Also, the pressure on current accounts may be less after the
drastic depreciation of EM currencies that we saw last summer. In fact, we expect this
depreciation to boost EM exports, in particular towards the US.
Less opportunistic investment, better technicals. The majority of crossover investorshave considerably reduced their exposure to EM. The withdraw of opportunistic/fast money
investments is therefore less of a threat for our market, most of EM hard currency bonds nowbeing held by dedicated investors typically driven by long-term macroeconomic criteria, the
latter still comparing positively for EM, in our view.
EM rating strongly anchored to the IG category
EM fundamentals holding better than DM.Although credit ratings are imperfect measures
of the overall sovereign risk (they indeed tend to underestimate the potential impact of global
factors, such as quantitative easing or tapering measures from the major central banks), the
changes in credit ratings still reflect relatively well the evolution of EM fundamentals over long
periods. Considering the EM and DM average ratings since 1996, it clearly appears that EM
fundamentals have considerably improved in the last ten years; they have therefore become
more resilient to global turbulence, including during the subprime and the EU Periphery debt
crises (see graph below).
This evolution is in sharp contrast with that of DM countries, which in average have been
downgraded by 2.5 notches since 2007. We expect EM to benefit from a slight upgrade in
2014, the asset class remaining well anchored in the investment grade (BBB-) category.
EM average rating* vs. Developed Markets
Source: SG Cross Asset Research *Based on simple average S&P, Moodys and Fitch ratings.
BBB
BBB-
BB+
BB
BB-
AAA
AA+
AA
AA-
A+'96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
DM (RHS)
EM (LHS)
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Although the overall rating of EM sovereign bonds should marginally improve in 2014, we
expect some important rating actions to be undertaken over the next twelve months,
including:
Potential upgrades: Philippines, Colombia, Mexico, Peru, Uruguay, Latvia, LithuaniaKazakhstan, Romania and Ukraine;
Potential downgrades: India, Brazil, Venezuela, South Africa, Croatia, Slovenia and CzechRepublic.
Many of these rating actions are already priced in by the market (such as the likely upgrade of
the Philippines or Colombia, or the downgrade of South Africa), but some of them may not be
fully anticipated by investors, which could imply a significant repricing, in our view. These
changes include:
Brazil to be downgraded.We see a continuous deterioration in inflation and fiscal balance,while GDP growth may disappoint on the upside. We therefore believe a downgrade of Brazil
to BBB- by one or two rating agencies is very likely, in spite of the very high level of FX
reserves. The downgrade should send a negative signal on the credit, and Brazilian bonds
could significantly underperform the EM sovereign credit index.
Mexico likely to be upgraded by S&P. The implementation of economic reforms(especially regarding the status of Pemex) has long been considered a precondition to any
upgrade. However, the relatively poor GDP performance has had a significant impact on the
credit rating; according to the IMF forecasts for 2014, Mexico should see a jump in GDP
growth from 1.2% in 2013 to 3.0% in 2014, representing the best improvement among Latin
American countries. We believe this improvement could trigger an upgrade from S&P to
BBB+, to be in line with Moodys and Fitch (S&P downgraded Mexico to BBB in Dec. 2009).
South Africa: At least two agencies triggering a downgrade. The deterioration in SouthAfricans fundamentals hasbeen continuous since 2009. In fact, the fiscal balance and the
C/A deficit stand at preoccupying levels, and an average rating of BBB will be very difficult to
sustain for the country. We therefore expect South Africa to be downgraded by at least two
rating agencies next year, although the country should remain in the investment grade
category. Nevertheless, we cannot rule out that these rating actions will be associated with
negative outlooks.
Ukraine should retrieve its single B status. As we write these lines, we assume that thegovernment will not sign the trade agreement with the EU this Friday. For the majority of
Ukraines watchers, the decision of M. Yanukovych is sending a negative signal, as in the long
term the country would have greatly benefitted from such trade agreement. However, we
believe that the reestablishment of the economic and political ties with Russia substantially
reduces the credit risk in the short term. Independently from political considerations, it is likely
that the rating agencies will revert their recent downgrades to reflect the lower risk of default
of the country (we assign a high probability that Russia will eventually provide financing
facilities and/or a gas deal to Ukraine).
SG expected 1Y change insovereign rating (notches)
-1.5 -1 -0.5 0 0.5 1 1.5
Korea
Chile
EstoniaCzech Rep.
Israel
Slovakia
Poland
Malaysia
Thailand
Lithuania
Latvia
Kazakhstan
Peru
Mexico
South Africa
Slovenia
Russia
PanamaBrazil
Bulgaria
Colombia
Philippines
India
Uruguay
Indonesia
Turkey
Romania
Croatia
Hungary
Sri Lanka
Vietnam
Venezuela
Ukraine
Argentina
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Underweight risk for the coming months
Favouring the low-beta names, for now. As the EM credit market is likely to be under
pressure during the four to five months of next year, the high beta names may underperformover the period. This should be particularly the case for Venezuela, Serbia, Croatia, Indonesia,
South Africa and to a minor degree Turkey. In the low beta space, we believe that Brazil is
also likely to underperform the index due to deteriorating fundamentals. The strong low beta
credits should be fairly resilient to the downside, especially the Philippines, Chile, Poland,
Colombia and Peru (see table below).
Starting in the spring, we think that EM dollar bonds will significantly outperform US
Treasuries, reflecting the continuous improvement in fundamentals. The adverse impact of
UST may not be fully compensated by spread compressions before this summer, but EM
bondsreturn should be back to positive territory during the second half of the year.
10Y dollar bonds spread to UST forecastsCurrent Current 10Y benchmark spread forecast Spread
10Y Yield Spread Q4 '13 Q1 '14 Q2 '14 Q3 '14 Q4 '14 Change10Y UST (Yield) 2.7 - 2.7 3 3.35 3.5 3.75 -
Chile 3.53 83 93 113 88 83 73 -10
Philippines 3.22 52 62 97 72 67 52 0
Mexico 4.08 138 123 152 113 96 83 -55
Poland 4.09 139 125 148 110 91 77 -62
Lithuania 4.11 141 127 151 113 94 80 -61
Colombia 4.12 142 127 155 116 97 84 -58
Peru 4.34 164 150 160 121 103 89 -75
Brazil 4.49 179 163 196 157 138 128 -51
Russia 4.51 181 166 195 156 136 124 -57Romania 4.81 211 193 233 193 173 163 -48
Turkey 5.04 234 212 269 228 207 200 -34
South Africa 5.05 235 215 262 222 201 193 -42
Indonesia 5.14 244 222 247 206 181 166 -78
Morocco 5.32 262 240 294 253 232 225 -37
Hungary 5.57 287 268 312 271 251 242 -45
Croatia 6.01 331 312 356 315 295 286 -45
Serbia 6.42 372 351 401 361 340 332 -40
Ukraine 9.66 696 674 679 637 616 610 -86
Venezuela 13.58 1088 1059 1141 1098 1075 1074 -14
EM Index 5.86 328 310 350 310 290 280 -48
Source: SG Cross Asset Research
During the phase of rally, high beta names should logically outperform the index,
including Ukraine, Serbia, Hungary and Croatia. We also see Indonesia and Turkey performing
well in such scenario. Although Venezuelan assets should remain under pressure due to the
sharp deterioration of the economic situation, the very high carry should partially protect the
absolute return.
In terms of positioning, we favour short duration exposures during the first part of the
year, the steepness of the curves remaining very directional. More specifically in the high beta
space, we favour the short end of Ukraine as the curve is likely to des-invert, we believe. In
Venezuela, we favour low-dollar priced bonds, overall, and would move away from the belly to
favour the wings for the curve. In Hungary, short-dated assets should also perform relatively
well. Lastly regarding Brazil, we tend to favour short- to mid-dated bonds over the long end,
as we expect the credit curve to bear-steepen.
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How to Trade EM Politics in 2014
Beyond election outcomes, changes in the political landscapecan drive long term value
This past year, politics once again played a significant role for emerging markets. European
sovereign issues took somewhat of a backseat, thanks largely to the actions taken by the ECB
in 2012 and some modest but sorely-needed steps towards a banking union early this year.
US politics, on the other hand, threatened EM and other risky assets in the form of fiscal
headwinds and yet another debt ceiling standoff. Within EM itself, for that matter, there was
no shortage of storylines. Most importantly, the Chinese Communist Partys Plenum meeting
yielded a set of reform goals that, however vague for the time being, raised hopes for gradual
economic reforms and a more sustainable growth path in the coming years. Mexicos push
towards landmark reforms, meanwhile, gained the attention of many investors looking for anew EM darling. Hungary and Poland, conversely, raised eyebrows over monetary policy
independence questions and pension reform, respectively.
Next year, we expect political headlines to continue to help determine value within EM. In a
number of markets, the focus will be on scheduled elections, while in others, political issues
outside the voting booth will demand attention. Below, we discuss by region the key political
events and trends we think will prove most important in 2014.
EMEA
Hungary: Chance of a positive policy surpriseThe key question in the upcoming Hungarian elections next April / May is whether Viktor
Orban and his Fidesz administration will retain a supermajority in Parliament. We expect that
Fidesz will hang firmly onto power, but that the party may not achieve the supermajority that
will enable them to so easily push laws through Parliament. Opposition parties E14, led by
former technocratic Prime Minister Gordon Bajnai, have teamed up with the Socialist Party
(MSZP) after intense feuding and are attempting to appeal to disparate segments of voters,
but face what may be an insurmountable uphill climb. Post elections, we expect that Fidesz
may ease up slightly on some of the punishing policies toward the banking sector and utilities,
providing the chance of a positive policy surprise (relative to the dire current state of affairs).
Many countries in the region are keenly watching developments in Hungary, andcontemplating using Viktor Orbans policies as a template.
Poland: StabilityThe latest government reshuffle included the replacement of Finance Minister Rostowski by
Mateusz Szczurek, formerly INGs chief economist for CEE countries. We believe that existing
fiscal policy is likely to remain intact. The country will hold local elections next year, followed
by parliamentary and presidential elections in 2015. Despite gains by the opposition Law and
Justice (PiS) party in recent polls, we expect the ruling PO party to remain in power, and will
focus on reviving growth next year ahead of the 2015 elections.
Romania: Expect some noise, as usualThe country will see a change in the office of the president following presidential elections in
2014, with current president Traian Basescu likely replaced by Crin Antonescu, current leader
of the National Liberal Party (PNL) and head of the senate. Ahead of the presidential elections,
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there is a risk that the government may stray slightly from current structural reforms and
budget objectives.
South Africa: Low political risk
With the African National Congress firmly entrenched in power, South African elections next
June are less about a change in power, and more a forum to witness the erosion of the ANC's
appeal. Pro-business Democratic Alliance - traditionally perceived as a white-led party - is
likely to hang on to strongholds in the Western Cape and gain incremental ground from the
ANC. Meanwhile, newly launched party Agang SA and its ideological star Mamphela
Ramphele will not have sufficient time to attract a broad following. One positive note for
markets will be the return of Cyril Ramaphosa to the ANC's leadership as deputy president, as
he brings with him clout from private industry and the potential to mend some of the strained
relationships between government and business.
Turkey: Expect some politics-driven volatilityLocal elections next March will test the appeal of ruling AKP, following the protests that
erupted earlier this year. Opposition parties remain weak, and do not constitute a credible
threat. However, they are likely to encourage protestors to return to voice concerns against
Prime Minister Erdogan's increasingly autocratic rule. And unless Erdogan manages to change
AKP's rules to enable him to stand as prime minister for a fourth term in the 2015 general and
parliamentary elections, he may have to opt instead to run for the presidential post opening up
in August 2014.
LatAm
Brazil: A negative balance of risksThe countrys presidential election in October will easily be the most significant political event
in the region in 2014. Incumbent President Dilma Rousseff has seen her popularity partially
recover from a downturn earlier this year, and is the early frontrunner. But Rousseff will need
to manage a difficult mix of economic conditions ahead of the vote, namely stubbornly high
inflation coupled with sluggish economic activity. How the Presidents administration
approaches fiscal policy in 2014 will be crucial. Markets have grown increasingly concerned
about Brazilian fiscal dynamics and the future trajectory of debt-to-GDP, and we see the
possibility for at least one rating agency to downgrade Brazils long-term sovereign rating this
year. Nonetheless, satisfying calls for tighter fiscal policies may ultimately be perceived to be
too politically unpalatable ahead of elections, putting the administration in a difficult place.
Barring an upset at the polls, we think the balance of political risks ahead of the elections isnegative from a policy standpoint.
Chile: Low risksThe focus will shift towards new policies under a presidency of Michelle Bachelet (who is
strongly likely to win the second-round vote next month). Bachelet has pledged to pursue an
ambitious social agenda and commit to new spending, but thanks to Chile's fiscal rules and
limits on the President's fiscal discretion, we think risks to Chilean assets are relatively
insignificant.
Colombia: Supportive politicsThe announcement earlier this month that sitting President Juan Manuel Santos will stand in
May's elections should be considered a positive development for markets. The notion of a
Santos re-election should mean less policy uncertainty and the continuation of a generally
investor-friendly administration (embodied in last year's cut on foreign investors' bond
earnings). Perhaps more importantly, it would mean continued negotiations with FARC rebels,
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with a successful resolution having the potential to raise business confidence and spur
investment.
Mexico: Some upside signals
Although the electoral calendar is empty in 2014, the political focus will continue to be on
supply side reforms. With fiscal reform already passed, energy reform is now likely to be
wrapped up next month. Nonetheless, negotiations over implementation of reforms will
continue into next year. That presents some additional risk, though in total we believe markets
have been slow to price in the positive impacts of energy reform, particularly in the case of the
MXN.
Asia
China: Reforms on trackHow effectively policymakers put the reform promises of the Plenum meeting into substantive
policy in the coming years may be crucial to the trajectory of broader emerging markets. In the
near term, we see risks to growth from the prospective financial liberalisation. The central
government may continue to maintain tighter liquidity conditions and dampen credit growth.
India: Politics expected to be market positiveA great deal of attention will be on India, with parliamentary elections set for early 2014.
Recent governments having leaned more towards populism than embarking on needed
reforms, and bills related to insurance, a national VAT, the tax code, and fuel are still pending
in parliament and are unlikely to be agreed upon prior to elections. Markets are justifiably
worried about a policy logjam in the case of a hung parliament; some state election results in
December may provide clues here. But in the more likely event of any of the two major partiesforming a coalition government, we believe the reform momentum would likely continue after
the elections and political risks are positively skewed.
Indonesia: Fiscal impact in the balanceThe country will hold presidential elections in July, with markets watching for any post-
election adjustment of oil subsidies, currently running at 3.0-4.5% of GDP and a major
component of the budget deficit. Given low expectations, we think that the chance of a
positive surprise is actually fairly high.
Thailand: Fiscal pressures from sticky domestic policiesAlthough Thailand isnt scheduled to hold general elections until 2015, the issue of rice
subsidies is likely to be a closely watched political topic next year. The government is facing
pressure from markets and ratings agencies to reduce such subsidies, but the path forward
may be politically difficult. Prior attempts failed, after angering farmers who constitute an
important support base for the current government.
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Key events on the political calendar in 2014
EMEACzech Republic Jan-Mar 2014 Formation of the new government
Hungary Apr-May 2014 Parliamentary elections
European Union May 2014 Parliamentary elections
Lithuania May 2014 Presidential elections
South Africa Jun 2014 General elections
Turkey Aug 2014 Presidential elections
Romania Nov 2014 Presidential elections
Croatia Late 2014 / Early 2015 Parliamentary elections
LATAMChile Mar 2014 President starts term
Colombia May 2014 Presidential elections
Brazil Oct 2014 Presidential elections
ASIAIndia May 2014 General elections
Indonesia Jul 2014 Presidential elections
Source: SG Cross Asset Research/EM
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EM FX ForecastsDec-13 Mar-14 Jun-14 Sep-14 Dec-14EUR/PLN 4.16 4.28 4.15 4.10 4.10
EUR/HUF 294 303 297 295 295EUR/CZK 27.00 27.00 27.00 27.00 26.80EUR/RON 4.40 4.48 4.42 4.37 4.37EUR/RSD 114 115 114 113 113EUR/RUB 43.30 44.01 43.24 42.75 42.13EUR/TRY 2.69 2.74 2.60 2.48 2.44RUB/BASK 37.00 38.00 37.75 37.75 37.50USD/RUB 31.84 33.09 33.26 33.66 33.71USD/TRY 1.98 2.06 2.00 1.95 1.95USD/ZAR 10.00 10.60 10.20 9.95 9.95USD/ILS 3.55 3.65 3.60 3.55 3.55USD/EGP 6.90 7.00 6.90 6.80 6.80USD/NGN 158.00 160.00 158.00 157.00 157.00USD/GHS 2.38 2.43 2.38 2.34 2.30USD/BRL 2.30 2.45 2.40 2.40 2.40USD/MXN 12.70 13.00 12.75 12.50 12.25USD/CLP 515 525 515 510 510USD/COP 1885 1900 1870 1860 1850USD/PEN 2.75 2.80 2.68 2.64 2.60
USD/CNY 6.10 6.10 6.12 6.09 6.08USD/HKD 7.75 7.75 7.75 7.75 7.75USD/INR 63.00 66.00 63.00 62.00 61.00USD/IDR 11000 11500 10750 10250 10250USD/MYR 3.16 3.25 3.20 3.13 3.13USD/PHP 43 44 43 42 42USD/SGD 1.24 1.27 1.24 1.23 1.23USD/KRW 1060 1060 1075 1090 1105USD/TWD 29.40 29.8