seb report: binary risks, looming relief in emerging markets

7/31/2019 SEB report: Binary risks, looming relief in emerging markets

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Emerging Markets Cross AssetsBinary Risks Looming Relief

EM FI Enjoys macro support

EM Equities Cheap could get cheaper

EM FX Buy options now, spot later

4 JUNE 2012


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Emerging Markets Cross Assets

Contents

General backdrop: Binary risks looming relief ............... ................. ................ ................ ................ ................ ................ ................ ... 4Financial gains evaporated ................ ................ ................ ................ ................ ................ ................. ................ ................ ................ 4Global economy set to avoid a recession...... ................ ................. ................ ................ ................ ................ ................ ................ ... 4Sharply lower inflation enables policy flexibility ................ ................ ................ ................ ................ ................ ................ .............. 6Political risks................. ................ ................ ................ ................ ................ ................ ................. ................ ................ ................ ........ 8Eastern Europe vulnerable to deleveraging................ ................ ................ ................ ................ ................ ................ ................. ..... 8EM bond fund flows resilient................... ................ ................ ................. ................ ................ ................ ................ ................ ........... 9

The long-term case for EM......................................................................................................................................................................11Fixed Income: Supportive macro ................ ................ ................ ................. ................ ................ ................ ................ ................ ......... 16

Lower inflation supports local bonds........... ................ ................ ................ ................ ................ ................ ................ ................. ... 16Structural case intact ............... ................ ................ ................. ................ ................ ................ ................ ................ ................ ......... 16Eurozone still a risk for EM .............. ................ ................ ................. ................ ................ ................ ................ ................ ................ . 18Inflation outlook revised down............... ................ ................ ................. ................ ................ ................ ................ ................ ......... 19Good environment for bonds in high-inflation economies ................. ................ ................ ................ ................ ................ ......... 19

Equities: Cheap to become even cheaper..................... ................ ................ ................ ................. ................ ................ ................ ...... 23EM equity flows...................................................................................................................................................................................25Valuation ranking model ............... ................ ................ ................ ................ ................ ................ ................ ................ ................. ... 27EM vs. DM, P/E discount.. ................ ................ ................ ................. ................ ................ ................ ................ ................ ................ . 27Technical Analysis MSCI EM Index (USD)........ ................ ................ ................ ................ ................. ................ ................ .............. 28

Currencies: Potential for major recovery in Q3...................................................................................................................................30EM FX look cheap in trade weighted terms.....................................................................................................................................30EM FX drivers ahead...........................................................................................................................................................................32External financing vulnerability .............. ................ ................ ................. ................ ................ ................ ................ ................ ......... 33SEB EM FX forecasts.... ................ ................ ................ ................ ................ ................ ................. ................ ................ ................ ...... 35Investment strategy .............. ................. ................ ................ ................ ................ ................ ................ ................ ................ ............ 35Cautious near term trade it through options........... ................ ................ ................ ................ ................ ................ ................. ... 35Still a bumpy road ahead...................................................................................................................................................................36How to trade it ............... ................. ................ ................ ................ ................ ................ ................ ................ ................ ................. ... 36

Cut-off date: 1 June, 2012

Editors:Mats Lind

Mats Olausson

Contributors:Julius DukstaDag Mller

Jurgis RosickasAnders Sderberg

The long-term case for EM:Kristina Styf

SEB X-assets Research

Contacts: see page 43.


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Executive summary: Binary risks looming reliefEmerging market (EM) asset values rose sharply in January but collapsed in May. On both occasions, Europe was theroot cause with investor concerns regarding the implications of the Eurozone debt crisis for the global economydriving sentiment changes. In the near term, we regard risks as binary and explosive in terms of potential marketimpact. While the Greek election on June 17 and the current problems affecting the Spanish banking system are

certainly not the only events driving market, they are the key focal points right now. If Greece elects a governmentdetermined to reject the bail-out package and Spanish banks fail to secure sufficient support the market outcome maybe similar to the Lehman crisis. In that case, we would expect the May sell-off to continue with markets being solelydriven by flight-to-liquidity. Indeed, the near-term technical outlook for EM assets is almost unequivocally bearish,

with investors quite prepared to ignore their strong fundamentals and attractive interest rates.

Nevertheless, despite the very real possibility of such developments occurring, they are not our main scenario.Instead, we think it more likely that the Greek election will return a new coalition willing to adhere to the EU/IMFagreement in return for the countrys all too necessary bail-out funds. We also expect Spain to receive a EUR 150bnsupport package and Portugal and Ireland to secure less onerous repayment conditions. If so, based on currentmarket pricing, we would anticipate a relief rally across financial markets, with further support during Q3 fromadditional quantitative easing by the US Fed and more substantial stimulative policies in China. Overall, our global

leading economic indicator (GLEI) suggests continued weak markets in the very near-term but improved momentumbetween August and the year end. Consequently, while risks are binary, our main scenario implies that the door is ajarfor a substantial recovery mainly in Q3. Of course, with the underlying problems facing the Eurozone unlikely to beresolved by then, we should expect further periods characterised by flights to liquidity. Still, the long-term EM caseremains intact. In this report we also present the research findings of our SEB X-Asset colleagues including keyconclusions for asset allocations within EM.

Of course, our own recommendations contained in this report do not make for an easy, uncomplicated tradingexperience. In our previous edition of EMXA in February we argued that the January rally had gone too far, too fast andthat a correction was imminent. It came later and was larger than we expected. For now, we recommend remainingdefensive pending a solution to the immediate problems besetting Europe while at the same time preparing for apotential relief rally, tentatively during Q3. EM bonds, on a currency-hedged basis are more resilient and are likely to

continue to gain from their structural undervaluation with further help from a benign inflation environment. We favourbonds in high-inflation economies. While we regard EM equities as inexpensive in both absolute and relative terms,we expect them to become even cheaper in the near-term. Within EM, we remain overweight in Asia and underweightin EMEA. Concerning EM FX, we recommend buying a EUR/MXN butterfly for the downside and buying a USD/HUF callspread now. We expect positioning, fundamentals and carry to progressively replace flight-to-liquidity as drivingforces in FX markets, creating several beneficial opportunities. For now, we prefer the possibility of missing out on theearliest stages of the expected rally rather than risk catching the falling knife.

MSCI EM & GBI EM (unhedged USD)EM FI ENJOYS MACRO SUPPORTModerate growth together with a benign inflation

environment helps EM bonds while global risk-aversion weighs. We see the structural case to onceagain deliver positive FX-hedged returns.

EM EQ CHEAP COULD GET CHEAPER

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

EM FX BUY OPTIONS NOW, SPOT LATERGiven binary and explosive risks now, we buy a 6mEUR/MXN butterfly for the downside and buy a 1mUSD/HUF call spread. FX drivers will turn more EM-conducive later providing various good opportunities

to buy EM spot.

400

500

600

700

800

900

1000

1100

1200

1300

1400

2006 2007 2008 2009 2010 2011 2012

MSCI-EM(Equities)

120

140

160

180

200

220

240

260

280

300

320

MSCIEMGBI-EM

Source: Bloomberg GBI-EMDiv.Global(Local


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General backdrop: Binary risks looming relief

EM stocks, bonds and currencies look cheap after

the sell-off in May, both fundamentally and from astrategic perspective. For now, however, theoutlook for EM assets is largely dependent ondevelopments in the Eurozone. Risks are binaryand potentially explosive. Victory in the Greekelection on June 17 by parties that reject the bail-out package could trigger an uncontrolled break-up of the Eurozone creating a flight to liquidityreminiscent of the post-Lehman period. EM assetswould suffer greatly in such a situation. In ouropinion however, the Greek vote will favouradherence to EU/IMF demands and remaining in

the Eurozone, at least for the time being. Givencurrent market pricing, this could pave the wayfor a substantial relief rally which we expect willbe further supported by other European initiatives(in the case of Spain, Portugal, Ireland andCyprus), US QE and Chinese economicstabilisation. Furthermore, our global leadingindicator predicts improving momentum fromAugust. Nevertheless, the deep-seated problemsaffecting the Eurozone will continue to haunt themarkets. We therefore expect periods in whichdrivers favouring EM (fundamentals, valuationand carry) are temporarily replaced by flights toliquidity. While this situation will limit therecovery of currently cheap EM assets, we seescope for substantial gains in coming quarters.

What did we say last time?In our previous report, published on February 16, weargued that the rally in higher risk assets in Januaryhad gone too far, too fast and that a correction wasimminent. The correction began in April and exceededwhat we had anticipated during May.

Financial gains evaporatedSignificant gains by EM stocks and currencies at thebeginning of the year have largely disappeared,leaving EM equities in particular down -2.5% in USDterms so far this year, which happen to be matched tothe first decimal by an equally big fall in DM equities.EM local bonds have performed well in USD hedgedterms, increasing 2.2%, i.e. satisfactory for such arelatively stable investment. However, includingcurrency effects, EM bonds have gained only 1.0%since the start of the year, which we regard asunsatisfactory given its frequent high volatility.

Similarly, currencies have failed to perform, havingreturned -0.4% vs. USD including carry, according tothe ELMI index. Excluding carry, our basket of 15 EM

currencies that we often refer to is down by 2.1% vs. USD

YTD after having lost a massive 6% during May.

400

500

600

700

800

900

1000

11001200

1300

1400

2006 2007 2008 2009 2010 2011 2012

MSCI-EM(Equities)

120

140

160

180

200

220

240

260280

300

320

MSCIEMGBI-EM

Source: Bloomberg GBI-EMDiv.

Global(Local

With the benefit of hindsight, we overestimated the

positive impact of the ECBs two LTROs andunderestimated the risks posed by Greece at the time ofour last EMXA report. Spains (probable) journey towards abail-out package is, however, consistent with our long heldexpectation.

Is this the time to enjoy the ride?So, the correction we expected finally arrived and did sowith a vengeance. The question now is whether this is thetime to increase exposure to EM assets, i.e. to Enjoy theride, but buckle up! as the title of our previous report read.Retrospectively, we certainly buckled up but have so far

not yet begun to enjoy the ride. For answers to thisquestion therefore, we must consider the outlook for aglobal economy which is still struggling to recover from theGreat Recession. In particular, we focus on key risks fromthe Eurozone, the Middle East and commodity prices.Others, such as the still largely untouched US fiscal deficitremain crucial parts of the equation.

Global economy set to avoid a recessionBehind the near term fluctuations in the global economiccycle, we think it important to bear in mind several keyfacts concerning the current business cycle. The recovery

following the Great Recession a few years ago has beenunusually weak by historical standards. Disappointingly,global growth has merely risen to trend, despite havingapplied record fiscal and monetary stimulus measuresthroughout large parts of the global economy. Witheconomic policy ammunition now largely depleted, theglobal immune system is weak. Meanwhile, excessiveleverage, that partly supported the so-called super cycle inthe middle of the last decade, has simply been switchedbetween different sectors. In reality, it has been made theresponsibility of governments. The question thereforeconcerns whether it will be passed on to pension savers

and others, as it has been in Greece. Deleveraging isongoing and must continue, effectively restricting growth

in affected countries.


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Index, per cent of disposable income

US: Home prices and debt

Home prices, S&P Case-Shiller (LHS)Household debts as a percentage of income (RHS)

Source: Standard & Poor's, Federal Reserve

88 90 92 94 96 98 00 02 04 06 08 10

50

75

100

125

150

175

200

70

80

90

100

110

120

130

140

Going forward, we expect global growth to fall below abit below trend this year and to rise just above nextwith our forecasts at 3.4% and 4.0% respectively in

purchasing power parity (PPP) terms.

The improvement in the US economy last autumnappeared to be spreading to other countries at the endof last year and the beginning of this. This perceptionobviously invigorated the market rally in January.However, it failed to follow through in March andespecially April. Our own SEB EM Surprise Indicator,for example, shows a sharp drop.

1211100908070605

1.0

0.5

0.0

-0.5

-1.0

-1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

SEB economic surprise indicator, Emerging markets

3-month average

More accommodative policies ahead?Meanwhile, two separate scenarios support the casefor more accommodative economic policies goingforward. Firstly, inflation has slowed even faster thanwe had expected (see p. 19) and looks to stabilise at orbelow targets in many EM. This will help facilitatefurther monetary easing in countries such as Chinaand Brazil. Also, importantly, even in other countries,current inflation is less of a restriction against usingmonetary policy measures if growth disappoints.

Secondly, the new French president Franois Hollandepresumably won the recent election on a platformpromising to switch economic policy from austerity togrowth. His ideas are shared by various colleagueswithin the EU as well as policy makers and economistsin international organisations and in academia. Steps

in that direction are therefore likely. Those countriesthat have already lost the confidence of markets willnot have the luxury of following that route. For many

others too, current high indebtedness implies relativelyrestricted room for manoeuvre. Further, the EUs new FiscalCompact will also set clear boundaries.

QE3 from the Fed in the fallWe expect more action from G3 central banks based on

demands for more policy action, given current low inflation,lacklustre economic recovery in the US and Japan, and arecession in the EU. We forecast QE3 from the Fed this fallwhile Japan will also continue to increase its balance sheet.The ECB will do whatever is necessary to provide bankingsector liquidity although the euro-system is already awashwith cash. Discussions regarding raising the inflation targetcontinue.

Per cent of GDP

Central bank balance sheets

ECB Bank of England Federal ReserveSource: ECB, Fed, Bank of England

02 03 04 05 06 07 08 09 10 11 12

5

10

15

20

25

30

35

5

10

15

20

25

30

35

Overall, the global economy is weak. Further economic

policy stimuli will dampen the effects of continueddeleveraging. We still believe the global economy can avoidrecession. Worldwide growth increasing from just below tojust above trend appears reasonable based on positivessuch as the fact that many EM and Northern Europeaneconomies are fundamentally sound and that many

companies enjoy very strong balance sheets.

SEB EM growth forecastsGiven recent economic and political developments, andbased on assumptions set out in this report, we expectbelow trend global growth this year to accelerate to just

above trend next year. With the EU climbing out of its mildrecession by 2013 and the US taking one more, small steptowards recovery, we forecast that the OECD region willincrease GDP growth from 1.6% this year to 2.1% in 20122013.

In our Nordic Outlookreport published on May 8, wereduced our aggregate EM growth forecast from 5.7% and6.0% this and next year to 5.6% and 5.9% respectively. Adisappointing data harvest in April worse GDP readings inQ1 than expected in some key countries justifies a furtherdownward adjustment to 5.2% in 2012 and 5.7% in 2013.

This downgrade revision coincides with increasingconcerns regarding industries in Emerging Asia. Q1 GDPfigures for much of the region were below expectations


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with China at 8.1% and India at a nine-year low of5.3%. Further, Q2 PMIs generally declined, particularlyin China.

The stabilisation/bottoming out that we expected

during Q1 now looks more likely to occur in Q2. Wehave therefore downwardly revised our respective fullyear 2012 and 2013 growth forecasts for China (to8.1% from 8.5%; 8.4% from 8.7%) and India (to 6.0%from 7.0%; 6.6% from 7.3%). We have also slightlylowered our Brazilian GDP estimates due to weakerthan expected data at the beginning of the year. Wenow expect growth to increase only slightly from 2.7%in 2011 to 2.9% (previously: 3.5%) this year withrecent major stimulus measures impacting in 2013when growth will accelerate to 4.3% (same as before).Our forecasts for many other countries remainunchanged. This is the case for Russia but we havedowngraded our growth forecasts for Ukraine.

BRICS PMI manufacturing, SA

RussiaSouth Africa

India50

BrazilChina,Official

Source: Reuters EcoWin

Jan Mar May Jul Sep Nov Jan Mar

11 12

35

40

45

50

55

60

65

70

35

40

45

50

55

60

65

70

Our expectation that growth momentum will improvefrom H2 2012 is based on the belief that morestimulative policies in countries such as China andBrazil are progressively implemented. Overall, EMgrowth appears more likely to bottom out in Q2 ratherthan Q1 2012, which is more consistent with the

implications of our Global Leading Economic Indicator,GLEI, developed by Mattias Sundbom. The GLEI pointsto continued weakness in the very near term to be

followed by sequentially improving momentum from

August through the end of the year.

Significantly however, this still comfortably qualifies as asoft landing with EM growth of 7.3% in 2010 partiallyreflecting base effects from the very weak performance in

2009 and 6.2% growth reported in 2011 still benefitingfrom overall lax policy prescriptions.

2010 2011 2012 2013

China 10.4 9.3 8.1 8.4

Indonesia 6.2 6.5 6.0 6.5

India 10.6 7.2 6.0 6.6

EM 7.3 6.2 5.2 5.7

Russia 4.0 4.3 3.8 4.1

Mexico 5.5 3.9 3.5 4.0

World (PPP) 5.3 3.9 3.4 4.0

South Korea 6.3 3.6 3.5 4.0

Poland 3.9 4.3 3.1 3.6

South Africa 2.8 3.1 3.0 4.0

Turkey 9.2 8.5 3.0 4.5

Brazil 7.5 2.7 2.9 4.3

Ukraine 4.2 5.2 2.9 4.0

Singapore 14.8 4.9 2.7 3.9

Lithuania 1.4 5.9 3.0 3.5

Latvia -0.3 5.5 2.5 4.0

Iceland -4.0 3.0 2.5 3.1

OECD 3.1 1.7 1.6 2.1

Estonia 2.3 7.6 1.5 2.5

Romania -1.7 2.5 0.5 2.5

Czech Rep. 2.7 1.7 -0.2 2.0

Hungary 1.3 1.7 -1.0 1.5

Source: OECD, SEB

SEB GDP forecasts

Sharply lower inflation enables policy flexibilityEM inflation rates have plummeted since February. We aresurprised, as the decline in both headline and core inflationhas been sharper than we had anticipated. Our forecastremains that inflation will decrease more gradually. Fallingprices of both food and crude oil and other commodities

explain much of the decrease though reductions in pricesof core items have also contributed to a surprising extent.Softer economic conditions are therefore probably a factor.However, we think it is encouraging that core inflation hasresponded so rapidly on the downside. What this shows isthat the credibility of EM central banks is stronger and thatknock-on effects from sharply higher food prices over thepast two years have not materialized.

This kind of stable, non-inflationary consumer pricedynamic is a valuable and relatively new fundamental assetfor EM economies. Its benign long term impact on bothcurrencies and bond yields should not be underestimated.

From a macroeconomic perspective, lower inflation createsroom for manoeuvre should the need for more stimulative


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policies arise. Furthermore, the supply situation isbenign going forward. For foodstuffs, most La Ninaeffects have according to forecasters dissipated whileinventories have greatly improved. As regards crudeoil, the Iranian situation still represents a risk.

May, 2012 Q2, 2012 Q3, 2011 Q4, 2012 Q1, 2013 Q2, 2013

EMEA

Poland 4.75 4.75 4.75 4.75 4.75 4.75

Czech 0.75 0.75 0.25 0.25 0.25 0.25

Hungary 7.00 7.00 7.00 6.50 6.00 6.00

Turkey 1W 5.75 5.75 5.75 5.75 6.25 6.50

Turkey O/N 11.50 11.50 11.00 10.25 9.50 9.00

S. Africa 5.50 5.50 5.50 5.50 5.50 5.50

Romania 5.25 5.25 5.25 5.25 5.25 5.25

Russia 5.25 5.25 5.25 5.25 5.50 5.75

LatAm

Brazil 8.50 8.00 7.50 7.50 7.50 7.50

Mexico 4.50 4.50 4.50 4.50 4.50 4.50

Asia

China 6.56 6.56 6.31 6.31 6.31 6.31

China RRR 20.0 19.5 18.0 17.5 17.5 17.5

Korea 3.25 3.25 3.25 3.25 3.25 3.50

India 8.00 8.00 7.50 7.50 7.50 7.50

Indonesia 5.75 5.75 5.75 5.75 5.75 5.75

SEB forecasts of policy rates until Q1 2013, %

Source: Bloomberg, SEB

Positively however, Saudi efforts to increase oil supplyto maximise the effect of sanctions against Iran havebeen successful supported by Libyan and Iraqidevelopments. According to our main scenario, crude

oil prices will increase only slowly going forward, whilefood prices will continue to fall.

Eurozone developments to dictate the nextEM market move whats in store?Turning back from the macroeconomic outlook tofinancial market developments, we recall that EMassets fell substantially during May. By now, theyarguably discount a scenario worse than is justified byour assumptions regarding global growth and themost likely developments in peripheral Europe.However, in our recently published Nordic Outlookwepoint to asymmetric and negatively tilted risks andemphasise that the next chapter in the single currencysaga could still go horribly wrong. The globaleconomic recovery remains extremely lacklustre and

the worlds economic and financial immune systemsare weak.

Consequently, EM assets generally look cheap. However,this does not in any way rule out the possibility that theymay become even cheaper. Certainly, the near termoutlook is very likely to be governed by developments inAthens, Madrid, Brussels and Frankfurt. In particular, theGreek election on June 17 has the potential to triggersignificant positive or negative changes in EM assetvaluations. Victory by parties that reject the bail-outpackage could trigger an uncontrolled break-up of theEurozone creating a flight to liquidity reminiscent of thepost-Lehman period. EM assets would suffer considerablyin such a scenario.

Near term uncertainty demands caution...Greek opinion polls have changed recently. Currentreadings may not be accurate in guiding the eventual resultincluding what a governing coalition formation might looklike. Risks are therefore biased towards markets

discounting an even greater likelihood of an extremelynegative scenario in the very near-term. EM exposure

should therefore be treated with care.

In our main scenario, however, we expect the Greek vote tofavour compliance with EU/IMF demands and remaining inthe euro, at least for the time being. A second inconclusiveelection result is, of course, also a possibility. If it occurs,we do not expect markets to give the Greeks the benefit ofany doubts pending the holding of a third vote. Instead, webelieve it will react quickly and defensively.

but our main scenario is EM bullish over thenext 3-6 monthsGiven current market pricing, a victory for Greecesprevious pro-austerity coalition parties ((New Democracyand PASOK) should pave the way for a substantial reliefrally. Towards the end of June and no later than Q3 weexpect four factors to provide further momentum to such arecovery:

Additional support for peripheral Europe

US QE3

Accommodative Chinese economic policies

A turnaround in leading indicators, however shallow, inAugust (SEB proprietary GLEI-indicator).

Regarding support for Europe, we expect Spain to receiveEUR 150bn intended to bolster its banking system. Cyprusis also expected to apply for and receive financial supportfrom the EU and IMF while Portugal and Ireland are likely toreceive somewhat leaner repayment conditions.Meanwhile, we do not expect the new French president torock the boat by implementing any destabilising reforms.His emphasis on shifting policies from austerity to growth

will, however, be recognised by strengthening EuropeanInvestment Bank resources with a further EUR 50bn, to be

leveraged up to EUR 300bn, at least in our opinion.


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In the US, a third round of quantitative easing this falllooks likely as Operation Twist ends, inflation risksremain remote, and the labour market recovery losestraction (see Nordic Outlookfrom 8 May). A policy shiftis due in China with recent developments arguing for ashift from fighting inflation to supporting growth. Weexpect authorities to implement wide rangingmonetary and fiscal policies although less so than in2008/09. It will, however, suffice to engineer a softlanding, evidence of which we expect to see in Q3 (seeour Strategy Focus EM from 24 May).

Finally, leading indicators have been bearish to mixedfollowing signs of improvement late last year andduring Q1 in many EM. Our leading indicator on theOECDs own leading indicator (GLEI) has still pointedto a turnaround, however shallow, in August. However,it will be insufficiently strong to cause the indicator to

show expansion before the end of this year. In otherwords, we should expect a slowdown tending tobottom out but not before the end of the forecasthorizon.

Eurozone challenges still unresolvedCrucially, the progress made so far in ring fencing thecrisis in peripheral Europe and the additional supportmeasures likely to follow in the near future do notfinally resolve the Eurozone debt crisis. At the end ofthe day, the euro project was launched as a politicalproject and that is where the main challenges lie going

forward. We have many more EU summits to lookforward to, probably with angst, even in the bestpossible scenario. Furthermore, as regards Greece, webelieve that even if the vote on June 17 produces agovernment willing to adhere to agreements with theEU/IMF to continue future bail-outs, the country iseventually more likely than not to abandon the single

currency.

and will disturb or possibly ruin the partyConsequently, while the relief rally will gainmomentum this fall for the reasons listed above,

eventually outstanding unresolved challenges for theeuro and the economies of its Mediterranean memberstates will return to haunt the market. In our mainscenario, we expect these problems to be dealt with.We therefore do not look for a fresh onset of aprolonged period of flight to liquidity. However,bumps on the road will create a difficult tradingenvironment and prevent EM assets from increasingparticularly rapidly beyond Q3 without new activemeasures towards a solution of the Eurozone crisis, wethink.

Iran still a risk, but sanctions biteThe situation in the Persian Gulf still represents a risk.Iranian rhetoric towards the international community

could be interpreted as an increased threat to extend itsnuclear program beyond its civilian capabilities. In part atleast, it is reassuring that the position has so far beencontained. Sanctions against the country have effectivelyhindered their efforts. Still, the situation will remain fragilegoing forward. The political window for military actionagainst Iranian sites will not be closed before the end of thesummer. Thereafter, the US election campaign enters itsfinal stages making a strike less opportune. Crude priceshave declined despite the embargo against Iranian oilhaving been put in place.

Political risksPolitical risks have moved further up the agenda in Chinawith the purge of influential Chongqing major Bo Xilai fromthe countrys political scene. Rather than being a part of apopular unrest indicating or driving potentially adverseeconomic outcomes, this should be seen more as an

intrigue within the highest echelons of the Party. As such,its economic consequences should be limited. Itnonetheless stands by its mandate to deliver continuousstrong growth, a task to which it will remain strongly

committed.

From a general perspective, the risk of widespreadinstability in EM has decreased as food prices have fallen.Ongoing normalization of crops should continue accordingto our forecasts, representing a key positive for the region.Nevertheless, countries such as Romania and Serbia areexperiencing a combination of economic pressure and post

election political tensions. Meanwhile, recent opinion pollsin the run-up to the Mexican presidential election haveshown that the PRDs candidate narrowed the gap to thePRIs Pea Nieto, a development badly received bymarkets. Nevertheless, we still believe Pea Nieto will winthe election on July 1. In Russia, Vladimir Putin has beenreinstalled as President. While we expect the status quo tobe largely maintained concerning both economic andpolitical reforms, risks are probably biased to the downside.

Eastern Europe vulnerable to deleveragingRisks to Eastern European EM have by now been

thoroughly highlighted. With the Eurozone crisisaccelerating, the issue however needs to be reviewed onceagain. Large refinancing requirements leave such

In conclusion, the key risks to EM in coming quarters are

as follows: Eurozone crisis escalates

Middle East tensions trigger an oil price hike

Food prices turn around and rise substantially,depriving EM central banks of room for maneuver

Political risks


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economies heavily dependent on foreign banks at atime when they are seeking to improve financial ratios.The results of targeted de-leveraging could havehighly adverse consequences. Also, borrowing maybecome more difficult in the event of a disorderlyGreek exit from the Eurozone. IMF calculations basedon official leverage targets from European banksproduced fairly bearish conclusions reported in itsGlobal Financial Stability Report (April). According tothe IMF, the most vulnerable countries are Hungary,Poland and Turkey. If capital inflows to EM economieswere to reverse as they did post-Lehman, the IMFestimates that their currencies might depreciate vs.USD by 15% per annum.

A slightly more positive message was issuedconcerning EM funding by the banking industryorganisation, the IIF. According to its EM Loan Survey

in Q1, an EM counterpart to the Federal ReservesSenior Loan Officer Survey in the US, banks are nowmore willing to lend. However, loan demand fromclients has declined, according to the survey, aworrisome development indicating that the impact ofstimulative monetary policies is weakening. To helpthe economy, fiscal policies must fill this void,substituting private demand for funds andinvestments. However, fiscal room for manoeuvre islimited in several of the worst hit economies. In EMgiant China, however, we expect continued cuts inreserve requirement ratios for banks and a rate

reduction in Q3 to be complemented by a moreaccommodative fiscal policy.

EM bond fund flows resilientSince our last edition of Emerging Market Cross Assets(EMXA) in February, both EM and (to only a slightlylesser extent) DM bond funds have reported generousinflows. At the same time, equities have sufferedsubstantial outflows. Higher Q1 demand for EM equityfunds began to reverse as early as March.Consequently, during Q2, EM equity outflows totalled2-3% of AUM. Conversely, flows to EM bonds

increased faster than to other asset classes.

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

-6

-3

0

3

6

9

12

15

18

23/05/2012

14/03/2012

04/01/2012

26/10/2011

17/08/2011

08/06/2011

30/03/2011

19/01/2011

Source: EPFR

% AUM

EM Bonds

EM Equities

DM Bonds

DM Equities

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

counterparts.

Regional cumulative flows to EM Bonds, 2011-YTD

-30

-20

-10

0

10

20

30

40

50

60

23/05/2012

14/03/2012

04/01/2012

26/10/2011

17/08/2011

08/06/2011

30/03/2011

19/01/2011

Source: EPFR

% AUM

EMEA

Asia

LatAm

However, during the week ended May 30, EM bond fundsposted their third biggest weekly outflow YTD. Absentdecisive action by European policymakers, fund investorshave continued to reduce their exposure to higher riskasset classes, while downgrading their expectations andlooking ahead to Greeces new elections on June 17. Flowsinto bond funds, which usually remain more resilient tomarket turmoil, lost momentum as safe haven demanddrove US and German debt prices even higher andinvestors reduced exposure to several riskier fixed income

asset classes.

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

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

30/05/2012

09/05/2012

18/04/2012

28/03/2012

07/03/2012

15/02/2012

25/01/2012

04/01/2012

Source: EPFR

USD bn

EM Equities

EM Bonds

During the week before, high yield bond funds reportedtheir biggest outflow in more than nine months at over USD3bn, becoming the worst performing asset in the BondFund category. At the same time, EPFR-tracked EM bondfunds posted a total outflow of USD 0.48bn while EMequity funds suffered a loss of USD 1.55bn. EM bond fundredemptions were evenly divided between local and hardcurrency mandated funds.


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10


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

-20

-16

-12

-8

-4

0

4

8

12

30/04/2012

29/02/2012

31/12/2011

31/10/2011

31/08/2011

30/06/2011

30/04/2011

28/02/2011

Source: EPFR

bn USD

EM Bonds

EM Equities

Superficially, the current situation may appear similarto the sell-off that occurred last August andSeptember when EM equity funds suffered severeoutflows and even bond funds faced losses. However,

current withdrawals are far smaller with last yearsmass exit impacted by investors reacting to the recentUS sovereign debt downgrade, persistently high oilprices, the aftermath of the Japanese earthquake andtsunami, and of course the Eurozones escalating debt

problems.

EM Bonds: Flows cumulative by currency, 2011-YTD

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

23/05/2012

14/03/2012

04/01/2012

26/10/2011

17/08/2011

08/06/2011

30/03/2011

19/01/2011

Source: EPFR

USD bn

Hard Currency

Local Currency

Blend Currency

Since our last EMXA in February, hard currency bondfunds have been in high demand, attracting flows ofaround USD 3bn, compared with USD 0.2bn and USD0.4bn by local and blend currency funds, respectively,with a few interim weeks posting net outflows. Hardcurrency funds are likely to continue to attract higherflows for some time yet provided investors maintaintheir preference for liquidity over carry.

With EMEA remaining at greatest risk of contagionfrom the European credit crunch we retain ourcautious view on the region. However, as Spanishproblems are increasing, Latin Americas relativeattractiveness may also be hurt. We expect Asian bondfunds to continue to attract inflows, particularly giventhe regions relatively greater resistance to slowingglobal growth, and its geographical distance from theepicentre of the highly problematic Eurozone debt

crisis.

Asset allocation next 3-6 months and keymessage each asset classFor EM asseets in general we see large downside risks. Atthe same time, there are good fundamental value in manymarkets and a good medium term return potential. Ourrecommendations imply a low allocation to riskier assetsfor now, while at the same time maintaining a readiness toexpand exposures if the risk picture would improve.

Looking at the least risky assets in our universe, thecurrency-hedged local bond yields, we maintain aconstructive veiw. Going into FX, we are more cautiouseven though we look to buy downbeaten currencies.Option strategies to hedge against adverse scenarios areour first recommendations there. In equities, we warnagainst getting trapped into strong values that soon mightfind themselves even stronger; again our recommendationsare on a look to buy basis. While being cautious on Europe

for all asset classes, we favour Asia in equities. Brazil andIndonesia look attractive both from a yield and currencyperspective, while we look positively on Chinese equities.

So, while repercussions from the Eurozone debt crisesperiodically triggers substantial outflows from EM fundsand EM countries in general, we firmly maintain our longterm bullish view on this part of the world. In the followingsection we present the findings of a recent study by ourcolleagues at SEB X-assets Research looking at The longterm case for EM with implications for asset allocation in

EM.


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11


The long-term case for EMThere are two key long-term arguments for emergingmarket currency exposure high interest rates andcurrency upside. Both arguments have received aboost from the debt crisis in the large industrial

economies. Western interest rates are effectively atzero, increasing the attraction of higher EM rates, andmoney printing is now the only policy tool left and thiswill ultimately hurt currencies. It hasnt happened yetbecause non-G7 countries have been recirculatingtheir surplus into G7 assets. This is a key reason whyglobal imbalances have not reversed yet and we haveseen 15 years of uninterrupted debt build-up in theWest due to overvalued exchange rates. But there arelimits to how much debt the West can take, and the

de-leveraging will require a lot more money printing.

Central bank balances, USD trn, and policy rate

Meanwhile, creditor countries now feel the sideeffects of holding exchange rates and interest ratestoo low for too long: high inflation, property bubbles,debt crises and misallocation of capital. This willeventually force them to let G7 currencies go if the G7central banks keep printing money. The end result islikely to be a currency crisis, but we dont know when:economists have called the imbalance unsustainablefor years. Until G7 currencies have been devalued,zero rates will increase the attraction of higher rates incurrencies with weak fundamentals. For now, both

arguments work but they work in different ways.

Three groupsNot all emerging market countries are equally exposedto both types of return potential. In order to getbuilding blocks to structure we group the universe intothree emerging market groups: those with carry, thosewith upside potential and those in between.Fundamentals and pricing of risk underpin rankingcountries in terms of global currency and bond market.The chart below shows accumulated current accountand budget balance for the past 11 years and bondyields at the end of 2011. Based on shared

characteristics we can group the countries into threebroad types of exposure.

10Y funding needs and 10Y bond yields

Upside

Carry

Transition

G7 currency

war losers

Upside

Carry

Transition

G7 currency

war losers

Carry countries have relatively weak fundamentals, butalso substantially higher yields to compensate for the risks,G7 currency war losers countries have the same kind ofweak fundamentals as the Carry group, but without thehigh yield. Upside countries have strong fundamentalsaccompanied by lower yields. These countries have

significant appreciation potential the day the rebalancingprocess begins in the G7 countries. Transition countriesare in between the two other groups, but their problem is

too little carry and not enough upside.

2011 10Y yields & 1996-2011 inflation

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0% 2% 4% 6% 8% 10% 12%

10Y yield 2011

1996-2011i

nflation

China

India

Indonesia

South KoreaSingapore

Russia

Mexico

Chile Poland South Africa

Taiwan

Thailand Malaysia

Turkey

Brazil

Source: Ecowin, GFDand SEBX-asset

USA

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0% 2% 4% 6% 8% 10% 12%

10Y yield 2011

1996-2011i

nflation

China

India

Indonesia

South KoreaSingapore

Russia

Mexico

Chile Poland South Africa

Taiwan

Thailand Malaysia

Turkey

Brazil

Source: Ecowin, GFDand SEBX-asset

USA

The difference between the groups is also evident ininflation history. In the past, many emerging marketcountries have experienced currency crises followed byhigh inflation and bond yields. Since then, structuralreforms and more sound fiscal management have overtime contributed to a more stable economic outlook.Current low bond yields for Upside countries are a result

of a long period of low inflation and strong internal andexternal balances, and entering this group will thus take a

long time.

The case for EMIn theory, the total return from spot and carry should onaverage cancel out over long time horizons. However,uncertain and variable emerging market inflation and thereserve currency status of thje major currencies meansthere will be a risk premium: carry above exchange ratedecline. Over the last 15 years most countries have beenpaying a bit carry on top of their exchange rate, more than

canceling out any currency depreciation.


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12


2000 and 2011 interest rates relative to US

-10%

-5%

0%

5%

10%

15%

20%

25%

China

Singa

pore

SouthK

orea

Taiw

an

Thail

and

Mala

ysia

Mexico

Polan

dCh

ile

Indo

nesia

India

Brazil

Turk

ey

South

Afric

a

Russia

2000 2011 Source: Ecowin , GFDand SEB X-asset

Average 2011

Average 2000

The question going forward is whether the current lowinterest rate environment will offer a risk premium.With most countries reducing their interest rates overthe last couple of years investors might expect carry tohave come down. Comparing carry in 2000 with carry

in 2011 it is evident that the risk premium was actuallylower in 2000 with most countries paying higher carryin 2011. With current US interest rates close to 0%,carry can virtually only be positive. It is not possible toreflect appreciation potential with negative carry in

this kind of environment.

2000 and 2011 10Y yield spreads relative to US

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

China

*

Singa

pore

SouthKo

rea

Taiw

an

Thail

and

Mala

ysia

Mexico

*

Polan

dCh

ile

Indon

esia*

India

Brazil

Turk

ey*

South

Afric

a

Russia*

2000 2011

Source:Ecowin ,GFDand SEB X-asset

Average 2011

Average 2000

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

Another consequence of more stable economicoutlooks are lower bond yields. As with carry, the bondyield risk premium is a relative game and with very lowUS bond yields the risk premium in bond spreads stillexists. Average yield spreads at the end of 2011 were

at the same level as in 2000.

Starting point: money market exposure in the3 groupsWe look at three options for investors to accessemerging markets in this report: the money market,the bond market and the equity market. We start bylooking at the performance of basic money marketpositions before we add asset class risk from bondsand equities. The chart below shows performancesince 2000 for emerging market money markets withopen FX for a USD-based investor. We include a new

group Upside ex China because Chinas capitalcontrols prevent access for international investors.

We include Nordic currencies as a reference as they are the

developed market equivalent to the Upside group.

Money market risk and return, real USD, 2000-2011

-2%

0%

2%

4%

6%

8%

10%

0% 2% 4% 6% 8% 10% 12%

Standard deviation

Realreturn

Upside

US T-bills

Source: Ecowin ,GFDand SEB X-asset

Nordic money market

Upside ex China

Carry: India, Brazil, Turkey,

South Africa, Russia

Transition: Mexico, Poland,

Chile, Indonesia

Upside: China, Singapore,

South Korea, Taiwan, Thailand, Malaysia Transition

Carry

Over the last 10 years investing in money markets outsideUS has involved higher risk, but also higher returns. Both

return and risk increases as we move from Upside toCarry and the differences are significant: Carrys risk isalmost twice as high, but the annual return is 7% higher.Nordic currencies have in fact been more volatile in USDterms than all EM groups, with a return in the low end ofthe range. An investor afraid of a G7 debt crisis should thusconsider if capital protection from Upside will add risk atlow returns for longer than he or she is prepared to wait:the longer it takes, the more attractive the direct returnsfrom Carry look. But the historical data obviously fail tocapture the missing carry argument: if currencies arelikely to rise over time, even a carry of zero would suggest a

long-term return well above the historical one. And with USrates at zero, there carry must be at least zero.

Cyclical risk: FX losses clustered in cyclical bearmarkets10 years is a long time in the real world, where mostinvestors are measured over significantly shorter timehorizons. Average long-term risk is interesting but asalways we want to emphazise cyclical risks and how lossesare distributed over time.

To do this in a structured manner we turn to the SEB Wavesallocation framework - allowing us to look at risks overdifferent time horizons. We note that the underlying datasample is limited, especially the strategic cycle is notrepresented by a large number of data points in each phaseand we should be cautious in drawing too strongconclusions. The higher number of tactical cycles makesthe tactical results more robust.

Our strategic analysis is based on a simple model thatbreaks the outputgap cycle into four phases, depending onwhether growth is above (expansion) or below trend(recession) and wheter credit conditions are easing ortightening. Over the past 40 years, recessions have lasted2-4 years, while expansions lasted from 4-8 years.


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13


Strategic money market returns, real USD, 2000-2011

-20%

-10%

0%

10%

20%

30%

Early recession Late recession Early expansion Late expansion

US T-bills Upside Upside ex China

Transition Carry Nordic money marketSource: Ecowin,GFDand SEB X-asset

Early recession is the worst phase from an investmentperspective, with elevated volatility and large lossesfrom risky assets. A cyclical safe haven, like US, has itslosses distributed to other phases than early recession.Emerging market money markets have their largest

losses concentrated to early recession and areobviously not safe haven investments from a cyclicalpoint of view. Decomposing money market returnsinto the underlying components we find that emergingmarket exchange rates are cyclical which shines

trough in the stratgic money market results.

Tactical money market returns, real USD2000-2011

-10%

-5%

0%

5%

10%

15%

20%

25%

Early downturn Late downtur n Earl y upswing Late upswi ngUS T-bills Upside Upside ex China

Transition Carry Nordic money marketSource:Ecowin,GFD and SEBX-asset

The tactical inventory cycle is also broken down intofour phases, depending on whether short-term leadingindicators are rising or falling and whether the changeis accelerating or decelerating. Over the past 40 years,each phase has lasted on average 4-6 months. Early

downturn is the most critical phase with elevatedvolatility and large losses. Tactical money marketreturns have showed less distinctive cyclicality thanthe strategic cycle. Upside has had its largest lossesin early downturn while both Transition and Carryshow defensive characteristics. Underlying exchangerates have been less cyclical in the tactical cycle,lowering the risk of losses in early downturn.

Adding bond and equity exposure: more riskEmerging market bonds, denominated in localcurrency and with 10 years duration, have offered

higher returns than local US bonds over the lastdecade. Bonds from the Upside groups have evenachieved this with lower risk than US bonds, but the

excess return is small. Carry has experienced close toequity like risks, but also a return close to normal equitymarket returns and far above the realised US equity return.Of course, the same argument applies here as in moneymarkets when it comes to the long-term return potential of

the Upside group.

Emerging market risk and return, real USD, 2000-2011

-5%

0%

5%

10%

15%

0% 5% 10% 15% 20% 25% 30%Standard deviation

Realreturn

Money market Bonds Equities

Upside

Transition

Upside ex China

USA

Source:Ecowin , GFD and SEB X-asset

Nordics

Carry

Carry

USA

Transition

Nordics

Upside ex China

Nordics

Upside ex China

USA

Transition

Carry

Upside

Upside

Emerging market equities have had much higher risk thanbonds and also far above US equities. All groups haveoutperformed US equities over the last decade withsignificantly higher risk-adjusted returns, but there is not aclear-cut risk/reward pattern as we found for both themoney market and bonds. In spite of the much higher risk,the historical return from EM equities has only beenmodestly higher than the return on EM bonds.

Cyclical risk: Upside bonds reduce cyclicallosses

Strategic bond returns, real USD, 2000-2011

-30%

-20%

-10%

0%

10%

20%

30%


US bonds Upside Upside ex China Transition Carry Nordic bonds

Source: Ecowin,GFDand SEB X-asset

Turning to the strategic investment cycle we find that localbonds have defensive characteristics and have had theirhighest return during early recessions. Open FX exposureincreases cyclicality for all emerging market groups, butonly the Upside has delivered positive returns in earlyrecession while both Transition and Carry haveexperienced losses: the fundamental strength of Upsideeconomies makes their local currency returns behave morelike thoese in the US, which also decline in recessions.Carry bonds have had losses close to 15% in early

recession, significantly higher than the other groups.Nordic bonds are also cyclical, but less than both

Transition and Carry.


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14


Tactical bond returns, real USD, 2000-2011

-10%

0%

10%

20%

30%

Early downturn Late downtur n Earl y upswing Late upswi ng

US bonds Upside Upside ex China Transition Carry Nordic bonds

Source:Ecowin,GFD and SEBX-asset

Tactical bond cyclicality is less pronounced thanstrategic. Local as well as emerging market bondshave had positive returns in early downturn over thelast decade, mainly due to less cyclical exchange rates

characteristcs.

Cyclical risk: first part of recessions verypainful for equities

Strategic equity returns, real USD, 2000-2011

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%


US equi ti es Up si de Up si de ex Ch ina T ra ns iti on C arry N ordi c equ it ies

Source: Ecowin,GFDand SEB X-asset

Local equities are cyclical and systematicallyunderperform in the worst part of the strategic cyclewith historical losses around 30% in early recession.Equity returns in USD show cyclical characteristics, butthe inverse relationship between appreciatingcurrency and equity returns leads to somewhatdampened losses. Nordic equities have been ascyclical as Carry equities, with losses around 45%.

Equity returns have recovered in the late recessionphase and stayed positive throughout the expansionphases.

Tactical equity returns, real USD, 2000-2011

-40%

-20%

0%

20%

40%

60%

80%

100%

Ear ly downturn L ate downturn Early upswing Late upswi ng

US equities Upside Upside ex China Transi ti on Carr y Nordic equities

Source: Ecowin, GFDand SEB X-asset

Tactical equity results are relatively similar to strategic, themain difference being the close to flat returns in the latepart of the downturn phase. Equity returns have recovered

in early upswing with extra ordinary high returns.

Constructing an optimal long-term emergingmarket portfolio

Emerging market allocation along the efficient frontier, 2000-2011

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

6.5% 8.5% 10.5% 12.5% 14.5% 16.5% 18.5% 20.5%Standard deviation

Upside MM Transition MM Carry MMUpside bonds Transition bonds Carry bondsUpside equities Transition equities Carry equities

Source: Ecowin, GFD and SEBX-asset

In order to illustrate how an investor can allocate withinand between the three emerging market assets we haveoptimised portfolios based on Upside, Transition andCarry. The optimisation is based on historical data overthe last decade and uses resampling in order to avoid someof the well known problems with traditional Markowitzoptimisation. The results should be used as indications.

Optimal portfolio at 10% standard deviation1%

1%

19%

42%

10%

8%

4%

10%

5%

Upside MM

Transition MM

Carry MM

Upside bonds

Transition bonds

Carry bonds

Upside equities

Transition equities

Carry equities

Source: Ecowin , GFD and SEB X-asset

The pie chart shows the optimal historical long-termallocation at 10% risk, giving an annual real return of 7.7%over the last 10 years. The portfolio is relatively balancedwith 60% allocated to bonds and the rest split betweenmoney market and equities. Within the asset classesCarry dominates the money market exposure, Upsidebonds and Transition equities. On an aggregated levelclose to half the portfolio is allocated to Upsidemakingthe portfolio more robust and better prepared if there is adebt crisis.


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15


Adjusting the portfolio to cyclical climate

Strategic efficient frontiers, 2000-2011

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0% 5% 10% 15% 20% 25% 30%

Standard deviation

Realreturn

E ar ly recess ion Late re ce ss ion E arl y e xpa ns ion Lat e exp ans ionSource: Ecowin,GFD and SEB X-asset

The long-term portfolio can be adjusted to fit thespecific strategic regimes. Money market and bondsare preferred at lower risk levels while the end of the

efficient frontiers are tilted towards equities andCarry but 10% standard deviation means you cannot go far out on the curves in all climates.

Tactical efficient frontiers, 2000-2011

0%

10%

20%

30%

40%

50%

60%

70%

0% 5% 10% 15% 20%

Standard deviation

Realreturn

Early downturn Late downturn Early upswing Late upswing

Source:Ecowin, GFD and SEBX-asset

On the tactical level money market and bonds areoverweighted in downturns, with a tilt towardsUpside. Equities regain strength in, mainly allocatedto Upside.

Adjusting the portfolio to the current climate

Current combined weight deviations from long-termbenchmark

Upside Transition Carry

MM 1% 4% -5%

Bonds 8% 1% -4%

Equities 2% -7% 0%

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

Based on the phase specific benchmark deviationsabove and our currenct views on where we are in the

strategic and tacitcal cycles we calculate two overlaysreflecting our current medium- and short-termbenchmark deviations. Combining the two overlays

with equal weights we end up in our current overlayrecommendation, illustrated in the matrix. Our mainscenarios in both the strategic and tactical cycles arereflected in overweights to both Upside and Transitionmoney market and bonds, at the cost of mainly Carry.Active views should be seen as ballpark qualitativeindicators of direction rather than specific detailedportfolio recommendations.


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16


Fixed Income: Supportivemacro

EM fixed income markets have been hurt by

recently increased risk-aversion. However,consistent with our structural case for EM bonds,currency hedged bond positions still show healthygains so far this year, unlike most other riskbearing asset classes. Furthermore, from a localcurrency bond perspective, several aspects of thepresent macroeconomic situation, most notablythe inflation environment, remain benign.Nevertheless, EM bonds, especially from CEEcountries, remain vulnerable to Eurozone risks.

Lower inflation supports local bonds

As we forecast in our February EMXA report,international inflationary pressure has further abatedas a result of lower prices on food and commodities ingeneral. Indeed, inflation rates have decreased fasterthan we expected. Furthermore, moderate growthforecasts for several countries that are neither strongenough to accelerate inflation, nor sufficiently weak toendanger sovereign solvency, support EM bonds.Nevertheless, overall, increasing risk aversion hasproduced a slight rise in EM local currency bond yieldsin May. Due to flight-to-liquidity driven demand fordeveloped market (DM) bonds, spreads have

increased more than yields. While the currency hedgedGBI-EM index has decreased after hitting a record highin early May, it is still a solid 2.2% higher than at thebeginning of the year, a strong performance for such arelatively stable index.

Currencies and credit spreads weighedRegarding more volatile indices that include currencyeffects, the erosion of gains during May has producedless impressive returns. In particular, the non-hedgedGBI-EM index has posted a YTD 2.0% gain which weregard unfavourably given its relatively higher risk.

EM and DM bond yields

5.5

6

6.5

7

7.5

8

Jan-10

Apr-10

Jul-10

Oct-10

Dec-10

Apr-11

Jul-11

Sep-11

Dec-11

Mar-12

Jun-12

0.5

1

1.5

2

2.5

3

Treasuryyield%p.a.

GBI-EM yield

5y Treasury yield

GBI-EMyield%p.a.

Source: Bloomberg

Hard currency index gains have also been eroded, althoughthe EMBI has still reported a 3.4% return since the end of2011. Gains in hard currency bonds earlier this yearmirrored (albeit subject to a lag) the stronger performancesof other risky assets in January, largely as we predicted in

our last EMXA.

GBI-EM local bond Indices

Index = 100 on Jan 2003

220

230

240

250

260

270

280

290

300

310

320

Jan-10

Apr-10

Jul-10

Oct-10

Dec-10

Apr-11

Jul-11

Sep-11

Dec-11

Mar-12

Jun-12

150

165

180

Hedged

unhedged

hedged

Unhedged

Source: B loomberg

Structural case intactReverting to currency-hedged performance, the robustpositive risk-adjusted return so far this year indicates thatour structural case for EM bonds remains intact. Severalfactors probably explain the asset class consistently strongrisk-adjusted outperformance over a long period. Prices arelower and both yields and returns consequently higher

potentially due to:

The home bias of wealthy DM investors

Risk aversion by local investors unable to diversifyaway from local inflation and political risks

A still incompletely developed local investor base

Price insensitivity of issuing governments beingprepared to pay a premium to build a local bondmarket and diversify funding.

EM Bond Returns, USD Hedged

100

110

120

130

140

150

160

170

180

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Index=100Jan12003

Source: Bloomberg

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


17/44

17


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

Picture: Hyperinflation in a still not Emerging Market

Bond yields remain well above current inflation rates,indicating that markets still offer a solid premiumreturn to those willing to bear EM inflation risk.Returns connected to inflation risk-premia are evenmore apparent at the country level, as discussed in the

February 2011EMXA report.

1

2

3

4

5

6

7

8

9

10

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

rate/yield,%p.a.

1

2

3

4

5

6

7

8

9

10EM yieldInflation

EM Inflation and Yield

EM bonds outperformed 2 months out of 3To illustrate the risk adjusted outperformance of EM bonds,we have used the standard hedge-fund metrics share ofpositive months. It simply states in how many months outof the total sample an asset has outperformed its risk-freefunding cost. Looking at the big EM indices since theirinception in January 2003, EM bonds look as strong in thismeasure as when comparing slightly more complexmeasures such as sharpe-ratios. A non-rewardinginvestment gives a return in excess of funding costs only inhalf of the months. Both EM and DM stocks have beenslightly better than this. However, currency hedged EM-bonds have had positive excess returns in 2 months out of3!

50%

55%

60%

65%

70%

EM-Bondshedged

EM

-Bondsunhedged

DM-Bondshedged

EM-Stocks

unhedged

DM-Stocks

unhedged

Share of Positive Months after Carry

Jan 2003 - May 2012

EM hard currency bonds affected by highervolatilityIncreased risk aversion and higher forward looking volatilityindices (e.g. VIX) immediately hit EM hard currency spreadsin May, in sharp contrast to the temporarily laggingrelationship between the VIX and the hard currencyspreads after Januarys risk rally from which we profitedbased on our recommendations in the February EMXAreport. EM hard currency bonds have also been harder hit

than BBB corporate credits during the bear-rally in May.

200

250

300

350

400

450

500

May-10

Aug-10

Nov-10

Feb-11

May-11

Aug-11

Nov-11

Feb-12

May-12

EMBISpreadtoUST,bps

150

190

230

270

310

BBBSpreadtoUST,bps

EMBI-spread

US BBB-spread

Regarding the historical relationship between VIXfluctuations and variations in the hard currency spread, the

reaction affecting the latter appears slightly exaggerated.


18/44

18


EM Hard Ccy Spread and VIX

200

250

300

350

400

450

500

Jan-10

Apr-10

Jul-10

Oct-10

Dec-10

Apr-11

Jul-11

Sep-11

Dec-11

Mar-12

Jun-12

10

30

50

VIXvo

la,

%p.a.

EMBIspread

VIX

sprea

d,b

ps

Source: Bloomberg

Regional differencesSignificantly, we note differences in regional

fundamentals. As we and others have observedseveral times, CEE countries are especially vulnerableto the ongoing crisis in the Eurozone. It should comeas no surprise if CEE hard currency spreads were mostseverely hit if problems intensify. Still, mitigatingfactors may apply. Hungary has progressed towardinitiating formal negotiations with the IMF. Productiondata for Polish products potentially part of supply-chains possibly leading to Asia via Germany haveremained resilient. Nevertheless, financialvulnerabilities pose regional risks justifying the

widened Hungarian spreads.

Regional Hard Currency Spreads

100

150

200

250

300

350

400

450

500

550

Sep

-10

Dec

-10

Mar

-11

Jun

-11

Sep

-11

Dec

-11

Mar

-12

Jun

-12

AsiaLatAmEurope

bpsp.a.

For less impaired regions such as Latin America andAsia, fundamentals look stronger. During the winter,hard currency spreads outside Europe did not increaseas much as they did in Europe; according to local EMBIindices (see nearby diagram). This spring, regionalspreads have moved in tandem, with those in Europenot increasing more than elsewhere. In fact, so far thisyear, the European hard currency index has narrowedwhile its Latin American counterpart has increased.

This, together with the lack of improvement in theEuropean situation, leads us to favour Latin America in

hard currency space, which is further supported by our

macro view on the region.

Depreciating currencies increase inflationpressure but help growthGenerally, EM countries have seen their currenciesdepreciate in May as global risk appetite once again hasstarted to deteriorate. In the longer term, this exacerbatesinflation pressure, both directly through more expensiveimports, and indirectly through a positive effect on growth.Local bonds will therefore be negatively affected while hardcurrency bonds could be helped somewhat by the positiveeffects on the growth outlook.

Eurozone still a risk for EM

Continuing problems in the Eurozone createmacroeconomic risks for EMs, especially those in Europe.We, the World Bank, the IIF and others have previouslyhighlighted the regions dependence on Eurozone banklending, recommending particular caution in the case ofCEE countries. Countries most at risk from deterioration incredit markets due to the Eurozone crisis include Hungary,Poland and Turkey, according to the IMFs Global FinancialStability Report (April) as discussed in the General section

of this report.

Inflation development shows value in local bondsBoth headline and core inflation have been well below ourexpectations. Reductions in the former have beengeographically diversified, with countries such as China,Russia and Brazil all reporting significantly slower priceincreases. It is tempting to regard currency appreciation inJanuary as the reason for lower inflation. However,currency movements have a much slower impact; we recallfor example the EM currency depreciation last autumnwhich failed to prevent inflation rates from falling backafter peaking. Lower inflation towards the end of winterwas much sharper than the gradual fall we had (and

continue to) forecast.

While lower commodity prices are the main contributors(with the crude rally in February 2011 adding a favourablebase effect), we have seen an even more conspicuousdecrease in otherwise usually stable EM core inflation. Weregard this as an example of how EM central bankscurrently enjoy solid trust citizens and corporations. Weshould otherwise have expected more stubborn coreinflation following global market commodity priceincreases over the past two years. However, EM inflationdynamics now appear much less influenced by high-

inflation expectations and compensation demands, andmore by supply-demand balances. This is extremelyimportant both for EM assets, for which it is long-term


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bullish, and EM policymakers, for whom it providesroom to manoeuvre.

1

2

3

4

5

6

7

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

rate/yield,

%p.a.

1

2

3

4

5

6

7EM spread

Inflation

EM Inflation and Yield-spread

Inflation outlook revised down

We reduce our inflation forecasts. Surprisingly lowcore inflation indicates a less inflationary price-wageenvironment. With growth moderating it is thereforereasonable to expect weaker core inflation goingforward. As for headline inflation, we forecast acontinued decline driven by further decreases in foodprices as seen by our commodities analysts. Croplevels are normalizing as is the weather, as La Nina

effects are now probably over for this time.

1

2

3

4

5

6

7

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Inflationrate,

%p.a.

1

2

3

4

5

6

7CoreHeadline

Average inflation in major EM countries

Good environment for bonds in high-inflationeconomiesFurthermore, we would like to emphasize howimportant the inflation outlook is for EM asset prices.Particularly as regards EM bonds, strong inflationexpectations together with a high premium oninflation risk often weigh on prices. Indeed, this is partof our structural buy-case for EM-bonds. From atactical perspective, we believe there is a good casefor buying, on a currency hedged basis, consideringthe historical sensitivity of EM bonds to inflation

developments. Yields have tended to rise afterincreases in inflation rates. Conversely, yields havetended to decrease as inflation eased, albeit more

slowly and with a lagged effect, as shown in diagramsnearby showing both local EM yields and their spreadsabove Treasuries relative to the inflation path. To completethe pattern, it is time for EM yields to begin significantlydecreasing, adding capital gains to positive carry whereyield curves slope upwards. Bonds gaining most from thisdevelopment include those in high-inflation countries withlarge premiums due to recently high inflation rates. Ofcourse, other factors usually present risks, particularly apotential risk-off driven slump in lower grade bonds.

Note on inflation measure:

Our CPI measure for EM comprises a weighted average for

China, Brazil, South Korea, Taiwan, Russia and Poland.

These countries have been selected based on their relative

importance and data availability. Weights are based on the

MSCI Equity index.

EMEA

Poland 4.0 2.5 2.7 4.3 3.8 2.8

Czech 3.5 2.0 1.4 1.8 3.2 1.8

Hungary 5.7 3.0 4.9 3.9 5.5 3.5

Turkey 11.1 5.0 8.6 6.5 9.5 6.5

S. Africa 6.1 4.5 4.3 5.0 6.1 5.5

Romania 1.8 3.0 6.1 5.8 3.0 4.2

Russia 3.6 5.5 6.9 8.5 4.5 5.5

Estonia 4.0 - 2.7 5.1 4.0 5.0

Latvia 2.8 - -1.2 4.2 2.5 2.1

Lithuania 3.2 - 1.2 4.1 2.5 3.0

Ukraine 0.6 - 9.4 8.0 3.6 7.0

LatAm

Brazil 4.3** 4.5 5.0 6.6 5.2 5.2

Mexico 3.4 3.0 4.2 3.4 3.6 3.5

Asia

China 3.4 4.0 3.3 5.4 3.5 3.8

Korea 2.5** 3.0 3.0 4.2 3.3 3.1

India* 7.2 - 12 9.4 6.8 7.2

Indonesia 4.5** 5.0 5.1 5.4 4.5 5.0

Singapore 5.4 - 2.8 5.2 3.5 2.3

*Wholesale prices ** May CPI Source: Bloomberg, IMF, SEB

CB target

2012

Av. inflation

2010

Av. inflation

2011

SEB f-cast,

av. 2012

SEB f-cast,

av. 2013

Current inflation, target and forecast, %April CPI,

y/y

Hungary: doubly at riskWe focus specifically on Hungary as it represents a coregeographical area for us and because it has high, volatileyields. After a recent field trip to Budapest we conclude thefollowing, both risks and yields are currently elevated.Periodically, Hungarian markets have weakened, beingespecially vulnerable following the abolition of the secondpension pillar. Consequently, the investor base forHungarian government bonds is insufficiently diversifiedand dominated by foreigners. This is especiallyproblematical as the country has huge debts and large

refinancing requirements. The local economy is depressednot only by the need to repay debt. Unpredictable fiscalreforms increase risk premiums and dampen investment


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appetite. These reforms are driven by the need toimprove finances by a government committed to itspromise to implement a costly flat-tax reform and to

hold property-taxes at zero.

Picture: Irina Ivaschenko, IMFs representative in

Budapest

More positively, export sectors are strong, generatingrevenues which enable the country to continue to paydown its external debt. In this context, softeningexternal demand is also a risk. The possibility of astand-by credit facility from the IMF being establishedhas an important stabilizing effect on Hungarianmarkets. The chances of the country successfullynegotiating such an arrangement have increased afterthe EU recently dropped its political pre-conditions forformal IMF negotiations to start. Another EU positive isits more optimistic view on the possibilities of Hungary

improving its fiscal position. Negatively though, formalnegotiations have yet to start. The IMF is alsoconcerned about the structural growth impactstemming from the unpredictability of Hungarian fiscalpolicy. As we write, the question of whether or not theHungarian central bank is independent has almost, butnot entirely, been resolved.

200

240

280

320

360

400

2007 2008 2009 2010 2011

5

7

9

11

13

15EURHUF

Hungary 5yr yield

yield,%p

.a.

From a portfolio perspective, the premium offered tocompensate for carrying Hungarys own unique risks isattractive due to diversification benefits. However, thecountrys heavy dependence on the Eurozone stillensures it remains a leveraged bet on risk sentiment in

global markets. Overall, we recommend near termcaution due to the countrys non-diversified investor

base where long positions are concentrated. Downside

risks tend to follow from such situations.

Baltic: Latvia still our regional favoriteLatvia remains our Baltic favourite due to its lower exportdependence and strong political management. S&P agrees

and has increased the countrys debt rating to investmentgrade; BBB- from BB+ on May 2. So far, markets have beenunresponsive to such developments. As a result, wecontinue to recommend buying Latvian hard currencybonds vs. Lithuanian ditto. See our May edition of BalticFixed Income for further details.

Latvian and Li thuanian 5-yr USD

3

4

5

6

Feb-12 May-12

3

4

5

6

Lithuania

Latvia

Y

ield,

%p.a.

Iceland: Recovering slowly but stronglyDespite continued liberalization of Icelandic capitalcontrols, they have been strengthened in one importantrespect. The right to repatriate all cash-flows frominstalment bonds, specifically HFF inflation linked bonds,has been cancelled. While latecomers to our HFF case may

have lost as bond prices plummeted on the announcement,those who bought at the time of our recommendation havemade attractive profits, which of course is the very reason

why controls have been tightened.

The countrys financial situation has improved slowly butstrongly, with the unwinding of the huge Landsbanki estateproceeding better than expected. Potentially destabilisingoffshore ISK holdings have also been substantiallyrewound. HFF bond owners would not face excessive risksby retaining Icelandic assets. From a currency regulationperspective, a switch into high coupon government bonds,

preferably the 8.75% 2019 would be best.South Africa, Indonesia and Brazil to benefit fromlow inflation environmentTo secure a geographically diversified exposure to theimproved inflation environment, we consider bonds inSouth Africa, Indonesia and Brazil.


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0

2

4

6

8

10

12

14

16

03 04 05 06 07 08 09 10 11 12

South Africa 10yr yield inflation

yield,%p

.a.

The focal point for political risks in South Africa is Mr.Malema, the former leader of the governing ANC partyyouth league (ANCYL). After being removed from hispost by the government who accused him of actingcontrary to the national interest by threatening tonationalize the mining industry, his popular base hasso far not revolted, as feared by many analysts. In thisrespect, risks are in the process of being unwound,with some way left to go. While lower food pricescould help, at present inflation rates have not yetbegun to decrease. As in the case of Hungary, localpolitical risks weigh on asset prices. Consequently, to adiversified global portfolio South African bonds offer

an additional return at little extra totalrisk.

Inflation in Indonesia have proved very benigndespite increasing to 4.5% over the past couple of

months; as late as 2008 prices were rising at double-digit rates. Recent action to support the depreciatingrupee focuses on this issue. With a low GDP per capita,reduced food prices have an important effect onhousehold economy. Domestic demand may thussupport growth when external demand softens. Bondyields have been trending steadily lower with morelikely to come.

0

2

4

6

8

10

12

14

16

18

20

2003

2004

2005

2006

2007

2008

2009

2010

2011

Indonesia 10yr yieldinflation

yield,

%p.a.

Brazil has continued to switch from monetary to fiscal

policy constraints. The monetary stance has softenedsignificantly, on the fiscal front; at least officialnumbers show some tightening. Nevertheless,

inflation developments have remained benign while growthhas decreased. The currency waris going in reverse withauthorities recently buying their own FX on the openmarket at just over USD/BRL 2.0 to prevent excessiveweakness. While domestic capacity appears limited,demand seems to have softened while inflation rates aredown, supported by international developments. Webelieve a couple of more short rate cuts remain likely, withauthorities now considering the consequences ofpotentially easing IOF taxes to strengthen the currency andstimulate investment. It all appears a very conduciveenvironment for lower yields.

0

5

10

15

20

25

30

35

40

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Brazil 2yryield

inflation

yield,%p.a.

Investment conclusionsWith European risks continuing to increase, most stronglyfuelled by Greek parliamentary uncertainty, and thenegative outlook for banking and macroeconomic stabilityin Spain, recommending specific securities is difficult. Wedo however highlight our previous recommendation to buyLatvian bonds vs. Lithuanian. For the hard currency space,we see value in Latin American sovereign credits followingrecent spread developments. Despite ongoing concernsregarding the Eurozone, Latin American credits haveunderperformed vs. CEE securities, leaving spreads

relatively attractive.

Bond basket

Over the past couple of years, we have used a table whichhas included a selection of our favourite bonds to expressour fixed income recommendations, concentrating onunhedged local currency positions, and comprising thosemost easily investable by ourselves and our clients. Inaddition, we offer to wrap these baskets (or indeed any

combination of EM bonds) in SEB certificates.

Having already positioned our basket on the basis of anexpected improvement in the global inflation environmentin our last EMXA, we largely reiterate our earlier call tobenefit from a continuation of this trend. Reflecting our

previously issued (see below) recommendation to takeprofits on the Lithuanian hard currency bond, we switch


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out of it in favour of a corresponding Latvian bond

consistent with our favourite trade (also below).

SEB EM Bond Portfolio February 13 2012 to January 1 2012

SEB

weight Yield Yield

13 -Feb 01-Jun `= i~=K rpa=K

Poland 5% A- 5.1% 4.9% JNMKTB OKOB JUKTB

Hungary 7.5% BB+ 8.5% 8.9% JNMKPB MKVB JVKRB

Lithuania 10% BBB 4.3% 4.0% MKMB OKOB OKOB

S. Africa 15% BBB+ 6.6% 6.4% JNMKOB OKSB JTKVB

Turkey 5% BB 9.3% 9.3% JRKMB OKVB JOKPB

S. Korea 10% A 3

seb report: binary risks, looming relief in emerging markets

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