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EM Strategy Plus Summary - 09 September 2016

Core Content

This report provides an analysis of emerging market (EM) strategies, focusing on portfolio flows, banking flows, credit default swaps (CDS), and currency dynamics. It outlines the current macroeconomic environment and highlights key risks and opportunities for investors in EM markets.

Main Points

• Low DM Interest Rates Continue to Attract EM Flows: Nominal and real interest rates in developed markets (DM) remain extremely low, which continues to push capital flows into EM, supporting EM asset prices.
• US Fed Rate Hike as a Risk: A September rate hike by the US Federal Reserve is a near-term risk, especially for Asian currencies. However, the impact is expected to be less severe than during the 2013 'taper tantrum' due to reduced cross-border banking flows.
• CDS Roll and Basis: The upcoming CDS roll on a six-month basis is a key technical factor. Buyers should roll into the on-the-run contracts, while sellers should consider holding onto the old contracts. Long basis trades are expected to underperform, and short basis trades are recommended, particularly in Latin America.
• Turkey CDS and FX Options: Turkey basis trades are closed due to the roll and upcoming Moody's review. It is recommended to buy a 1m USDTRY call option with a strike of 3.05 at an entry cost of 0.70%.
• China's RMB Regime: The CFETS Index and CNY fixing mechanism are becoming more transparent. The RMB is expected to continue depreciating against the basket, though the current regime is functioning well.
• Thailand's FX and Rates: Persistent balance of payment surpluses and FX reserves are forcing the Bank of Thailand to sterilize liquidity, which could become costly. This supports a bullish stance on local FX and rates.
• CEEMEA Outlook: A Fed rate hike could negatively impact EM, but the consequences may be less severe due to reduced cross-border banking flows. South Africa is the most sensitive to financial tightening, while Turkey's short-term implied volatility is low.
• Argentina and Peru: Argentina's inflation-linked Boncer 2021 appears to embed a more bullish scenario, but the report recommends staying on the sidelines. Peru's Soberanos curve is not cheap, with the short end of the curve trading below fair value.

Key Recommendations

Portfolio Flows

• EM saw significant inflows in August, totaling USD 25bn, bringing the year-to-date inflows to USD 77bn.
• Inflows were particularly notable in bonds and Asian equities.
• The report highlights that the 'push' factor of flows from DM to EM remains strong due to the wide yield spread.

Cross-Border Banking Flows

• Cross-border bank lending to EM has declined since 2014, with China, Brazil, and Russia seeing the most significant reductions.
• Turkey is the only country with an increase in cross-border lending, which is concerning in the event of a Fed rate hike.
• The report suggests that the impact of a Fed rate hike on EM may be less severe due to reduced reliance on cross-border flows.

Risks and Opportunities

• Risks: A Fed rate hike could disrupt EM portfolio flows, especially for Asian currencies. Turkey's credit profile is under review by Moody's, which could affect its market position.
• Opportunities: Short basis trades in Latin America, particularly Brazil and Mexico, are recommended. The report also highlights potential in EM high yielders and FX options.

Upcoming Events

• Asia: Bank of Thailand rate announcement, China's economic data, India's CPI and WPI, Indonesia's trade balance, and Singapore's exports.
• CEEMEA: Croatia's parliamentary elections, S&P review of Hungary, inflation data for Poland, and Russia's central bank rate cut.
• Latam: Brazil's retail sales, Chile's monetary policy meeting, and Argentina's CPI release.

Conclusion

The report remains cautiously optimistic about EM, emphasizing the importance of managing risks associated with a potential Fed rate hike and the ongoing CDS roll. It highlights the need for strategic positioning in FX and credit markets, with a focus on relative value and volatility management.