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EM Strategy Plus Summary - 04 September 2015

Core Content

This report provides an analysis of emerging market (EM) strategies and key trades for the week of 04 September 2015. It highlights the ongoing challenges in EM markets, focusing on China, Singapore, South Korea, Brazil, and the broader CEEMEA and Latam regions. The report also reviews the performance of various assets and evaluates the impact of capital flows, currency movements, and central bank interventions.

Main Views and Trades

Emerging Markets CDS Lags FX

• The CDS spreads have not moved significantly despite FX depreciation.
• This suggests that there is potential for wider CDS spreads if sentiment in EMs does not improve.
• The FX depreciation is more pronounced in commodity exporters, indicating stronger capital outflows.

China: Are Outflows Just CNH Carry Trade Unwinds?

• Capital outflows from China are not solely due to the unwinding of the RMB carry trade.
• The RMB carry trade has accounted for at least 40% of the total stock of carry trades.
• The unwinding of this trade is a marginal flow that impacts the PBoC’s FX reserves.
• The report highlights the importance of the CNH market in facilitating carry trade and the implications of its unwinding on FX demand.

China: CNY Peg - Same Same but Different

• The CNY peg has not changed significantly in practice, despite theoretical shifts toward a more flexible regime.
• The PBoC continues to manage the FX market, and any policy shift is likely to be gradual.
• The report suggests that the current situation represents an unstable equilibrium.

Singapore: SGD Rates Flying Too High

• SGD rates have continued to rise, indicating tighter financial conditions.
• The report recommends a neutral stance on SGD rates but suggests potential for band widening in October.
• The upcoming general election on 11 September is a key event to watch for policy changes.

South Korea: Buy USDKRW RKO

• The report recommends buying a 3m USDKRW call with a strike at 1200 and a reverse knock-out (RKO) at 1280.
• This trade is based on the expectation that the won will continue to weaken against the USD.
• The RKO feature makes the trade more attractive by limiting downside risk.

Brazil: Adjusting Up USDBRL Forecast

• Brazil's USDBRL forecast has been revised upward due to new factors.
• The currency is expected to be at 3.80 by the end of 2015 and 3.95 by the end of 2016.
• The BCB has not taken significant action, but the report suggests that Brazil has excess reserves and could sell USD spot to offset a reduction in swaps.

Key Information and Trends

• EM Performance: EM assets have continued to decline, with significant FX and equity sell-offs. The MSCI EM index fell by 2.1% week-to-date.
• Capital Flows: Capital outflows from China have been driven in part by the unwinding of the RMB carry trade, but not entirely.
• FX Dynamics: The USD has gained against EM currencies, with notable depreciation in the CNY, SGD, and KRW.
• CDS and FX: CDS spreads have not moved much, suggesting that FX is the more immediate driver of capital outflows.
• Interest Rates: The report discusses the potential for rate changes in various EM markets, including the possibility of a rate hike in South Korea and a pause in EM rate declines.

Trade Recommendations

• Buy 3m USDKRW call with 1200 strike and 1280 RKO
• Fly DI Jan18sJan19sJan21s
• Short CADCOP via 1m NDF
• Long CLP against a basket (CAD & AUD) via 1m NDF
• Short 3m SGDINR forward
• Buy 6m SGDKRW forward
• Re-enter Long MXN against a basket (CAD & AUD)

Summary Table of Key Positions

Conclusion

• The EM strategy team remains cautious about the outlook for emerging markets, particularly in light of China's economic slowdown and the lack of effective government policies in several countries.
• The unwinding of the RMB carry trade has been a key driver of FX demand, but not the sole cause of capital outflows.
• The report suggests that the current FX and CDS dynamics reflect an unstable equilibrium, with potential for further movements in the coming weeks.