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BNP PARIBAS MARKETS CALL Summary

Core Content

This document presents the BNP Paribas Markets Call for the week of 04 JUL 2018, focusing on Emerging Markets (EM) and their bear market opportunities. The report outlines the current state of EM markets, the impact of a stronger USD, and the outlook for EM currencies, equities, and bonds.

Main Points

• Trade Wars and Currency Wars: Trade wars are spreading to currency wars. The RMB has weakened by 6.5% against the USD since April 2018, despite China's stance against using FX as a trade tool. This depreciation provides a competitive advantage for Chinese exports, offsetting the 10% US trade tariffs.

• USD Tightening EM Financial Conditions: A stronger USD and higher USD Libor rates have contracted USD liquidity, tightening EM financial conditions. However, commodity-based EM currencies have depreciated by close to 10% since the start of the year, which supports their trade channels with China.

• US Economic Growth and USD Strength: US economic growth is outperforming the rest of the world, which should continue to support the USD in the short term. Despite recent increases in 10-year rates, US real rates remain below 80bp, which is supportive for EM and other risky assets.

• Flattening US 2s10s Yield Curve: The flattening bias on the US 2s10s yield curve is expected to continue due to markets not yet adjusting to the Fed's implied rate hikes. Long-end yields are also expected to be weighed down by reduced fiscal impulse by 2020.

• Inflation and Investment Implications: Higher oil prices are expected to push headline inflation higher. Investors may consider going long on inflation breakevens or swaps.

• EM Earnings and P/E Ratios: EM earnings expectations have fallen, but forward P/E ratios are lower due to faster equity price declines. EM equity profitability and ERP have improved, making EM equities attractive at current levels with significant dispersion.

• EM Carry Trade Unwinding: The unwinding of the EM carry trade has led to a correlated sell-off in EM bonds. Going forward, we expect greater differentiation based on fundamentals, which should increase dispersion.

• Trade of the Week: Investors who agree with the analysis may consider receiving rates in Brazil, where the official overnight rate is 6.50% and the central bank is unlikely to hike this year.

Key Contributors

• Robert McAdie: Global Markets Head of Strategy Research, BNP Paribas London Branch
• Michael Sneyd: Global Head of FX Strategy & Cross Asset Strategist
• Pierre Mathieu: Cross Asset Strategist
• Benedicte Lowe: Cross Asset Strategy Graduate
• Kris Gjini: Cross Asset Strategy Graduate
• Gabriel Gersztein: Head of GM Latin America Strategy & Commodity Quant Strategy

EM Currency Outlook

• Currency Performance: Most EM currencies appear slightly cheap compared to their macro fundamentals, with only a few (TRY, CZK, THB, PLN, HUF, COP) appearing significantly cheap.
• CLEERTM Model: BNP Paribas CLEERTM model-based projections indicate that these currencies are likely to recover over the next 6-18 months.
• Z-Scores: Z-scores are calculated based on % deviation adjusted for 12 implied volatility, with negative values indicating undervaluation.

EM Equity Outlook

• P/E Ratios and ERP: EM equities are on a comparatively low P/E, supported by rising profitability and attractive equity risk premiums. The recent sell-off has corrected P/E lower despite a softer earnings outlook.
• Value Opportunities: Equities in Korea, Hungary, Russia, and Taiwan appear to offer the best value, while bonds in Russia, Brazil, Turkey, South Africa, and Indonesia are attractive.

EM Bond Outlook

• Credit Spreads and Fundamentals: EM bond performance has started to re-correlate with US real yields due to the unwinding of the EM carry trade.
• Deteriorating Fundamentals: EM financial conditions have tightened due to higher CDS spreads and currency depreciation. The USD strengthening and weakening EM economic data have created a deteriorating backdrop for EM.

Impact of USD on EM

• Real Channel: A weaker local currency improves economic activity through increased export competitiveness and import substitution.
• Financial Channel: A weaker local currency reduces cross-border lending and investment, thus negatively impacting economic activity.
• BIS Estimates: A 3% rise in USD reduces capital expenditure by 3-5% over the following quarter and reduces bank lending by 1.4% over 2 quarters.

EM Economic Data

• Recovery and Dispersion: EM economic data is starting to improve, but dispersion in fundamentals remains high.
• Current Account: Countries with current account deficits and reliance on commodity exports are the most vulnerable if the global economy slows down.
• Growth Outlook: A robust growth is expected for at least one more year, but markets are wary of a potential downturn by the end of 2019.

EM Fund Flows

• Outflows Accelerate: EM fund outflows have started to accelerate after weak performance at the start of 2018.
• Orderly Sell-Off: The sell-off remains orderly and is not associated with large trading volumes usually seen during panic moves.

EM Country-Specific Analysis

Key Headwinds

• Stronger USD: A stronger USD negatively impacts EM financing but positively affects trade.
• Higher US Real Yields: Higher US real yields are pushing EM credit spreads wider.
• Weaker EM Economic Data: Weaker economic data in EM is a headwind for asset performance.

EM Fundamentals and Outlook

• Current Account and Commodity Exposure: Countries with current account deficits and reliance on commodity exports are most vulnerable to global economic slowdowns.
• Surplus Decline: The external surplus of EM countries has declined, driven by increasing funding requirements in India, Argentina, and Turkey.
• Recovery and Support: Despite a weak start, EM equities are showing signs of recovery and are supported by economic fundamentals and low rates.

Summary Table of EM Currencies

Trade of the Week

• Receive Rates in Brazil: The official overnight rate in Brazil is 6.50%, and the central bank is unlikely to hike this year. Despite political uncertainty, the risk and term premia are high, making the receiving the belly of the curve very attractive.

Dial-in Details

• Live Webcast: Available every Wednesday.
• Dial-in Numbers:
  • UK: Toll Free - 0808 109 0700
  • USA: Toll Free - 1866 966 5335
  • Other Countries: See table for detailed numbers.

Conclusion

The report outlines that EM markets are facing significant headwinds due to a stronger USD, higher US real yields, and weaker economic data. However, it also highlights potential opportunities in EM equities and bonds, particularly in countries with attractive real yields and improving economic fundamentals. The document encourages investors to consider the EM carry trade unwind and the potential for recovery in certain currencies.