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EM Strategy Plus Summary - 12 August 2016

Core Content

This report provides an analysis of Emerging Market (EM) strategies and highlights key risks and opportunities in various regions. It focuses on the impact of US monetary policy, cross-border banking flows, FX volatility, and credit dynamics on EM assets.

Main Points

1. US Rate Hike Risk

• A September rate hike by the US Federal Reserve is the most obvious near-term risk for EM assets, especially Asian currencies.
• US 10-year yields are likely to remain low even if the Fed hikes rates, as the Fed signals a modest rate trajectory and the term premium is expected to stay low.
• Cross-border banking flows have been shrinking, making Asia less at risk compared to the 2013 'taper tantrum'.

2. Themes of the Week

Asia

• Fade USDKRW CCS squeeze: USDKRW cross-currency basis (XCCY) has tightened sharply, driven by rising USD Libor and a duration mismatch between Korean exporter and domestic liability hedging flows. The current valuation suggests that it is cheaper to raise KRW-denominated debt than USD. We recommend receiving 3y USDKRW NDS at 1.09% with a target of 0.85% and a stop loss at 1.25%.
• Tactical long USDCOP: Despite a recent appreciation, we recommend being tactically long USDCOP to position for a recovery to the short-term fair value.

South Africa

• USDZAR put spread: We have taken profit on the 2m USDZAR put spread and recommend rolling it over to lower strikes with reduced leverage (from 1x2 to 1x1) to increase the delta position.
• USDZAR implied volatility remains elevated, but is expected to decline further as the rand appreciates against the USD.

Turkey

• Turkish markets, especially local bonds, have underperformed EM peers. A sharp recovery is unlikely due to uncertainty over the rating outlook and a deteriorating macroeconomic environment.

Peru

• Changes in pension fund regulations have led to reduced foreign currency deposits. Further USD supply could push the sol higher, supporting our long PEN recommendation.

3. New Recommendations

Key Information

• Cross-border banking flows have been shrinking, reducing the systemic risk from US policy adjustments.
• US real yields have turned slightly positive but remain extremely low, supporting EM asset prices.
• IMF financial package for Egypt is USD 12bn, with a credit-positive impact, though near-term Eurobond issuance may limit bond rallies.
• Brazilian Senate voted to put President Rousseff on trial, with the final impeachment vote expected during the August recess.
• Colombian economic indicators suggest a weakening trend, supporting the view that BanRep's rate hike cycle may be over.
• Chile's Q2 GDP is expected to show a larger-than-expected contraction, influencing the FX market.

Strategic Insights

• The report recommends receiving 3y USDKRW NDS due to current valuations being attractive for fading the CCS squeeze.
• Tactical long USDCOP is advised to capture potential appreciation.
• Reducing leverage on USDZAR put spreads to increase delta positions as the rand appreciates.
• High yielders such as Indonesia, Brazil, South Africa, and Poland are highlighted as positive opportunities.

Risks and Considerations

• USD Libor could continue to rise, affecting the USDKRW CCS curve.
• Korean issuers may still prefer USD debt if the domestic KRW market is not deep enough.
• Korean exporters may continue to use short-dated hedges if the CCS curve remains inverted.
• ZAR appreciation could encourage trend-following strategies, potentially slowing the rate of FX moderation.

Charts and Data

• Chart 1: USDKRW cross-currency basis is almost at par, indicating a tight market.
• Chart 2: 3y USDKRW CCS rate has increased from ~0.7% in July to ~1.1% in August.
• Chart 3: NDS curve inversion could be a hurdle for long-end assets to outperform.
• Chart 4: Ordinal ranking of 3y USD ASW on benchmark government bonds shows relative attractiveness.

Conclusion

The report maintains a cautiously optimistic stance on EM assets, emphasizing the importance of cross-border flows and FX dynamics. It suggests strategic positions in various EM currencies and bonds, with a focus on risk management and leveraging market conditions.