the emerging markets quarterly · em corporate credit strategy no shelter from the global storm 61...

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EMERGING MARKETS RESEARCH December 2011

THE EMERGING MARKETS QUARTERLY

GLASS HALF FULL – TAKE A SIP

Barclays Capital | The Emerging Markets Quarterly

6 December 2011 1

CONTENTS

OVERVIEW

Glass half full – Take a sip 4 We are adopting a more constructive stance toward emerging asset markets, on valuation grounds and on the view that eurozone policymakers are at last converging on a policy framework that can restore financial stability to the region.

EM Credit Portfolio...................................................................................................................................19 EM Local Bond Portfolio .........................................................................................................................20 FX Views on a Page..................................................................................................................................21 EM Trade Summary .................................................................................................................................23

MACRO OUTLOOK

Asia: Deflector shields powering up 26 The deceleration of activity has been gradual, with domestic demand still buffered by tight labour markets, resilient asset values and the confidence that Asian governments can engineer a soft landing.

EEMEA: Euro crisis, balance sheets, and geopolitics 33 The region as a whole remains more exposed than others to the euro area crisis. While a full-blown crisis has been avoided, given close trade and banking links, growth forecasts for EM Europe have been revised further down and external financing risks are now higher.

Latin America: Cooling 38 We are once again shaving our growth forecast for the region. European credit jitters and lower global demand pose the largest risks to our outlook and will continue to drive price action. Exchange rates will remain a central piece of policymaking in Latin America.

MARKET OUTLOOK

Asia: Stepping into the light 42 Asian IRS curves are likely to continue steepening as markets price in rate cuts. Bonds will likely outperform swaps once central banks cut rates. Non-Japan Asian currencies should outperform the USD and EUR, but underperform G10 commodity and EM currencies.

EEMEA: Saving(s) for a rainy day 49 The effects of W. European bank deleveraging put the CEE region in a generally weak spot because of its balance sheets. Outside this block, however, the medium-term knock-on effects from the euro area crisis are likely to be more contained. This argues for being bullish select commodity-related EEMEA assets, eg, in Russia.

Latin America: Cautiously re-engaged 54 The expectation of policy announcements that will contain, yet not eliminate, tail risks in Europe, along with attractive valuations and technicals across LatAm asset classes, warrant our call for investors to re-engage cautiously.

EM CORPORATE CREDIT STRATEGY

No shelter from the global storm 61 We enter 2012 with a cautious stance on LatAm/EEMEA corporate credit. We recommend a neutral allocation to the asset class versus benchmarks. We expect Asian high grade to post total returns of 4-4.5% and high yield corporates to return 13-15% in 2012.


6 December 2011 2

COUNTRY OUTLOOKS

Emerging Asia

China: Easing into unknown waters ..............................................................................................74

Hong Kong: Prepare for worse........................................................................................................78

India: High inflation to deter monetary easing............................................................................81

Indonesia: Defensive easing ............................................................................................................85

Korea: Holding pattern, for now .....................................................................................................88

Malaysia: Growth outperformance in 2012.................................................................................91

Philippines: Policy support on the way .........................................................................................94

Singapore: A gradualist response to the slowdown...................................................................97

Sri Lanka: Turning more cautious ............................................................................................... 100

Taiwan: Hand on the fiscal pump ............................................................................................... 103

Thailand: Look beyond the flooding ........................................................................................... 106

Vietnam: Challenges remain......................................................................................................... 109

Emerging EMEA

Côte d’Ivoire: The long wait for positive catalysts ................................................................... 112

Croatia: New government, old problems................................................................................... 114

EU Currency Pegs –

Latvia, Lithuania, Bulgaria: Determined to succeed, but legacy risks remain....................... 118

Czech Republic: Flirting with recession...................................................................................... 123

Egypt: Fire fighting.......................................................................................................................... 127

Ghana: A fist full of dollars............................................................................................................ 131

Gulf Cooperation Council (GCC): Sheltered, but risks are on the horizon ......................... 134

Hungary: Hungarian dances......................................................................................................... 138

Israel: Strong macro fundamentals, pushing downward....................................................... 143

Kazakhstan: Staying on the right side of oil .............................................................................. 147

Lebanon: Between a rock and a hard place .............................................................................. 150

Nigeria: Inflation worries persist .................................................................................................. 154

North Africa: New chapters, old worries.................................................................................... 157

Poland: Addressing the crisis without fiscal space.................................................................. 161

Romania: Feeling the burn ............................................................................................................ 165

Russia: When oil dependence is a good thing.......................................................................... 169

Serbia: In the risk zone ................................................................................................................... 173

South Africa: Growth risks temper the mood........................................................................... 176

Turkey: Soft-landing scenario at risk.......................................................................................... 180

Uganda: Silver lining on inflation................................................................................................. 184

Ukraine: Sliding deeper into the risk zone ................................................................................. 186

Zambia: New leadership amid global uncertainties ................................................................ 190


6 December 2011 3

Latin America

Argentina: Price for perfection..................................................................................................... 192

Brazil: Fear of slowdown................................................................................................................ 197

Central America and the Caribbean: Hurricane season is over ............................................ 201

Chile: Resistant but not immune ................................................................................................. 205

Colombia: Oil-driven boom and fiscal consolidation.............................................................. 209

Mexico: Coming to an abrupt slowdown .................................................................................. 213

Peru: Growth threatened by social conflicts ............................................................................. 217

Uruguay: In decent shape ............................................................................................................. 221

Venezuela: Monetizing the electoral campaign ....................................................................... 223

Overview of Key Economic and Financial Indicators .............................................................. 228

Global Forecasts .............................................................................................................................. 229

World at a Glance............................................................................................................................ 230

Official Interest Rates and Forecasts .......................................................................................... 231

FX Forecasts and Forwards .......................................................................................................... 232


6 December 2011 4

OVERVIEW

Glass half full – Take a sip We are adopting a more constructive stance toward emerging asset markets, on valuation grounds and on the view that eurozone policymakers are at last converging on a policy framework that can restore financial stability to the region. We expect the reduced tail risk of a catastrophic outcome in Europe to lift markets, given defensive positioning and cautious sentiment.

While we think the time is right to re-engage with risk, we expect markets to remain exposed to global macro risks from Europe and elsewhere for the foreseeable future, leaving volatility high and circumscribing to some extent the scope for a powerful and lasting market rally. The global economy is still, after all, slowing, and some bank de-leveraging will still be playing out.

For EM assets, this backdrop likely means a re-allocation back to EM, although not at the pace of 2009. There will be funds that can be put to work in assets that have limited exposure to European risk (from both sovereign and banks), where balance sheets are less problematic, and where yields are high. The market downdraft in the second half of 2011 has created compelling value in emerging market assets. We would generally avoid countries closest to the European crisis. Prospective returns on local bond markets seem most promising, on our generally bullish assessment of the 12-month outlook for EM FX, but on a volatility-adjusted basis, EM external debt also looks appealing.

For the past half year, we have adopted a cautious stance toward emerging markets, on concerns that the European sovereign debt and banking crisis would negatively influence global markets, including emerging asset markets. While it will take time for the European crisis to be brought fully under control, and risks from outside Europe may come to the fore once the current situation recedes, we think that policy momentum in Europe has reached levels that significantly reduce the most serious tail risks from the region. Motivated by this reduction of tail risks, as well as supportive valuations, positioning and sentiment, we are coming around to a more positive assessment of EM asset markets as the new year approaches.

Koon Chow +44 (0)20 7773 7572

[email protected]

Michael Gavin +1 212 412 5915

[email protected]

Alanna Gregory +1 212 412 5938

[email protected]

Figure 1: Volatile markets and highly correlated…

Figure 2: …dragging EM lower

0

1020

30

4050

60

7080

90

Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-1140

60

80

100

VIX Global Asset correlation (RHS)

80

90

100

110

120

130

140

150

160

Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-1180

100

120

140

160

180

200

220

EM local government bonds (FX unhedged)EM Credit (excess returns)MSCI EM equities (FX unhedged, RHS)

Index of cumulative returns, January 2009 = 100

Note: Correlation in weekly returns of global equities, high-grade credit spreads, commodity prices, and the dollar exchange rate. Source: Barclays Capital

Source: Barclays Capital


6 December 2011 5

Europe – A way forward at last? For some months, our call on Europe has been that it lies within the authorities’ power to avert worst-case scenarios, but that this would require policy reforms and institutional adaptations that are painful and controversial enough that market conditions would need to become more threatening before effective action is forthcoming. As 2011 draws to a close, the precarious situation of Italian debt markets, a potentially dangerous credit crunch in eurozone banks, and signs that even stronger sovereign credits in the eurozone are at risk of market pressure seem to have galvanized policymakers to more concerted efforts to forge consensus on a comprehensive policy framework. They have yet to announce a convincing response to the crisis. But for the first time, we think that the outlines of a policy framework have been identified that would be sufficient to restore financial stability. As we have written in more detail (see What will it take to save Italy (and the euro)? 24 November 2011 and A proposal to restore euro area stability, 18 August 2011), we think such a program will require three key elements:

Strong policy efforts by the affected countries to improve prospects for economic growth and restore fiscal sustainability. This effort is important not only for its own sake, but also to catalyze policy efforts by external actors, including the rest of Europe, the ECB, and the IMF. (See also Italy: The time to act, 21 June 2011)

External financial support to help financially weaker countries through what is likely to be an extended period of economic and financial adjustment, and short-circuit the unstable ‘vicious circle’ debt market dynamics that might otherwise threaten the adjustment. This financial support is likely to come from the EFSF, the ECB, and the IMF.

Some clarity on an institutional end-game that offers the expectation that the post-adjustment budgetary and monetary arrangements will be less crisis-prone than the existing arrangements have proven to be. This is likely to involve some sort of financial risk-sharing, combined with stronger institutional constraints on sloppy or risky budgetary practices.

While it will be some time before negotiations surrounding the required policy adjustments and institutional adaptations are complete, we think that the risk of a cataclysmic financial event in the eurozone has declined significantly.

We think that financial stress is finally eliciting

a political response

Figure 3: Global Macro survey results – What do you think will be the key theme for financial markets in 2012?

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Global recession Euro-area crisis Increasing concernsabout the US fiscal

position

A sharp slowdownin China

Elections andpolitics in the

advanced economies

Improved risksentiment

Source: Barclays Capital Global Macro Survey, November 2011

Policy momentum areas should reduce the risk of a cataclysmic

financial event in Europe

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6 December 2011 6

But curtailment of the most severe tail risks that had until recently seemed increasingly plausible does not mean elimination of Europe as a source of anxiety and market volatility. The economic and financial rehabilitation of Portugal and Ireland remain works in progress, and it would be rash to rule out a market-unfriendly event in one of those countries. We also doubt that we have heard the last unsettling word from Greece, where the debt restructuring may (or may not) be sufficient to address the country’s debt overhang, but does little to lay a foundation for competitiveness and growth. The financial stress that afflicts the eurozone banking system is unlikely to abate immediately; at least a mild credit crunch and recession are pretty much baked into the outlook, and the risk of worse remains alive. Still, to reduce significantly the tail risk of a eurozone financial collapse is to do a lot and justifies a somewhat less defensive approach to risk.

China, the US, and other risks on the 2012 radar screen Europe is the dominant risk in markets today, but it is not the only one that may unsettle investors in the months to come. We begin with China not because it is the biggest concern, but because it is one that is likely to play out in the near future. Despite our below-consensus forecast for 2012 growth (8.1%, down modestly from 8.4% in September), we continue to consider a Chinese hard-landing quite unlikely, unless imported from worse-than-expected economic developments abroad. That said, Q1 is the weakest quarter in our forecast and the one, therefore, in which market doubts about the depth and duration of the deceleration seem likely to be most intense. If doubts about China return as a major market concern, it is likely to be early in the year.

Our sense is that the U.S. economy is, for now, a smaller than usual blip on investors’ risk radar screen, as the recent run of reassuring economic data has at least temporarily beaten back anxiety about a double dip recession. Although this reduces the expectational ‘cushion’ provided by an exaggerated pessimism, on balance it seems that investors’ expectations remain realistic about coming quarters, and arguably pessimistic about the longer run. This is a good thing, because the US recovery is likely to remain substandard until the housing market regains its footing, and that may be some time off. We are forecasting growth of only 2.5% in 2012 and 2013, which is marginally above consensus for 2012 (Figure 6). That said, we continue to consider a U.S. double dip recession very unlikely, unless caused by a financial shock meaningfully larger than the one that has already occurred.

We continue to view a hard landing in China as unlikely,

unless imported from abroad

Although we forecast a modest recovery in the US, expectations

are in line with the muted outlook, and we consider the

risks of a ‘double dip’ to be low

Figure 4: China – Modest deceleration in our forecast, but to slower medium-term growth

Figure 5: Equity valuation and policy regimes

4

5

6

7

8

9

10

11

12

13

2008 2009 2010 2011 2012 2013

China real GDP (% y/y)

Barcap forecasts

0

5

10

15

20

25

30

35

40

45

50

Jan-60 Jan-70 Jan-80 Jan-90 Jan-00 Jan-10

S&P 500 PE Avg

Postwar boom

Policy disorder

'Great moderation'

Source: CEIC, Barclays Capital Source: Haver Analytics, Barclays Capital


6 December 2011 7

We have reduced our forecast of global growth in 2012, the result mainly of a large downward revision of the forecast for Europe and a smaller downgrade in EM (much of which stems from weakness in external demand created, in large part, by falling European demand). However, we believe that most commodity prices will remain resilient to the downturn. We expect oil prices (both Brent and WTI) to reach about $120/bbl in Q4 12 and are forecasting strong gains in copper, aluminium, and other base metals and most precious metals (with silver the lone exception). The outlook for agricultural commodities is more mixed.

Figure 6: Barclays Capital forecasts: Growth deceleration in 2012

Current forecasts Barclays vs. Consensus

Q4 11 vs. Q3 11 Barclays Forecasts

2011 2012 2013 2011 2012 2011 2012

Global 3.6 3.3 3.8 0.0 -0.2 0.0 -0.4

G10 1.4 1.4 1.9 0.0 -0.1 0.0 -0.5

Euro area 1.5 -0.2 1.0 -0.1 -0.7 -0.1 -1.2

Japan -0.4 1.7 1.4 -0.3 -0.5 0.1 -0.7

US 1.7 2.5 2.5 -0.1 0.4 0.1 0.1

EM 6.3 5.5 6.1 0.0 -0.3 -0.1 -0.4

China 9.1 8.1 8.4 0.0 -0.4 0.0 -0.3

EM Asia ex-China 5.6 5.4 6.4 -0.1 -0.3 -0.4 -0.5

EMEA 4.5 3.0 3.9 0.2 0.0 0.2 -0.5

Latin America 4.4 3.5 3.9 0.1 -0.3 -0.2 -0.4

Source: Consensus Economics, Barclays Capital

Markets have so far given the U.S. a pass on its fiscal imbalances, despite their size compared with (for example) most of Europe. This may be due to the US government’s lower debt stock, which provides the country with time to address the problem. It probably helps that the Fed has been financing a substantial share of the Treasury’s issuance, and among private investors Treasuries continue to function as a safe haven that does well in risk-off periods. It may also have to do with the view that the US needs an election to form a consensus that does not now exist on how to repair the broken fiscal structure. We have some sympathy for this last perspective, but it highlights the salience of the November 2012 national elections. These will quite likely be an important market focus by the second half of the year.

It is too early to know whether investors will approach the upcoming U.S. elections with hope, anxiety, or some combination of the two. But it seems to us that the downside in an unsuccessful election, by which we mean one that does not create a political configuration in Washington that is capable of breaking the existing stalemate over budgetary policy, is large. An additional four years of policy drift in Washington would leave the US at risk of policy imbalances that are different in kind but comparable in gravity to the policy disorder of the 1970s.

Risk reduction or risk rotation? This set of risks, and others, has been overshadowed by more imminent threats created by the eurozone debt crisis. But especially if that crisis gradually recedes in perceived severity, we think investors should contemplate the possibility that, rather than a major reduction in perceived macro risks, we experience a rotation from anxiety about Europe to anxiety about the US and Japanese fiscal predicaments, or geopolitical tensions in the Middle East, or other as-yet unimagined risks that may materialize over the course of the year. Simply hunkering down until the risk-laden and volatile macro environment goes away strikes us as a bad strategy.

We think that commodity prices will remain resilient, despite a

2012 slowdown in global growth

US fiscal policy may arise as a market concern within

the context of the November elections

The bigger question is whether there is another four years of policy drift, with imbalances

festering as a result

There is always something new to worry about, but taking

‘time out’ from the market is no option…


6 December 2011 8

Investor positioning is light The risky macro environment is, of course, reflected in investor positioning and market sentiment. Investor positioning, as reported in the Barclays Capital Global Macro survey, has been light and getting lighter all year. In the most recent survey, only 8% of respondents reported ‘large’ or ‘at limit’ positions, while 50% report running ‘light’ or ‘very light’ positions. Mutual fund flows suggest substantial risk-reduction by retail investors as well; this reached extreme levels in July and August, but while outflows from equity funds have subsequently slowed, flows have remained steadily negative in recent months, suggesting that retail risk reduction has been ongoing.

Investor sentiment is hard to measure, and a moving target in any case, but the available evidence suggests that investors are defensively positioned in response to risks of the sort that we have been discussing, despite a reasonably widespread perception that asset markets offer reasonable value. In November, 80% of our survey respondents thought that global equity markets were undervalued or fairly valued. Investors generally report realistic return expectations, with a majority anticipating returns of -5% to +5%.

Of course, light positioning can get even lighter, assessments of value can be revised lower, and cautious sentiment can become even more cautious; this is exactly what happened during 2011. Still, the fact that investors are lightly positioned, despite a generalized perception that markets offer fair or better value, offers technical support for risk markets and reason to expect markets to respond positively to a reduction in perceived risks.

In emerging markets, the economic and financial context is similar in many respects to the global context. According to our survey, EM investors are somewhat more worried about China than is the broader investor base, which is to be expected, given the high economic and financial exposure of much of the emerging world to China. But the key pre-occupation is Europe, and as the situation there deteriorated in the second half of 2011, EM assets sold off in response, in many cases to an even more exaggerated degree than advanced markets.

…particularly as investor positioning in risky assets is light

Figure 7: Global Macro survey results – How would you characterize the size of positions you are currently running?

Figure 8: US mutual fund flows suggest retail investors have been reducing risk since mid-2011 (USD mn)

0%

10%

20%

30%

40%

50%

60%

Very light Light Average Large At limit

Q1 Q2 11 Q3 11 Q4 11

-35,000

-30,000

-25,000

-20,000

-15,000

-10,000

-5,000

0

5,000

10,000

Dec-10 Mar-11 May-11 Jul-11 Sep-11 Nov-11

Equity Bond

Source: Barclays Capital Global Macro Survey, November 2011 Source: Investment Company Institute

Moreover investor perception is that even with the global

slowdown pro-cyclical markets offer value


6 December 2011 9

Strategy overview If, as we expect, the current high levels of risk aversion abate along with perceived tail risks of a cataclysm in Europe, money will likely be put back to work again in parts of the emerging market. We think the time is right to position for this, but recommend that investors favour areas where the direct connections – economic or banking – with the euro area are light. We are mindful of the EM slowdown, but yields and spreads in EM are attractive and, if anything, the global developments of the past twelve months have cemented prospects of lower-for-longer yields in the (shrinking list) of advanced economy safe havens. We are not sketching a world of ample asset re-allocation – European banks are de-leveraging – but for economies and markets with low external refinancing needs and healthy leverage levels, this is not a bearish environment.

Figure 9: On a risk-adjusted basis, which EM asset class is likely to perform best in the next three months?

Figure 10: What is the biggest downside risk to EM asset markets in the next three months?

0%5%

10%15%20%25%30%35%40%45%

Corporatecredit

Equities Externaldebt

Foreignexchange

Localcurrency

debt

Q2 11 Q3 11 Q4 11

0%5%

10%15%20%

25%30%35%40%

A double-dip

recession inthe globaleconomy

Europe’sdebt crisis

China’shard

landing

Acommodityprice shock

andinflation

Political oreconomic

problems inEM

Source: Barclays Capital Global Macro Survey, November 2011 Source: Barclays Capital Global Macro Survey, November 2011

Figure 11: EM external sovereign bonds have sold off even more than USD investment-grade credit (spreads, bp)

Figure 12: High correlation suggests the dominant role of global macro drivers

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Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 Jul-11

EM Average CDX IG

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1.00

Nov-10 Feb-11 May-11 Aug-11 Nov-11

Rolling 60d correlation: EM, IG CDS

Note: EM yield is unweighted average of 5-year CDS spread of Brazil, Colombia, Mexico, Panama, Peru, Poland, Russia, Hungary, Romania, Bulgaria, Turkey, South Africa, Indonesia, Philippines, Thailand and Malaysia. Source: Bloomberg, Barclays Capital

Note: Correlation (first principle component) of changes in 5-year CDS spreads of Brazil, Colombia, Mexico, Panama, Peru, Poland, Russia, Hungary, Romania, Bulgaria, Turkey, South Africa, Indonesia, Philippines, Thailand and Malaysia. Source: Bloomberg, Barclays Capital


6 December 2011 10

In EM sovereign credit, we favour high-quality liquid benchmarks names such as Brazil and Mexico. We also favour commodity exporters, most notably Russia, Qatar, and Venezuela.

In EM local rates, we recommend outright long positions in markets where yields are high, curves are steep, and in some cases countercyclical monetary policy can be applied without punishment from FX depreciation. Our favoured outright longs are Malaysia, Korea, Brazil, Mexico and South Africa.

In FX, we recommend long positions in the high growth/commodity currencies, namely, the MXN and BRL (options based), and the RUB, KRW, MYR and SGD (cash). We continue to recommend short positions in CE currencies, as a macro tail risk hedge for our overall EM longs, but also to leverage our view on European bank deleveraging flows.

Sovereign credit – A safer haven At the beginning of 2011, we thought EM sovereign credits would confront modest headwinds from a prospective rise in US Treasury yields as the US and global recovery gained ground, but would gain support from continued economic recovery and strong credit markets. Based on this market context, we had forecasted total returns of around 4%, outperforming US Treasuries by about 450bp. We expected about 15bp of spread compression in the “core EM” credits (the benchmark excluding the volatile high yielders Argentina, Venezuela and Ukraine), and the high-yielders to outperform the core by 12pp.

Our forecast of the US Treasury market turned out to be too pessimistic, and we did not see the economic recovery our economist had forecasted, particularly in the G4 countries, as Japan suffered setbacks from the earthquake; the US recovery was more mild than expected; and, most importantly, the euro crisis grew more serious than we had anticipated and morphed from a sovereign crisis into a banking crisis. The last occurrence has led to deterioration in global credit conditions in the form of decreased liquidity and higher volatility, which has materialized in the form of spread widening, not tightening.

In this environment, the “core” credits have widened about 85bp YTD, and the high-yielders have widened about 240bp YTD as of December 2, 2011. Despite this, the benchmark has still delivered total returns of 8.0% YTD, well in excess of our forecast, but in a very different global market context.

Regarding regional differences, we are beginning to see some differentiation in the form of underperformance from Emerging Europe. We began to see this in 2010, and it re-emerged in 2011. As the euro crisis deepened in 2011, so did the underperformance of Emerging European credits relative to their Latin American and Asian counterparts, reflecting the region’s close proximity and financial ties to the eurozone and certain economies’ specific public financial challenges, such as Hungary.

The outlook for 2012 is constructive Our global credit team is forecasting a very solid year for investment grade corporate credit, with US investment grade spreads tightening about 40bp. We expect EM sovereigns to remain closely coupled to US investment grade corporates, as close to 60% of the index is now IG rated, and the historical correlation with global credit markets has been quite high.

In this more benign risk environment, fundamental valuations may increasingly matter again – and these generally seem generous in EM credit, in our view. The implied breakeven default rate of the Barclays Capital Global EM USD index is c.5.8% (assuming a 25% recovery rate). We note that a global issuer basket with a similar rating composition would

The lessons from 2011

US Treasuries continue to be the safe haven of choice for

investors

Growth was more fragile than we had expected, weighing on

the credit universe

Solid total returns despite spread widening

Beta – IG corporate credit should be a pillar of support

Fundamental valuations also look generous based on implied

breakeven default rates


6 December 2011 11

have exceeded this default rate only during the 1930s depression (Figures 14 and 15). Of course, risk premia in EM spreads are driven by many other factors than actual default expectations (such as global risk sentiment, relative valuations across different asset classes and liquidity). However, in an environment of abating tail risks, the fundamental value reflected in EM spreads should allow for some spread compression, in our view.

Our upbeat assessment of emerging sovereign fundamentals is reflected in our assessment of probable rating actions during 2012. While we expect downgrades in several smaller issuers, we expect upgrades of significant issuers including Brazil, Turkey, and Indonesia.

Figure 13: Credit ratings upgrade/downgrade outlook for 2012

Upgrades Downgrades

Brazil (1 notch) El Salvador

Indonesia (1 notch, H1 12) Hungary

Panama (1 notch) Croatia

Turkey (H2) Egypt

Uruguay (1 notch)


From a technical perspective, EM sovereign bond supply is once again very favourable for the Latin American and Asian benchmark names in 2012, but could be a challenge in EEMEA. Our 2012 forecast of supply in Latin America (ex-PDVSA) is more than covered by interest and amortization payments that will flow back to investors. In Asia, the supply outlook remains supportive, with governments focused on containing deficits and shifting issuance to local currency. However, the large net issuance needs could easily create pressure points for CEE credits such as Hungary and Romania, in our view.

Figure 14: Index-implied b/e default rates – our constructive outlook for IG corporates suggests support for EM

Figure 15: Current EM spread levels would have over-compensated for all except the 1930s default period

0%2%4%6%8%

10%12%14%16%18%20%

Dec-02 May-04 Oct-05 Mar-07 Aug-08 Jan-10 Jun-11

Global EM (25% Recovery Rate)US IG (40% RR)US HY (20% RR)

Breakeven default rates of bond indices

peak at c. 60%

0%

1%2%

3%

4%

5%6%

7%

1920

1925

1930

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1945

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1995

2000

2005

2010

Current b/e default rate Global EM bond index (25% RRass.)

Hist. default rates of a similar rated global issuer basket

Source: Barclays Capital Source: Moody’s, Barclays Capital

EM supply outlook is very constructive for LatAm

and EM Asia


6 December 2011 12

Figure 16: Gross and net EM sovereign hard-currency supply forecast 2012 (USD bn)

Region Gross supply

forecast Interest payments

plus maturities Net supply

forecast

Asia 5.5 4.7 0.8

EEMEA 42.5 28.2 14.3

LATAM 28.4 27.6 0.8

LATAM (ex PDVSA) 21.4 25.8 -4.5

Total 76.4 60.5 15.8

Total (ex PDVSA) 69.4 58.8 10.6

Note: Strictly sovereign issuance only, with the exception of PDVSA. Source: Barclays Capital

Lastly, we expect US Treasuries to remain range-bound, with the 10y bond rising to approximately 2.25%, about what is priced in the US forward curve and implying roughly flat returns to US Treasuries next year. Indications from the Fed are that rates will remain low for quite some time and that there is no monetary tightening in the pipeline, so we should not see a shock from global interest rates.

In this context, we are forecasting spreads to tighten about 40bp over the course of 2012, in line with US investment grade credits, generating a total return on the benchmark of about 7.0%, outperforming US Treasuries by a similar amount (for detailed projections, see Figure 17). We expect the 88% of the index that is not Argentina, Venezuela or Ukraine to return about 5.7%, roughly 120bp higher than our global credit strategy team’s forecast for US and European high-grade credit returns.

Figure 17: EM sovereign credit market outlook, YTD as of December 2, 2011

OAS (bp) OAD Weights (%) Total returns (%)

31-Dec-10 2-Dec-11 12m F Bench. Model 2011 QTD

2011 YTD 12m F

EM Portfolio 263 366 327 7.1 100 100.0 3.7 8.0 7.0

Arg, Ven, Ukr 824 1064 990 5.4 12.7 13.6 7.1 4.7 15.8

Other 180 265 230 7.4 87.3 86.4 3.2 8.5 5.7


We are overweight the high-yielding names, expecting them to outperform the core EM credits by about 10pp in the coming year. However, this overweight position is due solely to a large overweight position in Venezuela; we keep Argentina at neutral and Ukraine at underweight. We overweight Venezuela on the basis of persistently high oil prices, attractive valuations and good technicals: it remains a large underweight among investors. We also view the credit’s low correlation with the global environment as a positive. We like the short end of the PDVSA curve, specifically the PD17N and PD16.

Despite the gloomy macroeconomic environment in Argentina, we choose to keep the credit neutral in our portfolio, given its attractive valuations. We are not overly concerned that a credit event will materialize, therefore, we continue to recommend earning the carry and stay in the short part of the curve (Boden 15), which remained relatively liquid in the recent sell-off. With regard to Ukraine, although we do not think a near-term credit event is likely, we choose to remain cautious on the credit, given the lack of IMF financing, the widening of the current account deficit and the apparent intention of the government to issue new Eurobonds when the market permits. However, we note the attractive carry of shorter-dated instruments.

US Treasuries likely to remain range bound as well

These top-down factors argue for respectable total returns

Allocation themes: O/W select high yielders, ‘high growth’

names and benchmarks

Argentina – Gloomy fundamentals but priced in


6 December 2011 13

We remain constructive on the higher-quality names and note three key themes for 2012:

Overweight the most liquid benchmark names (Brazil, Mexico, Indonesia): Liquidity has been key for the past quarter, and likely to continue in 2012. Volatility is likely to remain elevated, and regulatory pressures on advanced-economy banks will likely continue to inhibit secondary market-making. In this environment, investors may place a premium on liquid names, in order to best take advantage of swings and market movements.

Overweight commodity names with a resilient growth story (Venezuela, Russia, GCC): Oil prices have remained resilient in 2011 and our commodities team has forecasted a strong outlook for 2012 based on both supply and demand dynamics. Strong oil prices resilient growth, and modest contagion from the eurozone in these commodity-exporting countries should support these credits.

Underweight those credits with closest links to the eurozone (Hungary, Croatia, Bulgaria): It is no secret that the immediate outlook for the eurozone is bleak, even if it looks increasingly likely that a financial disaster will be avoided. More than 50% of respondents to our Global Macro Survey think at least one country will exit the eurozone, our economists are now forecasting a recession in 2012, and the ongoing eurozone bank de-leveraging poses a direct threat to funding to central Europe. The outlook for Hungary is particularly somber; high debt ratios and unsustainable policies have led to one downgrade by Moody’s, and we think another downgrade is likely in 2012 (Figure 13).

Relative value trades in EM sovereign credit We highlight several relative value trades that our strategists have uncovered that are consistent with the investment themes above. The technicals behind them are supportive, and we expect the recommendations to perform well in an environment where investor pessimism eases and dislocations in the market ease.

Sell the basis in select LatAm: hedging activity in liquid benchmark CDS has moved the CDS/cash basis into positive territory for many names across LatAm. While liquidity conditions may be challenging, we think there are interesting opportunities in Colombia, the Mexico short end and the 10y sector of the Brazil curve (Brazil 2021s). In EEMEA, we see an opportunity to sell the basis in Russia at the short end of the curve, specifically selling 3y CDS, sell Russia USD 15s. This should perform as CDS hedges eventually come off.

Our cautious view on most Central European credit contrasts with a more positive view on commodity/oil-supported names. Fundamentals remain resilient in Russia, Kazakhstan and parts of the GCC, and with limited contagion links to Europe, the general spread widening over the past months has offered opportunities for relative value longs in this space. We recommend selling a basket of Russia/Kazakhstan/Dubai 5y CDS versus buying a basket of Croatia/Romania/Czech 5y CDS.

EM corporates – More cautious but expected returns in line with sovereigns With regard to EM corporate credit, we hold a cautious stance. Our 2012 returns forecast is based on a scenario wherein a credible backstop for European sovereign funding is established and a financial crisis is averted. Spreads then return to a fundamentally justifiable level. This entails our EM corporate index (primarily LatAm/EEMEA corporate credit) tightening from its current level of 540bp to 460bp by the end of 2012, generating total returns of 6-8%, comparable to our expected return for EM sovereigns. In Asia, we look for high grade to post excess returns of 400-450bp and for high yield corporates to return 13-15%. Our forecast of returns is the median of a range of potential outcomes; the fat left tail to this sanguine forecast explains our cautious stance.

Themes in sovereign credit

Overweight relatively liquid issuers

O/W in strong growth/ commodity sovereigns:

Venezuela, Russia and GCC

U/W those vulnerable to eurozone contagion:

Hungary, Croatia, Bulgaria

Positive basis trades

Intra-EEMEA relative value trades

6-8% expected total returns for EM corporate credit in 2012


6 December 2011 14

Local rates/bonds – Avoid those with balance sheet baggage Performance in the rates and local bond space is likely to hinge on the health of public and private sector balance sheets. This should determine whether policymakers can conduct counter-cyclical monetary policy or whether monetary easing is punished by currency depreciation. In Latin America and Asia, we think the prospects for local rates markets (FX hedged and unhedged) look good because balance sheets there are generally healthy and monetary frameworks generally credible.

Turning briefly to the 2011, rising global interest rates and inflationary pressures caused us to take a more cautious stance on local bond markets. We thought that yield compression would be limited and FX gains and carry the main source of returns. Inflationary pressures biased us towards inflation-linked instruments, where available.

While inflation did put significant pressure on yields, many EM economies did not extend their policy tightening cycles as much as we had anticipated, as global growth concerns began to resurface. Furthermore, as the euro area debt crisis began to unravel, a handful of economies reversed course and began easing monetary policy, causing short-end rates to rally. As we entered H2 11, a new wave of volatility swept through FX markets, causing local bonds perform better on an FX-hedged, rather than an FX unhedged, basis, contrary to our expectations.

The outlook for 2012 should be better but with a potential sting in its tail 2012 should look better for investors in local bonds, as we start from a point where EM currencies are at generally cheaper levels and, in some cases, have meaningfully overshot what can be justified by economic contagion from developments in the euro area. We expect this over-reaction to reverse. Growth is slowing in the majority of EM economies, inflation pressures for the immediate months are likely to abate and the majority of EM policymakers are likely to join those who have started to cut interest rates.

The scale of cuts is not likely to be substantial (our economists forecast 50-100bp over the next 12 months), but it should span the regions, including China, India, Indonesia, Philippines, Brazil, Mexico, Chile, Poland Russia and Romania, ie, benchmark names in EM local bond portfolios. Even where policymakers are still hawkish and worried about inflation, we see rates on hold or an increased willingness to let capital flow to FX appreciation as a way to contain inflation when the opportunity arises.

The lessons from 2011

Inflation pressures increased, but global growth and

market concerns dominated

Figure 18: Investor flows to EM local bond funds held up remarkably well

Figure 19: Foreign holdings, as a share of total local bonds, are not something to worry about if global risk levels ease

-15,000

-10,000

-5,000

0

5,000

10,000

15,000

20,000

25,000

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Hard-ccy Local-ccy

YTD cumulative EM dedicated bond fund flows (USD mn)

0%5%

10%15%20%25%30%35%40%

Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11

Indo Malaysia Turkey

Poland SA Brazil

Mexico Korea

Source: EPFR global Source: Barclays Capital

FX has overshot, to the downside

Monetary policy is turning to easing


6 December 2011 15

Rates in the majority of EM markets have proven themselves a defensive asset class, and despite the large swings in risk appetite in the past few months, the majority of EM local yields have been stable, resistant to concerns of a vicious circle being sparked by currency depreciation. The high correlation between EM local bond fund returns and spot FX in the past year suggests the majority of holdings are not currency hedged. This raised market concerns earlier this year that spot depreciation could lead to EM local bond fund underperformance, eventual redemptions, bond sales and yield increases. This has not been the case in terms of either redemptions (with the exception of a couple weeks in September) or bond price action. This indicates to us that EM local bonds passed a big stress test. The average yield on our benchmark EM local bond index is 6.12% (4.37 duration): significantly above the safe havens in the advanced markets and not hugely different, either, from the ‘stressed’ names in peripheral Europe.

We think 2012 should be a solid year for local bond markets, particularly in Asia and Latin America. In our portfolio, we are forecasting total returns of about 9%, with about 4.9% coming from FX returns. This compares to YTD performance of 2.45% FX unhedged, 4.36% FX hedged in 2011.

The sting in the tail (end of 2012) could be in inflation. Already, easy global liquidity conditions are being augmented by monetary easing in EM, and while these are probably not going to feed through to inflation when large parts of the global banking system are under pressure, this cannot persist for ever. One can envisage a scenario in which a bottoming out in global growth and the combined effects of past liquidity injections feed into global commodity prices and inflation at exactly the same time, risking a repeat of what occurred at the beginning of 2011. We are conscious of the warnings by our commodity research colleagues of the supply constraints in some key markets (oil in particular).

Allocation themes: Overweight select LatAm while underweight EEMEA Even if the global market outlook is turning slightly more constructive, we face the daunting reality that is a very likely slowdown in the growth rate and a reduction of savings ready to allocate to EM. This is negative for structurally weak balance sheets dependent on foreign savings to cover budget and external deficits – and means underperformance in FX, but also large constraints in the ability to run countercyclical monetary policy.

A proven defensive asset class and with decent yield levels

Figure 20: 2011 (bp) yield changes set apart those with credit issues/funding pressures from those that do not…

Figure 21: … and the latter are exactly the ones where monetary policy can be eased

-300

-200

-100

0

100

200

300

400

ITL

TRY

ESP

RU

BH

UF

FRA

THB

PLN

KRW ILS

CZ

KJP

YM

YR MX

USD ID

RG

ERG

BP SAA

UD

BRL

2y 10y

Trading on the business cycle

Trading on 'credit' issues

JPY

CZKZAR

TRY

RUB

MXN

PLN

GBPUSD

HUF

BRL

IDRGER

AUD

ILS

-150

-100

-50

0

50

100

150

200

250

300

0 2 4 6 8 10 12 142y bond yields (%)

2s10

s bo

nd y

ield

cur

ve s

prea

d

Size of bubbles = Barcap forecasts of rate cuts in 2012

Source: Barclays Capital Source: Barclays Capital

Likely contributions to return from carry, spot appreciation and some yield compression

The inflation dragon is resting for a while

Relative balance sheet health will determine who can run

countercyclical monetary policy and outperform on FX


6 December 2011 16

The EEMEA region – particularly central Europe and to a lesser degree countries such as Turkey – has already adjusted domestic rates to more difficult external liquidity conditions. Additionally, technical contagion channels have further undermined local rates markets as well; in the case of central Europe, the large presence of Western European-owned banks, has meant that in the past few months, heightened perceptions of counterparty risk have pushed up interbank rates, filtering into bond pricing.

In our EM local bond portfolio, we placed EEMEA bonds (notably Central Europe) as underweight. Intuitively, Asia should be at the exact opposite end of the spectrum, given the strong public debt metrics here, yet we feel that Latin America is a more appropriate block to overweight, given the yield advantage and similar scope for spot FX appreciation.

Rate steepeners also make sense in the names where balance sheet constraints are absent. The front ends of curves are likely to be anchored by interest rate cuts or market expectations of them, while the back ends may underperform, as this flexibility on balance sheets means the ability and willingness to run countercyclical fiscal policy as well. This should naturally hold up long-end yields from prospects of greater bond supply, as well as from the prospects that these economies are likely to rebound the fastest and, at some stage, face inflationary pressures once again. Our highest conviction on steepeners is in Asia, where, as discussed in our macroeconomic section, fiscal policy can be loosened. The commodity exporters (Russia, Brazil in particular) may also be adjusting their fiscal levers as well, and we would not be surprised by curve steepening in the Russia OFZ and cross-currency swaps curves.

Favoured trades by regional blocks Our highest conviction directional rate longs are in Malaysia, Korea, Brazil, Mexico and South Africa.

In Asia, we remain overweight India, Malaysia and Korea. In India, policy easing expectations are likely in Q2, resulting in the 2s5s curve steepening, and barring another fiscal/inflation shock, we recommend owning front-end bonds. In Malaysia, commodity prices, policy easing expectations and global risk sentiment are likely to drive the IRS curve. Our favoured tenor is the 2y (we have a recommendation for leveraged investors to receive 1y1y versus paying 5y). Lastly, we remain cautious on Indonesian bonds, which have one of the highest non-residents positioning in Asia. We recommend going underweight on the index and long 5y bonds on expectations of rate cuts.

In Latin America, we remain constructive on Brazil and Mexico. In Mexico, our expectation that Banxico will cut the policy rate 50bp in Q1 has arguably been validated by Mexico's FX Commission to provide USD when market conditions are stressful, capping FX volatility. The rates market, meanwhile, is pricing no easing but rather expects the next move to be a hike. We see the most value at 1y1y and on Mbono ’14. In Brazil, we expect further cuts in the Selic rate to 10.00%, but the Pre-DI curve is already pricing aggressive cuts out to 2012 and a swift reversal of the easing. As a result we see better value for directional longs further out on the curve, particularly the Jan’17 and Jan’21 NTN-F and Jan’22 BRL global bonds.

We do have some positive recommendations on EEMEA FI, mainly outside CEE. We favor South Africa and Russia, where yields have already adjusted to tighter liquidity global market conditions, whilst country balance sheet looks reasonably strong. For cash investors, we suggest owning SA bonds (Sep’15 R157) and while the curve is very steep, the belly of the curve strikes the best balance of attractive carry/roll-down without too much global rates premia. In a deleveraging environment, low foreign holding of local bonds and low

Underweight EEMEA, overweight LatAm

Curve steepeners – particularly in Asia; KRW and INR 2s5s

steepeners are attractive

EM Asia – Anchored by monetary easing and prospects

for controlled FX appreciation

LatAm – Also supported by monetary easing, which is not as

yet fully priced into Mexico

EEMEA – High yields, in spite of strong balance sheets, make South Africa and Russia local

bonds attractive (FX unhedged)


6 December 2011 17

dependence on foreign savings flow is a big advantage. Russia offers both of these and high yields. The OFZ should perform, and we suggest owning 5y bonds. The ruble Eurobonds (Russia ’18) are a good FX-unhedged long for investors unable to access the OFZ.

EM FX: Looking for yield and commodity positions

We have a constructive medium-term view on EM FX based on our view of portfolio allocation back to EM, but it is nuanced by prospects that even though risk-aversion may ease, the EUR/USD is still likely to move lower. Our G10 colleagues are forecasting EUR/USD of 1.20 in 12 months’ time, with loose monetary policy in the eurozone weighing on the EUR, irrespective of the greater investor comfort with developments inside the zone. Historically, a lower EUR/USD has meant a fall in EM FX relative to the USD as well. This occasion should see some differences though, as we are starting from a base where EM currencies have already cheapened, meaning that a lower EUR/USD is already priced in. In Figure 22, there is a greater clustering of EM currencies in the bottom left zone, representing a basic measure of cheapness, reflecting the spot depreciation of the past month. The currencies that are farthest away from Europe should stand the best chances of doing well.

Carry in EM FX is significantly lower than volatility (historical or implied) at present. But the gap between carry and vol should narrow going into 2012, making some currencies appealing again from a pure carry perspective. This would likely include the RUB and BRL, both of which we think warrant tactical longs, but probably not the TRY right now (given the large external funding needs of Turkey).

While the outlook for EM FX seems broadly positive, we are not turning uniformly bullish, in light of global risks that will linger through 2012, and the still-significant vulnerability in much of the emerging world. We are happy to be long currencies that can do well in a climate of only modest sustained capital inflows. These, in our assessment, are currencies with either strong BoP positions right now (low external refinancing needs, C/A surplus or small deficits) or where the positions could improve as commodity prices hold up. The commodity currencies arguably can get a double dose of global liquidity through a return of direct (portfolio) capital flows and from high commodity prices to which a less risk-averse climate contributes.

Asset flows back to EM should also help EM FX

EM currencies have cheapened, and if vol can fall, the carry will

look interesting as well

Figure 22: EM FX valuations on REER and BEER metrics are decent

Figure 23: As vol eases, some of the EM levels of carry will look interesting again*

IDR

KRW

INR

TWD

ILS

RUB

ZAR TRY

RON

CZK

PLN

HUF

MXN

CLP

BRL

ARS-30%

-20%

-10%

0%

10%

20%

30%

40%

-30% -20% -10% 0% 10% 20% 30%BEER

REER

Rich

Cheap

IDR

KRW

INR

TWD

ILS

RUB

ZAR TRY

RON

CZK

PLN

HUF

MXN

CLP

BRL

ARS-30%

-20%

-10%

0%

10%

20%

30%

40%

-30% -20% -10% 0% 10% 20% 30%BEER

REER

Rich

Cheap

-5

0

5

10

15

20

25

30

BRL

CLP

CO

P

MX

N

HU

F

PLN

CZ

K

RO

N

TRY

ZA

R

RU

B

ILS

TWD

INR

KRW

Carry Hist. Vol Implied Vol

Note: *REER measure is spot/average of 10y REER. Source: Barclays Capital Note: *1y carry versus two measures of 1y volatility. Source: Barclays Capital

Favour currencies that can survive on a diet of modest

long-term capital inflows


6 December 2011 18

The commodity currencies that best fit into these themes – and our favoured longs – are the ZAR (which we recommend being long via the bonds), RUB and BRL (via an options structure that enhances carry without adopting an excessively optimistic short-term view). The MXN is not exactly a typical commodity currency, but valuations metrics are good, positioning technicals are very attractive and it may benefit from a positive contagion from BRL. We have a similar option structure as the BRL in our long MXN recommendation.

Asian FX longs most definitely fits in the camp of strong BOP; our highest conviction recommendations there are in the SGD (versus the basket), KRW (ratio call spread versus the USD) and MYR (versus the TWD). These are unlikely to do as well as LatAm or the higher yielding Asian currencies during an initial risk-on period. But they have good long term appreciation prospects and are backstopped by policymakers who have demonstrated a willingness to draw on large FX reserves to stem currency volatility.

CEE is our favoured location for shorts. As discussed in Euro area bank deleveraging: How much and how painful?, 22 November 2011, even in a scenario in which euro zone banks withdrawal capital slowly, EM Europe will still facing a daunting 2012 (and beyond) of low credit growth, working off FX exposures and poor GDP growth. From a longer-term perspective, this accelerates a bank deleveraging process that started after the Lehman crisis and puts a firm brake on what had been a long term-trend of growth catch-up and real FX outperformance of other EM blocks. Our short recommendations in the PLN, RON, HUF and CZK (versus the ILS) work in isolation but also as a tail risk hedge against some of our other EM FX longs.

Commodity currency longs in cash or options space

EM Asia FX – A likely location for ‘safe longs’

Putting your shorts in CEE

Figure 24: A decade of commercial bank flows has supported CEE (BOP data, % GDP)…

Figure 25: … bolstering growth and a sharp convergence in FX that may need to go into reverse

-4%

-2%

0%

2%

4%

6%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Developing Asia CEE Latin America

80

85

9095

100

105

110115

120

125

2000 2002 2004 2006 2008 2010

CEE Developing Asia Latin America

REER (2005 = 100)

Source: IIF, Barclays Capital. Source: Barclays Capital

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6 December 2011 19

EM CREDIT PORTFOLIO

OAS (bp) Weights (%) Duration Bias Total Returns (%) Bonds we recommend…

31-Dec-10 2-Dec-11 12mF OAD Benchmark Model Adj.

Duration 1w 2011 QTD

2011 YTD 12m F Buying Selling

EM Portfolio 263 366 327 7.1 100 100.0 Long 7.9 1.2 3.7 8.0 7.0 Arg, Ven, Ukr 824 1064 990 5.4 12.7 13.6 over Short 4.7 3.1 7.1 4.7 15.8 Other 180 265 230 7.4 87.3 86.4 neutral Long 8.4 1.0 3.2 8.5 5.7 EM Asia 165 247 198 7.5 15 16 over Long 9.6 1.2 4.5 9.3 6.7 Philippines 139 204 164 8.2 7.2 6.3 under Long 8.6 1.5 5.0 10.8 6.0 Philip '24s, '25s, '30s, '34s Philip '13s, '14s, '15s, '16s, '17s Indonesia 166 255 195 7.1 6.4 8.7 over Long 11.5 1.1 4.6 8.6 7.3 Indo 14s, 15s, 16s, 17s, 18s, 20s, 21s, 37s, 38s Sri Lanka 304 454 404 5.9 0.7 0.7 neutral Long 7.5 0.1 1.0 2.7 8.1 Vietnam 359 511 471 4.9 0.5 0.3 under Short 2.5 0.1 1.5 5.4 7.5 Vietnam 20s EMEA 216 358 341 6.3 39 36 under Neutral 6.4 1.6 1.6 4.0 5.3 Turkey 168 337 316 7.1 10.0 10.2 neutral Neutral 7.3 2.1 1.4 2.4 5.5 Turkey 15s, 16s, 17s, 18s, 19s, 19N, 20s Russia 197 290 243 5.9 9.4 11.7 over Long 8.8 1.6 4.9 7.1 6.2 Russia 28s, Russia 30s Russia 15s Qatar 152 225 177 6.8 4.7 5.0 over Long 8.6 -0.3 -0.7 6.9 5.8 Qatar 40s,42s Poland 165 303 294 5.8 3.0 3.0 neutral Long 6.9 2.9 1.7 3.4 4.0 Poland 21s, 22s Lebanon 303 355 385 4.4 2.7 1.4 under Neutral 2.3 0.4 1.5 6.6 2.5 Ukraine 444 878 976 4.4 2.0 1.3 under Short 2.2 3.3 -1.1 -5.8 4.9 Ukr 12s, 13s Ukr 20s, 21s Hungary 416 589 640 6.8 1.9 0.0 under Short 0.0 -0.4 -3.2 0.4 3.1 Hungary 20s, 21s, 41s South Africa 152 212 187 7.1 2.0 0.8 under Neutral 2.8 3.1 2.6 9.5 4.3 Lithuania 259 436 369 5.5 1.6 2.2 over Neutral 7.6 3.4 2.1 3.6 8.4 Lithuania 17s, 20s, 21s Croatia 311 623 653 6.6 1.0 0.5 under Neutral 3.2 0.7 -2.0 -5.8 5.0 Egypt 197 494 503 8.1 0.4 0.0 under Short 0.0 1.0 -4.9 -7.0 5.0 Egypt 20s Latin America 333 409 354 7.9 45 47 over Long 8.9 0.9 5.3 11.3 8.7 Brazil 136 171 126 8.1 11.7 15.8 over Long 11.5 0.4 3.7 11.7 5.8 BR41 Mexico 146 175 130 8.5 9.8 11.4 over Long 11.9 0.0 3.9 13.1 5.9 MX 40, MX 100yr Venezuela 1065 1196 1076 5.4 7.0 8.7 over Short 5.4 3.1 10.1 13.3 19.7 PD 17N, PD 16 Argentina 571 912 832 5.8 3.6 3.6 neutral Short 4.6 2.9 5.9 -6.3 14.3 Boden 15 Colombia 169 184 154 7.8 3.9 2.4 under Short 3.8 0.7 3.7 13.4 4.6 CO 27, CO 33 CO41 Peru 162 207 157 10.8 2.8 2.9 neutral Long 22.2 0.4 6.1 15.2 8.0 PE33, PE50 PE37 Panama 158 190 155 9.2 2.5 0.4 under Short 1.2 0.0 4.9 14.7 5.7 PA 36 Uruguay 173 204 174 10.2 1.7 1.0 under Short 4.8 -0.4 8.7 16.8 6.0 UY25 El Salvador 303 436 456 9.1 1.1 0.0 under Short 0.0 0.0 3.7 5.9 3.5 EL Salv 35 Dominican Republic 372 551 536 5.3 0.5 0.5 neutral Short 4.2 0.2 3.9 3.6 6.8 DR21 DR27 Off-Index Allocations 261 424 434 4.0 1.9 1.2 under Neutral 2.8 0.1 2.3 0.2 4.1 Abu Dhabi 130 170 180 4.2 0.9 0.0 under Long 0.0 0.1 0.6 5.5 1.5 ADGB14s Bulgaria 221 388 398 2.8 0.3 0.0 under Neutral 0.0 -0.1 0.2 1.3 3.6 Bulgaria 15s Gabon 246 403 413 4.7 0.2 0.5 over Neutral 10.5 0.5 6.8 4.9 4.0 Gabon 17s Pakistan 727 1358 1368 3.8 0.2 0.3 neutral Short 3.5 0.2 4.7 -9.4 13.5 Ghana 361 521 531 4.6 0.2 0.4 over Neutral 8.9 -0.1 7.1 5.2 5.1 Ghana 17s



6 December 2011 20

EM LOCAL BOND PORTFOLIO

12/2/2011 Weights Total Returns FX Unhedged (%) Bonds we recommend…

Duration Yield to Worst Mkt val Current Market Model Past Week QTD YTD

12m Forecast Buying Selling

EM Local 4.47 5.95 1,452,545 100% 100.00 100.00 4.03 -4.58 3.21 9.33

Latin America 3.74 8.25 412,870 28% 28.45 33.18 over 5.15 -4.99 5.26 13.94

Brazil 2.35 9.96 230,540 16% 15.58 20.11 over 5.52 -4.24 7.26 15.66 Jan 17 NTNF, Jan 21 NTNF, Global BRL Jan 22

Chile 4.23 5.04 5,412 0% 0.36 0.09 under 1.69 -3.55 -2.52 10.49 May 18 BCP

Colombia 4.55 6.62 57,936 4% 3.92 4.40 over 1.12 -5.51 6.97 10.76 Local TES Jul 24

Mexico 5.64 6.03 108,045 7% 7.84 8.48 over 6.94 -7.91 0.14 12.94 Jun27, Nov 36s, Nov 38

Peru 8.35 5.96 10,937 1% 0.74 0.10 under 1.45 12.00 12.27 6.90 May 15

EEMEA 4.31 6.60 429,556 30% 29.08 23.20 under 4.60 -11.21 -4.61 1.92

Czech Republic 5.90 3.23 45,692 3% 3.04 0.00 under 5.72 -10.34 2.20 -9.84 Apr 17s May 25s

Hungary 3.59 8.16 32,731 2% 2.22 1.01 under 8.02 -20.45 -3.68 -8.04 13E, 14D

Israel 4.42 3.64 44,384 3% 3.01 2.77 under 1.20 -4.21 -0.34 8.03 Sept 13s Feb 19s

Poland 4.09 5.19 96,793 7% 6.60 3.74 under 2.75 -15.86 -6.51 -6.09 Apr 16s Oct 20s

Russia 4.11 7.68 68,627 5% 4.70 3.20 under 3.92 -8.88 2.70 5.15

South Africa 5.91 7.55 76,907 5% 5.15 7.20 over 8.40 -9.66 -9.93 13.80 R157s

Turkey 2.13 10.06 64,422 4% 4.38 5.28 over 3.48 -9.25 -11.49 5.57 Jan 16s, Jan 21s

Asia 5.10 3.99 610,119 42% 42.47 43.62 neutral 2.88 0.16 7.04 11.32

India 6.95 8.79 8,067 1% 0.54 0.75 over 3.17 -11.35 -9.68 20.34 IGB GS 2018, GS 2015

Indonesia 7.11 6.56 58,981 4% 4.00 3.01 under 2.57 7.78 21.40 9.12 INDOGB May 2022 (FR61)

Malaysia 4.93 3.38 79,797 5% 5.43 6.50 over 2.28 -1.16 2.87 11.43 MGS Sep 18

Philippines 7.14 5.33 38,076 3% 2.57 2.44 neutral 2.70 10.03 14.34 8.80

South Korea 4.39 3.59 355,800 24% 25.24 26.42 over 3.11 -2.23 6.07 11.95 3-5y bonds

Thailand 6.06 3.34 69,398 5% 4.69 4.50 neutral 2.61 3.93 2.77 10.07 ILB176A



6 December 2011 21

FX VIEWS ON A PAGE

Currency Tactical bias Strategic directional view Current strategy/trades we like

Vol adj 6m

returns Score (1-5)

Emerging Asia

IDR Bullish The recent underperformance of the IDR vis-à-vis the wider region is likely to reverse as risk aversion ebbs.

0.28 4.10

THB Bullish The performance of the THB has been remarkably resilient, despite political change and the effect of flooding on economic activity. Expansionary monetary and fiscal policy should support economic growth and the currency.

0.47 4.00

CNY Bullish We expect the USD/CNY to move lower as the PBoC leans against still-elevated inflation.

0.46 3.95

INR Bearish Overvaluation, weak fundamentals, and the risk of capital outflows that would ensue if risk appetite worsens point to INR underperformance.

Long USD/INR 1m NDF 0.41 3.80

MYR Bullish Resilient growth, a healthy fiscal position, and the roll-out of the government’s divestment programme should support the currency.

Long MYR/TWD 3m NDF 0.40 3.65

KRW Bullish Elevated inflation, robust exports growth and a tight labour markets augur for KRW appreciation.

Short USD/KRW 1x2 put spread (strikes: 1095 and 1070)

0.24 3.40

TWD Neutral While economic activity remains relatively firm, inflationary pressures are benign, running at about 1.0% y/y. As such, the CBC has little incentive to allow the TWD to appreciate if risk appetite improves.

Long MYR/TWD 3m NDF 0.13 3.20

SGD Bullish We expect the MAS to maintain a bias towards currency appreciation near the centre of the NEER policy band, which we estimate to be +/-275bp with a +2% slope.

Long SGD vs USD (60%)-EUR (40%) basket

0.16 3.00

PHP Bullish The central bank’s preference for the PHP not to be an outlier in terms of regional performance points to modest currency appreciation.

0.14 2.65

HKD Neutral Rising CNY deposits onshore could result in the “RMB-isation” of the economy.

-0.17 2.60

Latin America

CLP Neutral Its clean technical positioning will allow the CLP to appreciate as soon as global risk appetite is restored.

0.03 2.85

PEN Neutral Expensive, as it does not price a risk premium. 0.07 2.65

MXN Neutral The MXN has too much risk priced in. While it is exposed to global risks, Banxico’s latest FX intervention caps the downside.

Sell 3m ATMF USD call/MXN put (ref spot/fwd: 13.6469/13.7461)

0.05 2.60

BRL Neutral BRL has supportive technicals and, like Mexico, a relatively high risk premium priced in. It is still exposed to global risks.

Sell 3m ATMF USD call/BRL put (spot/fwd ref: 1.7908/1.825)

0.12 2.50

COP Bearish Valuation has improved, but technical positioning limits the upside. Uncertain M&A-driven dollar demand.

0.07 2.25


6 December 2011 22

Currency Tactical bias Strategic directional view Current strategy/trades we like

Vol adj 6m

returns Score (1-5)

Emerging EMEA

TRY Neutral/bearish Turkey’s high external funding needs and uncertain monetary policy will likely weigh against the lira relative to the stronger currencies in EEMEA.

Short TRY/long ZAR 0.11 3.55

RUB Bullish Russia’s resilience to euro contagion is supported by sticky oil prices and argues for going long the RUB against a EUR-USD basket. Strong local growth and higher yields should help retain capital in the country.

Short EUR-USD basket/long RUB

0.21 3.55

RON* Bearish We are cautions on CEE currencies, and while NBR intervention is helping, we are concerned about bank-related capital outflows and persistent poor growth in Romania.

Long EUR/short RON 0.09 3.30

PLN* Bearish We recommend short PLN, given the more fragile conditions for Poland, with poor growth and large external financing needs.

Long EUR/short PLN 0.12 3.20

ZAR Bullish Strong commodity prices and attractive local asset prices (on bonds) should mean capital inflows if global liquidity conditions stabilize. This should benefit the ZAR more than other high beta EEMEA currencies,

Short TRY/long ZAR 0.17 3.10

HUF* Bearish Weakest private and public sector balance sheet among CEE, high dependence on capital flows and exposed to euro area bank deleveraging. IMF program is needed, but would probably only slow the adjustment of the HUF.

Buy a 3m EUR call/HUF put spread (315-345 strikes)

-0.12 3.00

ILS Neutral/Bullish Opportunity for an RV trade against the CZK, given Israel’s stronger balance of payments and lower vulnerability to euro area contagion. The ILS should benefit from our house view of lower EUR/USD (and the past correlation between ILS/CZK and EUR/USD).

Long ILS/Short CZK -0.15 1.90

EGP Bearish The CBE has tried to stabilize the EGP against capital flight, but FX reserves have fallen sharply. It may need to take a hard decision in a couple months to allow a ‘float/devaluation’ before reserves fall below a prudential level.

-0.26 1.85

CZK* Neutral/Bearish Strongest balance sheet among CEE countries; however, the currency should still suffer, as the Czech economy may slip back into a recession.

Long ILS/Short CZK -0.16 1.60

UAH Neutral High carry (25% for 3m via NDF) reflects investor fears of devaluation. An agreement with the IMF or Russia on gas imports may alleviate these concerns. The outlook on the UAH is binary, given the significant long-term external refinancing needs.

KZT Neutral/bullish Commodity producer (oil) and positive C/A create a cushion for uncertainty in global capital flows. However, low liquidity in this FX cross may limit the appeal of this currency.

Note: *Versus EUR. The variable score is an index which ranks EM currencies according to the vol-adjusted returns, PPP valuation, carry, systemic risk, basic balance/GDP and reserves accumulated over the past 5y/GDP. For more details on the trade recommendations, please see the EM Dashboard. Source: Barclays Capital


6 December 2011 23

TRADE SUMMARY

Country Rates Credit Foreign Exchange

Emerging Asia

China Hold 2s5s steepeners as China leads easing efforts in Asia. Look for opportunities to switch to 1s5s once fixings drop below short-end rates.

On a portfolio level, we prefer to set up tail-risk hedges such as buy protection on China (ie, buy 5y CDS) versus selling Korea.

India CRR cuts likely in early FY12-13 if inflation moderates and rate cuts are likely in Q2. Position via 2s5s steepeners.

RBI OMOs will likely take out duration risks and with policy likely turning, we prefer owning front-end bonds.

In a “risk-off” scenario, we still expect the INR to underperform within Asia. In such a scenario, we recommend buying a 1m USD/INR NDF (entry: 51.63, target 54.0, stop: 51.00; spot ref: 51.33).

Korea While rate cuts are unlikely in the near term, we think there is room for 2s5s sector to steepen, as improving credit fundamentals give the BoK room to react quickly in case risk aversion increases. We are overweight Korean bonds and recommend going long 3-5y tenors.

Buy a 1x2 1m USD put/KRW call spread, strikes at 1095 and 1070 (spot ref: 1129; 1m forward: 1132; ATM 1m vol: 13.3%; entry price: 18bp; maximum payout: 11.7:1).

Malaysia We expect 1y1y rates to outperform 5y IRS. We recommend long positions in 3-5y bonds on FX appreciation and domestic support for bonds.

Long MYR/TWD 3m NDF (entry: 9.58, target 9.80, stop: 9.50; spot ref: 9.63).

Philippines We recommend legging into Indonesia bonds on weakness versus the Philippines.

Singapore We expect the 1y forward 3s10s curve in SGD IRS.. We also expect SGD 5y5y to outperform HKD 5y5y IRS.

Long SGD basket vs. USD (60%) and EUR (40%).

Taiwan We recommend 2s5s steepeners in Taiwan on softening credit growth.

Thailand We recommend going long 5y bonds, as rate cuts are likely to support the front end even as supply concerns remain.

Indonesia long 5y INDOGBs on expectations of rate cuts, but stay underweight versus benchmark

We recommend legging into Indonesia bonds on weakness versus the Philippines


6 December 2011 24


Emerging EMEA

Croatia/ Serbia

Buy a basket of Romania/Croatia/Czech 5y CDS versus selling a basket of Russia/Kazakhstan/Dubai 5y CDS; Serbia 21s as an attractive switch from other SEE credits (Hungary, Bulgaria USD 15s).

Czech Republic

Long ASW, paying 6y IRS vs. 6y bonds (Apr 17), as deleveraging led to significant ASW widening. In a more risk-friendly environment, CZGBs should outperform swaps.

Buy a basket of Romania/Croatia/Czech 5y CDS versus selling a basket of Russia/Kazakhstan/Dubai 5y CDS.

Short CZK/long ILS. This cross tends to fall when EUR/USD drops, as we expect it to do. Attractive levels for the trade, and the Czech economy is more exposed to euro area.

Hungary Buy 3m T-bills, financed by FX implied rates.

Remain underweight Hungary USD bonds.

Buy 3m EUR call/HUF put spread (315, 345 strikes). Capital outflows should weigh.

Israel ILS DV01 2y5y steepener. Curve is likely to steepen further on BOI rate cut prospects.

Short CZK/long ILS.

GCC Long/overweight Qatar long end; sell a basket of Russia/Kazakhstan/Dubai 5y CDS versus buying a basket of Romania/Croatia/Czech 5y CDS.

Maghreb/ Mashreq

Take profits on Morocco €20s longs (potentially as a switch into Qatar within the MENA region)

Poland Receive PLN 1y1y fwd on monetary policy easing perspective.

Long EUR/short PLN. Target 4.70 as Poland’s large external funding weighs on the zloty.

EM Europe’s currency pegs

Remain overweight Lithuania cash credit, sell/underweight Bulgaria USD 15s.

Romania Buy a basket of Romania/Croatia/Czech 5y CDS versus selling a basket of Russia/Kazakhstan/Dubai 5y CDS.

Long EUR/short RON. External funding needs amidst poor local growth should weigh on the RON.

Russia Buy OFZ 5Y or the ruble Eurobond Russia ‘18s.

Upgrade Russia to Overweight; sell a basket of Russia/Kazakhstan/Dubai 5y CDS versus buying a basket of Romania/Croatia/Czech 5y CDS; sell the short-end basis (3y CDS versus Russia 15s).

Short basket EUR-USD/long RUB. Fast domestic growth, high carry and an increasing need to founding should slow the pace of capital outflows.

South Africa Favor mid-part of the curve as a bullish trade without too much global rates market beta and still decent carry/roll-down. For cash investors, we recommend owning 5y r157 bonds

Long ZAR/short TRY. SA has a stronger BoP than Turkey, which, together with a more transparent monetary/FX policy stance, should benefit the ZAR relative to the TRY.

Turkey Long med- to long-tenor bonds (Jan 16s, Jan 20s), given the attractive yields and Turkey’s strong fiscal dynamics. But expect upward pressure at the short end of the local curve; CBT may drain liquidity to support FX. We recommend paying 1y, 2y forward CCS, which offers positive carry.

Move Turkey credit to neutral from overweight.

Long ZAR/short TRY.

Ukraine Long shorter-dated bonds (Ukraine 12s, 13s) for carry. Underweight longer-dated instruments.

Sub-Saharan Africa

Buy 1y/2y bonds in Uganda, 1y/5y bonds in Zambia and 1y bonds/FGN Feb'13s in Nigeria, FX unhedged.

Long Ghana 17s; hold on to Cote d’Ivoire 32s, add on dips below 50.

Long UGX, ZMK and NGN as FX leg to the FI trades.


6 December 2011 25


Latin America

Argentina Neutral because underperformance risks remain (FX pressures). Yet high beta to global factors may drive the performance. Long in short-end through Boden15. We see limited upside in GDP warrant.

Brazil Buy Jan13-Jan15 DV01-neutral flattener: market is pricing too low a terminal rate in the current cycle and too fast a normalization thereafter. We are overweight Brazil rates in our local portfolio through Global BRL Jan22s or Jan21 NTNF or Jan17 NTNF.

We are overweight: negative net supply, attractive valuations and recent underperformance are the catalysts for our position.

Sell 3m USD call/BRL put or sell 3m USD call/BRL put spread to hedge downside risks. Global risks should prevent USD/BRL from rallying much and lead to 1.85, although even higher levels should be capped by BCB.

Colombia Underweight through due to supply risk and tight valuations. We like Brazil 41s against Colombia 41s. Sell short-end basis.

Overweight local TES to take advantage of medium-term appreciation potential of the COP.

Mexico Monetary policy trades: receive 1y1y forward TIIE; buy Jun14 Mbonos. We are overweight in out local portfolio, as rates are cheap: buy Jun 27, Nov 36 and Nov 38 MBonos as a medium-term position.

Overweight position due to limited supply and still relatively high liquidity, combined with relatively attractive valuations.

Sell 3m USD call/MXN put or sell 3m USD call/MXN put spread to hedge downside risks. Global risks should prevent USD/MXN from rallying much (we expect 13.90 in 3m). FX intervention limits sell-off beyond.

Panama Underweight due to its outperformance and low liquidity.

Peru Underweight to make room for Mexico and Brazil overweights. Rates do not offer value anymore.

We move the credit to Neutral from Overweight, despite attractive valuations, since we are concerned that escalation of the mining conflict may have a further effect on the spreads.

Venezuela Overweight due to willingness/ability to pay, high oil prices and clean technicals. We still prefer the short end of PDVSA curve (PDVSA 15s) and also like the PDVSA 17s New. The PDVSA 37s also look attractive.



6 December 2011 26

MACRO OUTLOOK: ASIA

Deflector shields powering up Monetary easing to date has been selective – led by economies possessing larger policy buffers – with the belief that inflation is now manageable. The deceleration of activity has been gradual, with domestic demand still buffered by tight labour markets, resilient asset values and the confidence that Asian governments can engineer a soft landing. Policymakers are also prepared to ease fiscal policy aggressively – if needed. We have also seen an increase in swap lines that could quickly deploy the region’s massive reserves to mitigate the risk of outflows associated with bank deleveraging.

We see three sources of growth moderation in Asia in 2012. First, concerns over European bank deleveraging could continue to sap sentiment-sensitive activity, despite Asia’s relatively low exposure to European funding. For now, the impact of deleveraging on Asia has been mild, with no visible disruption to trade finance. Second, the contribution from net exports will weaken, as Europe’s ability to consume deteriorates further amid still-high commodity prices. Third, private investment is likely to be anaemic, as firms postpone business expansion plans amid continued exchange rate volatility.

Ironically, the stabilisation in activity that Asia is currently experiencing in the final months of the year could fade in H1 12, albeit gradually. We expect a larger transmission from weaker exports into domestic demand, which is expected to soften labour markets from current full employment conditions. In this edition of the Quarterly, we adjusted our growth forecasts lower for seven economies in 2011 and for seven economies in 2012. We expect regional GDP growth to slow to 6.8% in 2012 (2011: 7.4%), before bouncing back to 7.4% in 2013. This represents downward revisions of 0.2pp in 2011 and 0.4pp in 2012 – most of which is coming from the weaker contribution from net exports and investment in Q4 11 and H1 12. Slower growth is expected not just in the continental economies of China and India, but also in trade-oriented Asia. Indeed, countries that we consider to be the more leveraged to global growth cycles – namely Taiwan, Singapore, Philippines, Malaysia and Thailand (See Figure 2) – have also seen downward revisions to growth.

Figure 1: Larger downward revisions to GDP growth forecasts in 2012, before a rebound in 2013

-2

0

2

4

6

8

10

EM Asia CN HK IN ID KR MY PH SG TW TH

2011F 2012F 2013F Forecast change from Sep EMQ

GDP Growth (% y/y)


Wai Ho Leong +65 6308 3292

[email protected]

Rahul Bajoria +65 6308 3511

[email protected]

Prakriti Sofat +65 6308 3201

[email protected]

Joey Chew +65 6308 3211

[email protected]

We have cut our regional growth forecast for 2011 by

0.2pp, to 7.4%, and for 2012 by 0.4pp, to 6.8%


6 December 2011 27

Figure 2: Who is most leveraged to the global growth cycle?

Lag structure

Leverage ranking Country

Correlation to global growth

Initial shock

comes after Shocks

continue for Salient characteristics of economy

Trade openness (2011F,

% of GDP)

1 Taiwan 74.0% 0-1 quarters 5 quarters Relatively less diversified compared with its regional peers. Exports largely centred on electronics – LCDs and semiconductors. Taiwan produces mainly low-margin intermediate components, not end-use products

127%

2 Singapore 73.4% 0-1 quarters 6 quarters Singapore is the world’s most open economy. This is mitigated by trade flows and industrial production that are highly diversified – across electronics, pharmaceuticals and marine engineering (it produces 90% of the world's shallow water oil rigs).

292%

3 Philippines 68.3% 0-2 quarters 8 quarters Significantly less diversified. The main area of specialisation is electronics (and in lower-margin testing and assembly activity, not production), which results in electronics accounting for 70% of exports.

53%

4 Malaysia 67.6% 0-2 quarters 6 quarters Reasonably diversified across mineral fuels, palm oil, petrochemicals and electronics. However, high trade openness means Malaysia is leveraged to global cycles.

175%

5 Thailand 48.8% 1-2 quarters 8 quarters Reasonably well diversified across automotives, computer peripherals (monitors, hard drives) and petrochemicals; also a large food exporter.

137%

6 Korea 48.2% 0-

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