CIO WM Research 19 September 2013

Investing in emerging marketsCan EM survive an environment ofnormalized global bond yields?

“EM countries are better equipped to confront an external shock,both with more flexible exchange rate regimes and larger stocks offoreign reserves.”

After underperforming in 2012, emerging markets (EM) equities haveoutperformed developed markets and are up 13.4% from their Junelows, nearly twice as much as the S&P 500. In our view, this reflectsimproved economic activity in the US, EU and China, and more stablecommodity prices. It also seems to suggest that markets have digestedan increase in yield to 3% of the 10-year US Treasury, and to 4% forthe 30-year bond.The rebound in EM is also the result of an oversold technical position.Whether this is the beginning of a more sustainable trend for EMdepends critically on what lies on the other side of the currentjunction, both globally and in EM. In our latest publication titled “Thecase for emerging markets, revisited,” our team of global analystsexamined questions central to the emerging markets story.

One question we address is: Can EM can survive an environment ofnormalized global bond yields? In responding, we analyzed the impacton EM of all Federal Reserve tightening episodes of the last 25 years,all cases of market-based tightening when the US 10-year real yieldincreased at least by 100bps, as well as the market conditions thattriggered the 1997 Asian financial crisis. The table below displays theimpact of these tightening episodes on EM asset prices, the value ofthe USD (DXY) and commodity prices.

We conclude that tightening periods are not necessarily associatedwith generalized EM asset price declines and reversals in capital flows.During periods of strong US and global growth, increasing commodityprices and relatively well telegraphed monetary policy action, asobserved in the 2004 and 1999 cycles, EM assets performed well andcapital inflows remained strong. This is why it is important that theexpected end to QE in the US occurs in an environment of economicgrowth. On the other side of the spectrum are the 1994 cycle, whentightening was followed by a US and global slowdown, and the1997 Asian crisis following deteriorating fundamentals in Japan. Inthese episodes, EM assets were hit hard particularly in countries withheightened external vulnerabilities.

Jorge O. Mariscal, Regional CIO Emerging Markets, UBS FSjorge.mariscal@ubs.com, +1 212 821 6350

This article was originally published outside theUS and has been customized for US distribution.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosuresthat begin on page 3.

We believe the current tightening environment in the US is not likelyto be as adverse to EM as the 1994 or 1997 episodes and that gen-eralized EM asset price declines should not be expected considering:(i) tightening is occurring amid a global recovery, albeit moderate, (ii)the Fed and other central banks are trying to telegraph their inten-tions carefully, and (iii) in general EM countries are better equippedto confront an external shock, both with more flexible exchange rateregimes and larger stocks of foreign reserves. Furthermore, while theUS is tightening, Japan is in an aggressive easing mode, which shouldultimately be positive for emerging Asia. Europe is also expected tomaintain loose monetary policy for some time.

The above is not true for everyone in EM. We expect a period of globalbond yield normalization to increase emerging market differentiationalong the lines of external financing vulnerabilities, private sectorleverage, and overall macroeconomic strength. Countries with largeexternal financing needs and exposure to short-term capital flows areparticularly exposed to heightened competition for capital. Amongthe most vulnerable ones from a current account perspective wefind Turkey, South Africa, India and Indonesia. However, also Brazil,Hungary, Poland and even Mexico have seen some pressure owingto large exposure to foreign holdings of their domestic bonds. Coun-tries relatively better positioned are China, Russia, South Korea andthe Philippines. Our analysis suggests that EM are becoming an evenmore heterogeneous bunch, increasing demand for more granularunderstanding of individual countries and assets, and active portfoliomanagement.

Tightening periods and performance of EM assets – last 25 years

Start End FedFundsRate

10yrTreasury

Yield

10yrReal

Yield

DXY Com-modity

MSCIEM

EMBI CEMBI

01-May-13 21-Aug-13 0bps 126bps 129bps 0%

31-Aug-10 10-Feb-11 0bps 122bps 156bps 25% 12% 2%

31-Dec-08 10-Jun-09 0bps 173bps 199bps 9% 39% 14% 20%

29 30-Jun-06 425bps 45bps 21% 75% 26% 16%

29-Jun-99 31-May-00 175bps 35bps 6% 27% 5% 17% n.a.

11-Jun-97 11-Aug-98 0bps 7% n.a.

31-Jan-94 31-Mar-95 300bps 155bps 163bps 8% n.a.

Source: Bloomberg

Investing in emerging markets

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Appendix

Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abruptchanges in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher creditrisk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities itbelieves have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual Stateregistration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law,WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued injurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws.For more background on emerging markets generally, see the WMR Education Notes, "Emerging Market Bonds: Understanding EmergingMarket Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December 2009.Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (inthe investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereignhas defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yieldingbonds for shorter periods only.Please note that these bonds may not necessarily be registered with the US Securities and Exchange Commission nor blue-skyed in the US.

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