seb report: still good value in emerging markets

8/6/2019 SEB report: Still good value in emerging markets

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Emerging Markets Cross AssetsNo free lunch, but a good smorgasbord

EM FI Still outperforming DM

EM FX Market drivers to support

EM Equities - Profits sheltered by top line

24 MAY 2011


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Emerging Markets Cross Assets

Executive Summary: No free lunch, but a good smorgasbordFor a few weeks in April, and for the first time this year, Emerging Market (EM) stocks and bonds together attractedmore cash investment than their Developed Market (DM) counterparts. Was that a turning point following theirlacklustre performance in Q1 when EM equity funds reported substantial outflows? Will the good values in EM assets

be realised? In answer we see obvious potential risk concerning the performance of EM assets over the next 3-6months, mainly including: 1) liquidity connected with terminating US QE2; 2) political volatility in MENA countriesspreading to major oil exporting countries; and 3) disorderly Greek debt reconstruction.

As regards the latter concern, our main scenario discounts defaults in peripheral Europe. Importantly, however, we donot expect their implications to derail a further global economic recovery. In part, this reflects the fact that EM arecontinuing to cement their newly acquired status as centres for growth and stability within the global economy, facingup to their task of helping to drive the global economy forward. While higher inflation has been, and will remain,rightly in focus, prices are hardly spiralling out of control while EM policy rate increases are being cautiouslyimplemented. Indeed, they represent a normalisation of monetary policy, testifying to their respective countries fasterand more solid post-crisis recovery.

As DM begin to catch up within the business cycle, the GDP growth advantage held by EM will decline althoughremaining significant. Therefore, as the global recovery progresses, albeit with occasional problems, our generalmacroeconomic outlook implies a scenario in which attractive values are realised. We favour EM currencies and expectstocks to outperform bonds. However, partly due to the more advanced EM business cycle, and also because of thegenerally low valuation of EM bonds, we continue to expect them to outperform their DM counterparts.

Within a multi asset EM portfolio, we favour overweighting EM stocks and recommend assuming the currency risk. At the

same time, local EM bonds remain significantly undervalued, as they have been for a long time. Consequently, an idealallocation would include a fairly large share of such bonds, especially if hedged by a short exposure in DM bonds in case ofpositive global growth surprises. Overall, while we do not suggest there are any free lunches to be had we do see anappetising smorgasbordof trading opportunities with an attractive risk reward balance over the next 3-6 months. Ourfavourites are to buy Turkish local bonds vs. UST with currency risk, buy Polish 5s vs. Hungarian 3s going long PLN/HUF,and buy the Lithuanian short end in euros. We also suggest a risk seeking reallocation in our SEB EM bond portfolio and seegood value in buying an FX basket with long positions in CNH, KRW and MYR vs. short positions in GBP, JPY and USD.

MSCI EM & GBI EM (unhedged USD)EM FI STILL OUTPERFORMING DMGiven current high yields, we once again expect EMbonds to outperform their DM counterparts. Risks

include upside global growth surprises.

EM FX MARKET DRIVERS TO SUPPORTAccording to our main scenario, EM FX will strengthenas carry, central bank activism and fundamentalsbecome key growth drivers. Nominally, ISK, TRY and

KRW should appreciate most by year-end.

EM EQ PROFITS SHELTERED BY TOP LINEDespite current headwinds, we expect the MSCI EMindex to increase by 10% to 1275 by year-end, due to

attractive valuation and good earnings growth.

400

500

600

700

800

900

1000

1100

1200

1300

1400

2006 2007 2008 2009 2010 2011

120

140

160

180

200

220

240

260

280

300

320

GBI-EM

Div.Global(LocalBonds)MSCI EM

GBI-EM

MSCIE

M

(Equities)

Source: Bloomberg


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Macro: Facing up to the taskEmerging markets (EM) continue to cement theirnew position as centers of growth andstabilitywithin the global economy, facing up to the task

of helping drive the global economy forward.Faster inflation has rightly been in focus and willremain so. However, prices are not spiralling outof control and increases in EM policy rates arebeing implemented without panic. Instead, theyrepresent a normalisation of monetary policy,testifying to their countries faster and more solidpost-crisis recovery. As developed markets beginto catch up within the business cycle, the GDPgrowth advantage held by EM will diminish butremain significant. Key risks to our positive EMmacro scenario include liquidity related to ending

US QE2, a disorderly Greek debt reconstruction,and political volatility in MENA countriesspreading to heavier oil exporting countries.

Our previous report was published in February, in themidst of the escalating MENA crisis (or opportunity), aperiod during which a substantial reallocation ofcapital occurred from EM equity funds (the big winnersin the preceding 18 months) particularly to US equityfunds due to less concern for a double dip in economicactivity. The report was entitled Correction, not trendreversal. Reflecting the contemporary tilted

positioning and shaky risk/reward outlook, it wassubtitled Defensive tilt until good value is released.

Subsequent EM asset performanceOverall, EM assets remained under absolute, butespecially relative, pressure for several weeks.However, by mid-March good value began to berealised. Still, developments have been problematicwith high commodity prices, the initiation of a centralbank exit strategy, MENA instability and Greek debt

concerns, all unsettling markets to various degrees.

Bond Indices, USDIndex 100 = Feb 1 2011

95

97

99

101

103

105

107

109

Feb-21 Mar-08 Mar-23 Apr-07 Apr-22 May-07

MSCI EMGBI-EM

EMBI+

Source: Bloomberg

Over the entire period since our last Emerging MarketsCross Assets (EMXA) on February 21, EM equities have

gained 1.8% in absolute and 2.7% relative to DM equitieson a USD-denominated basis. The benchmark EM externalbond index, EMBI+ is up 4.6% while the benchmark indexfor domestically denominated debt valued in USD, GBI-EMis 5.8%, also measured on a USD-denominated basis.

Fifteen large EM currencies have recovered by a total of2.8% against the USD. In nominal trade weighted terms(NEER) the performance was stable in late 2010 and earlythis year but the latest data (April) show an appreciation of

1.3%.

15 EM currencies, equal weigth. 100=1 Jan. 2004

EM FX spot vs. USD

Source: Reuters EcoWin

jan

10

apr jul okt jan

11

apr

100.0

102.5

105.0

107.5

110.0

112.5

115.0

117.5

Index

100.0

102.5

105.0

107.5

110.0

112.5

115.0

117.5

Global economic backgroundProspectively, we begin by analysing what is happening tothe global economic environment. The outlook for growthin OECD economies this year has deteriorated butimproved for 2012 compared to our last report in February.In particular, we expect a temporary deceleration in the UScausing us to cut our forecast for 2011 from 3.6% to 2.8%.This largely reflects a surprisingly weak Q1 performanceand erosion of disposable income by higher food andenergy prices. However, we project a recovery in 2012 asthe labour market continues improving and companies arehighly optimistic. With strong corporate balance sheets,private sector savings are set to fall. We believe economicactivity will increase by 3.8%, well above the consensus

forecast.

Meanwhile, Japan is also suffering the economicconsequences of its various disasters although we estimate

that growth will improve next year as the effects ofreconstruction projects impact. Western Europe isincreasingly characterised by a two speed development.Greek debt reconstruction looks increasingly inevitable, akey EM risk and one we discuss in more detail at p6.

EM protects global growth in 2011 but relativeadvantage decreases in 2012Overall, we have raised our Euro-zone growth forecast afew notches to 2.2% for both 2011 and 2012, albeitlowering our OECD forecast for this year to 2.4% from2.8%. However, continued strength within EM limit our

Global GDP (PPP) forecast revision to 0.2%, easing to4.3% in 2011 from 5.0% in 2010. Next year, worldwide


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growth will accelerate to 4.5%, i.e. in line with trend in

both 2011 and 2012.

However, the GDP growth advantage for EM willdecline, as we forecast a decrease in aggregate EMgrowth from 6.5% this year to 6.2% next, lowering our

2012 EM GDP forecast below that of, for example, theIMF. This reflects two factors. Firstly, we regard EM aswell ahead of developed markets within the businesscycle and believe that while normalisation of monetarypolicy will be responsibly implemented in order to limitinflation risks, it will do so at the expense of (already

high) growth.

Secondly, and obviously interlinked, we expect asharper deceleration in two EM giants: China andIndia. Therefore, our higher growth forecasts for, forexample, Brazil, Mexico, Poland and Russia are

insufficient to offset downward pressure on theaggregate EM forecast. It is crucial, however, tounderstand that EM growth of 6.2% in 2012 canhardly be described as critically low. Instead, itreflects the fact that the business cycle is maturingand that we are no longer living in the euphoric supercycle that precede the Great Recession.

2009 2010 2011 2012

China 9.1 10.3 9.3 8.5

India 8.0 10.4 8.0 7.0

EM 2.7 7.3 6.5 6.2Indonesia 4.6 6.1 6.2 6.5

Turkey -4.8 8.9 5.8 4.8

Malaysia -1.7 7.2 5.5 6.0

Russia -7.8 4.0 5.3 5.0

Taiwan -1.9 10.8 5.2 4.9

Estonia -13.9 3.1 5.0 4.5

Ukraine -15.1 4.2 4.7 4.5

South Korea 0.3 6.2 4.5 4.3

Mexico -6.1 5.5 4.5 5.1

Poland 1.7 3.8 4.5 4.6

Thailand -2.3 7.8 4.3 4.1

World(PPP) -0.5 5.0 4.3 4.5

Brazil -0.6 7.5 4.2 4.7

Lithuania -14.7 1.3 4.0 4.5

South Africa -1.7 2.8 3.7 4.2

Latvia -18.0 -0.3 3.7 4.3

Hungary -6.7 1.2 2.7 3.0

Czech Rep. -4.1 2.2 2.5 3.5

OECD -3.4 2.8 2.4 3.1

Iceland -6.9 -3.1 2.2 3.4

Romania -7.1 -1.3 2.0 4.0

Source: OECD, SEB

SEB GDP f-cast

One factor supporting high growth in EM is the recovery inprivate sector credit growth. With the conspicuousexception of many countries in Emerging Europe, EMentered the global financial crisis with banking systemscharacterised by much lower leverage and less troubledassets. Aggregate lending to the private sector neverstalled and over the last year has regained momentum.

Source: IIF

This is also the case in Emerging Europe subject to twoimportant differences compared to the pre-crisis borrowingfrenzy current credit growth is much more modest and isprimarily domestically financed. With household andcorporate indebtedness still low, especially in Latin Americaand Emerging Europe, the credit engine is likely to continuedriving future EM growth.

A few cautious wordsWhile the general outlook for EM remains generallypositive, several improvements may still be thought

desirable with three policy areas of particular significance:

1. While aggregate fiscal and external balances inEM remain in better shape than in their developedcounterparts, current account deterioration istaking place in several key countries. In Turkey,the deficit is likely to reach 8% of GDP this yearwith the structural trade deficit aggravated by verystrong domestic demand, and high oil prices.

Negatively, financing is largely derived fromportfolio investments. Indeed, even if the countrymaintained access to financial marketsthroughout the Great Recession, its high externalfinancing requirements represent a risk in theevent that risk aversion once again unexpectedlyresults in a withdrawal of liquidity.

In Poland, the current account deficit increased to3.3% of GDP last year. However, correcting forhigh, negative errors and omissions in thecountrys Balance of Payments data, it may in factbe twice as large. Brazil also suffers from anincreasing external deficit. At only 2.3% of GDPand with large continuing FDI inflows, financing is


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not a problem. However, the deficitemphasises that the currency is highly valuedand that the competitive situation isdeteriorating (Dutch Disease). For all thesecountries, especially Turkey, a better balancebetween fiscal and monetary policieswould have been adequate with the formertaking a much larger share of theresponsibility for dampening domesticdemand.

2. In our view, exchange rate policies inEmerging Asia, particularly in China, havebeen sub-optimal. In previous reports wehave presented the arguments favouringfaster appreciation. In our February report westated that authorities would increasinglytolerate FX appreciation. In part, this is what

has occurred although there is, in ouropinion, more to do; see our FX sectionbelow.

3. Finally, we note an element of complacencyamong EM policy makers concerningstructural reforms. The paradigm shiftinvolving implementation of structuralreforms in EM over the past decade hasproved sufficient not only to guide mostcountries through the financial crisis but alsohelp them secure their current positionswithin the global economy against a

background of growth and stability. However,while in relative terms, policy makersprobably feel that additional structuralreforms are not as urgently required, webelieve that is a mistake. Future growth andstability would be enhanced, we believe, ifgreater reform momentum could beregained.

SEB EM surprise indicator

SEB surprise indicator, Emerging markets

Index, cumulative level

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Source: Bloomberg, SEB

Over a shorter period, we are guided by our EMsurprise indicator - a normalized average of the

surprises affecting a sample of Bloomberg consensusestimates for the EM Big Five; China, Brazil, India, Russiaand South Africa. We track approximately 20 indicators, allequally weighted in our metric. If the index of accumulatedforecast deviations is trending upward, surprises areskewed towards higher stronger better growth thanexpected, and vice versa.

Following the sharp negative deviation between forecastand actual data that occurred during the financial crisis andglobal recession, macroeconomic data once again beganoutperforming expectations from mid-2009. Since the endof last year until very recently macroeconomic figures haveon average been largely in line with market expectations.

The year began with positive macroeconomic momentumonly to be replaced by a sudden sharp setback in April.Early indications for May, however, indicate a rebound

although the situation remains unclear for now. Secondquarter data could even deteriorate as (still) highcommodity prices erode consumption, monetary policytightening in EM begins to impact and the impact ofproduction disruptions in Japan is felt. Such a slowdown issuggested by the recent fall in the output to inventory ratioin recent global manufacturing PMIs.

Source: IIF

The SEB surprise indicator suggests that the EM businesscycle has begun to progress, consistent with the growth

scenario on which this report is based. If indicator volatilitycontinues to increase over the next two quarters it mayimply a turning point in the business cycle, although wewould regard such a development as premature.

Key risksThe key risks to our generally positive EM macroeconomic

scenario are as follows:

1. Liquidity squeeze in connection with the end of US QE2

2. Disorderly Greek debt reconstruction and

3. Political volatility in MENA countries spreading to

heavier oil exporting states.In the following discussion we analyse each of these risk

factors.


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1. Fed quantitative easing coming to an end?We expect unconventional monetary stimulusmeasures to unwind gradually, and therefore avoid therisk of a sudden negative trigger to enter the market.The US exit strategy is scheduled to begin in Junewhen planned bond purchases end. However, we willbe well into the second half of the year before the Fedceases reinvesting both principal and dividends.Therefore, the real test for the market will occur then.Although this implies a tighter monetary policy weexpect only a limited effect on rates and liquidity.

Firstly, this position is believed to be largelydiscounted by the market. Secondly, the substantialincrease in liquidity has not filtered into financialmarkets but instead remained on bank balance sheets.Thirdly, such a move will be taken by the Fed in orderto reflect an improving economy (otherwise we should

expect the exit plan to be postponed).

US monetary base and M2 growth rates

Source: Ecowin

96 98 00 02 04 06 08 10

M

onetarybase(thousandbillions)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

M2,percenty/y

-2

0

2

4

6

8

10Adjusted monetary base (right)M2 (real)M2 (nominal)

When the Fed stopped buying government bonds inOctober 2009 it did not result in any large upwardpressure on yields. When it ceased purchasingmortgage bonds in March 2010 we saw rapid yielddeclines. Nevertheless, the steep US yield curve (2y-10y) will be monitored closely. Any sudden sharpmoves could signal a larger effect on markets fromFed activity.

Government Benchmark Bonds

US 10y - 2y yield curve

US Gov Benchmark bonds spread 10-2y10 Year2 Year


May

09

Aug Nov

10

Feb May Aug Nov

11

Feb May

BPS

200

210

220

230

240

250

260

270

280

290

Percent

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

A sharp bear flattening of the US yield curve couldsignal deteriorating expectations concerning the

business cycle that previously found support from the FedsQE2 program. We expect US monetary policy to tightenfrom its current extremely loose position. We forecast afirst rate hike in early 2012 with total increases of 175bpsduring the rest of the year.

If this proves correct, it will of course lift the short end.Consequently, we should expect an increase in the 2y yield.However, if the long end of the curve does not respondaccordingly or even moves in the opposite direction themarket will have opted for a more negative scenario. In thatcase, risky assets in general and including EM assets (due

to liquidity constraints) would perform poorly.

2. Next wave of the European debt crisisA second crucial risk is the European debt crisis. We regardGreek debt renegotiation as inevitable. We also think ithighly likely that Ireland and Portugal will also be forced

into some form of debt renegotiation, although later. Inaddition, there is a strong probability that Spain will seek aESFS/ESM and IMF bail-out. According to our mainscenario, the Greek solution will involve hard restructuringwith a haircut of 50% on private debts (vs. approximately40% currently discounted by the market) and bankrecapitalisations.

Although this scenario involves historical components(developed countries defaulting, being a reflection of theparadigm shift we have been discussing in recent years) itis vital to emphasise that according to our main

assumptions, such a development will be manageable forthe Euro-zone within the framework of its existing crisismechanism and further fiscal tightening. It will, however,imply continued strains on economic, financial and politicalsystems and large risk premiums and volatility for

financial markets.

These will be periods when EM assets also come underpressure. However, the market is now better prepared. EMassets were badly hurt when Greece hit the headlines backin April 2010, but subsequently less so as Ireland andPortugal followed suit. Furthermore, we believe Europeaninstitutions, the IMF and countries involved have both the

motivation and capacity to postpone debt restructuringuntil next year. Doing so will provide time for bankingstress tests to be performed and evaluated by markets. Inconclusion, we expect a continued global economicrecovery despite a new wave of European debt crisis.

3. MENA and oil pricesA third risk to the overall optimistic macroeconomicscenario for EM is represented by the possibility thatpolitical unrest in MENA countries spreads to larger oilexporting countries in such a way as to disrupt oil supplies.While some oil exporting EM would obviously benefit from

a further improvement in terms of trade, most are net oilimporters and all EM would suffer an inflationary effect ifthis risk were to materialise.


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Regional instability is far from being resolved. In theimmediate future we expect oil prices to remain high.During the second half of the year, however, webelieve they will fall due to more favourable supply-side conditions with, for example, a resumption ofproduction in Libya. Overall, we have raised our Brentoil price forecast for 2011 from an average of USD90/barrel to USD109/barrel. Next year we expect theprice to fall back to USD 95/barrel. In the followingsection we broadly elaborate on commodity prices andtheir impact on inflation and interest rates in EM.

Other risks include political developments,especially in Thailand but also in connection withupcoming elections in Turkey, Poland and Peru. InThailand the July elections may offer an outlet ofpolitical tensions but a scenario with reneweddestabilisation can in now way be ruled out with

demonstrations or even a new military coup. In Turkeyand Poland, we expect the outcome of elections inJune and October respectively to be market supportivewith current government reaffirming their positionwith positive implications for structural reforms ingeneral and fiscal policy tightening in particular. Thesecond round of the Peruvian presidential election onJune 5 also merits close monitoring. In particular it willbe interesting to see whether the winner of the twomore populist run-off candidates (centrists failed inthe first round) lives up to promises made to follow theexample of Brazil rather than Chavez Venezuela.

Headline Inflation Seen LowerLocal yields down, curves flatter and break-eveninflation lower; that is our key message.

EM Yield Aggregates

6

6.2

6.4

6.6

6.8

77.2

7.4

7.6

7.8

8

Jan-10 Apr-10 Jul-10 Oct-10 Dec-10 Apr-11

EM

LocalBondYie

lds,%p.a.

1.5

2

2.5

3

3.5

4

EM

ShortRates

,%p.a.

GBI-EM yields

ELMI short rates

Source: Bloomberg

On average, local bond markets appear satisfied withthe management of monetary policy so far. Theincrease in short rates has in fact been accompaniedrecently by a decrease in bond yields, aggregated overthe EM universe. The two high-inflation index-linked

bond markets, Brazil and South Africa are also pricing in

slightly lower break-even inflation rates.

Still, an important driver behind EM local bond yields hasbeen their tight correlation with Treasuries, with globalbusiness cycle expectations a plausible common factor. A

significant decrease in treasury yields despite the imminentend of QE2 has coincided with both lower local EM bond

yields and softer growth expectations.

EM Yield Indices

5.5

6

6.5

7

7.5

8


0.5

1

1.5

2

2.5

3

Treasuryyie

ld%p.a.

GBI-EM yield

5y Treasury yield

GBI-EM

yield%p.a.

Source: Bloomberg

Nevertheless, we regard the combination of yield flatteningand slightly tighter break-even spreads as an indicationthat EM central banks have so far weathered pressures

exerted by growth induced inflation with market approval.

Break-Even Inflation Rates

1

2

3

4

5

6

7

Jul-10 Oct-10 Jan-11 Apr-11

Break-e

venInflation,

%p.a.

US TipsBrazilSouth AfricaKorea

Source: Bloomberg

No surprise to running inflation, upward pressureon core remainSince February, running inflation in EM has developed inline with our forecast (reported in our previous EMXA). Ournew forecast is basically the same as its predecessor with

headline inflation expected to peak early in the second halfof this year. And still we see core inflation to continue torise during the year to soften only gradually in 2012 and


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onwards which will keep pressure on monetary

policymakers.

121110090807060504

7

6

5

4

3

2

1

7

6

5

4

3

2

1

CPI in selected emerging market countries, % y/y

Core

Headline

Food prices remain highFood prices have levelled out, albeit at a high level,

while crude oil has decreased, especially concerningcontracts for future delivery.

50

100

150

200

250

300

2000 2002 2004 2006 2008 2010

IndexValue

UN Food Price Index

Source: Bloomberg

UN Food Price Index

All in all, we expect average inflation turning down in2012 towards inflation targets in most countries.

EMEA

Poland 4.5 2.5 2.7 3.7 2.8

Czech 1.6 2.0 1.5 2.0 2.5

Hungary 4.7 3.0 4.9 4.4 3.6

Turkey 4.3 5.5 8.6 6.0 6.3

S. Africa 4.2 4.5 4.3 4.7 5.3

Romania 8.3 3.0 6.1 6.5 5.0

Russia 9.6 6.5 8.8 9.3 7.6Estonia 5.4 - 3.0 5.0 4.0

Latvia 4.5 - -1.1 4.4 3.1

Lithuania 4.4 - 1.2 3.5 4.0

Ukraine 9.4 - 9.1 9.5 9.0

LatAm

Brazil 6.5 4.5 5.9 6.2 5.0

Mexico 3.4 3.0 4.4 3.8 3.7

Asia

China 5.3 4.0 3.3 4.9 4.4

Korea 4.2 3.0 3.0 4.3 3.3

Taiwan 1.3 - 1.0 2.0 2.0

Malaysia 3.2 - 1.6 3.5 3.2

Thailand 4.0 1.75 3.3 4.0 3.4

India* 8.7 - 10.5 7.5 6.9

Indonesia 6.2 5.0 5.1 7.1 5.9

*Wholesale prices Source: Consensus Economics, SEB

SEB f-cast,

av. 2011

SEB f-cast,

av. 2012

Current inflation, next year target and forecast, %

Apr CPI, y/y CB target,

2011

av. 2010

While crop forecasts have been dragged down by adverselocal weather conditions, last years dire global situation isunlikely to be repeated. Base effects on food prices aretherefore gradually becoming supportive of lower inflationreadings.

Commodity correction shows headline volatilityworks both waysCommodities in general corrected sharply downward byaround 10% in early May, a move which shows the dangersof following the trend in volatile prices too closely whenassessing the inflation outlook. Nevertheless, it is valuableto remember that economic activity is an importantcommon factor behind both commodity prices and generalinflation pressures.

Commodities

60

70

80

90

100

110

120

Apr-10 Jul -10 Oct-10 Jan-11 Apr-11

USD/Barrel

200

260

320

380

CRYIndexValue

Crude, nearestcontract

CRYCommodityIndex

Source: Bloomberg

Reserve management has been doublysupportiveOur analysis in the previous edition of EMXA has also beenvindicated concerning the effect of inflation pressures inmaking policymakers restrict the build-up of FX-reserves.Taking the EM-universe overall, the increase in FX-reserves(measured in SDRs) has ground to a halt, most probablysupporting EM currency appreciation vs. USD since our lastEMXA report.

Thousand billions

FX reserves in SDR

Developing Countries Industrial CountriesSource:IMF

00 01 02 03 04 05 06 07 08 09 10

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

SDRs

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

But some CBs still fuel inflation through FXHowever, for some countries, reserves continue toaccumulate rapidly, despite strong inflation pressures, withBrazil an obvious example. Regardless of the current rate of


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accumulation, the substantial reserves held representa powerful weapon in helping cool inflation pressuresfrom currency appreciation through hard-currency

sales.

1

2

3

4

5

6

7

8

06 07 08 09 10 11

Inflation,y/y%

-20

0

20

40

60

80

100

120

ReservechgonqtrUSDbn

Inflation y/y

Reserve Change qtr

Brazil: Inflation and FX-Reserve Changes

Source, Bloomberg

Caution still justified, rebalancing neededWith most EM economies still enjoying very highgrowth, their central banks must cautiously defendtheir inflation targets. As noted in our May edition ofNordic Outlook, stronger EM currencies would be oneappropriate tool for doing so. Allowing currencies tostrengthen would both serve the goal of lowering EMinflation rates and rebalance the global economy.Exports from indebted DM would help satisfy growingdemand in EM, supporting current slow DM recoverieswhile moderating the business cycle in EM.

Asset AllocationLooking into the question of asset allocation, makeboth strategic and tactical valuations. The lattercurrently favors equities, while the former, as usual

shows the need for larger allocations into EM-bonds.

Large fluctuations in flow of fundsAfter some flattening of net inflows to EM debt fundsand even momentous outflows from EM equities dueto an reduced developed markets risk premium at thebeginning of this year the correction subsequently

materialized, fully consistent with our expectations.

Net flow of funds EM FI & EQ, YTD

-8.00

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

18/05/201

1

04/05/201

1

20/04/201

1

06/04/201

1

23/03/201

1

09/03/201

1

23/0

2/201

1

09/02/201

1

26/01/201

1

12/01/201

1

Source: EPFR

bn USDEM Bonds

EM Equities

Rising energy prices, a mixed start to Q1 corporate earningsresults, Portugals sovereign debt problems and Japanscrises subsequently drove investors away from developed

markets once again.

After suffering outflows in Q1 (investors withdrew over 20%

of their USD 84bn in EM equity investments in 2010) this year,for two weeks in April investors moved more funds back intoEM assets while reducing those held in their DM counterparts,according to data covered by EPFR.

So far this year, Russia has remained the jewel in the EMcrown in general, and amongst BRIC markets in particular,benefiting from high energy prices and a low valuation. Tosome extent Japans nuclear crisis was regarded as positivefor South Korean exporters causing investors to switch intoKorean equities. Capital controls in Brazil, imposed todampen speculative money flows, are important inexplaining the disinclination of investors to move capital

back into the market.

The recovery of flows into EM was driven by retailinvestors. DM bond funds suffered when retail investors,representing up to 80% of the market monitored by EPFR,withdrew cash from the municipal bond market.

The Aprils increase in inflows to EM reflects both cyclicaland structural factors. As we elaborated in our last twoEMXA reports the multi-speed nature of the post-crisisrecovery has resulted in a cyclical widening of growthdifferentials between advanced economies and EM.Structural factors suggest that capital flows to EM are likelyto be sustained over the long term, albeit with periods ofincreased volatility.

Fed model suggests equilibriumA Fed model1 valuation approach provides a tool withwhich to evaluate the risk reward of holding equitiescompared to a risk-free bond investment. In general themodel argues that if the earnings yield on equities (E/P) ishigher than the yield received by buying a bond, investorsshould divest bond holdings and buy stocks.

There are several practical shortcomings to this model,

especially in trying to apply this approach to assets outsideUS markets; what is a risk free rate?; should it not be a realbond yield?; what about differences in volatility?; whattriggers revaluation trends (the timing aspect)?; is a ratio of1.0x a true equilibrium? However, it offers significant foodfor thought.

1The Fed-model was named by Edward Yardeni of Prudential Securities based

on research conducted at the Federal Reserve in the mid-1990s. The modelstudies long term treasury bonds and expected equity returns. However, theFed has never endorsed the approach and the model can in fact be found to

have existed in various forms long before this particular version wasidentified.


11/36

11


We have adopted the basic thoughts behind the Fedmodel in examining pricing of EM assets. The relativevaluation of EM stocks and EM hard currency bondssuggests that equities are undervalued, with stockscurrently offering an earnings yield of 9.4%. Theimplied hard currency yield, derived from US treasuriesand the EMBI+ spread, is 4.8%. Therefore, the EMstocks/bond yield ratio is 1.9x vs. an historical averageof 1.4x. Adding one standard deviation produces aratio of 1.7x. Consequently, EM stocks appearextremely cheap.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Apr-04

Oct-04

Apr-05

Oct-05

Apr-06

Oct-06

Apr-07

Oct-07

Apr-08

Oct-08

Apr-09

Oct-09

Apr-10

Oct-10

Apr-11

MSCI EM value from a Fed-model approach

equities inexpensive

equities expensive

+1stdv

-1stdv

Note: P/E 12m fwd vs. UST5y and EMBI+ Source: FactSet, Bloomberg, SEB

We also find a similar situation, albeit not as extreme,when comparing the earnings yield of DM equities

(MSCI World index) with US treasuries.

However, for a true EM investor the alternative to EMstocks is perhaps not hard currency bonds but rathertheir local currency counterparts. In the graph belowwe have made the same calculation using instead theimplied GBI yield. We have also added the relativeperformance between the GBI and MSCI EM index.

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

0.1

0.15

0.2

0.25

0.3

0.35

0.4MSCI EM value from a Fed-model approach

equities inexpensive

equities expensive

+1stdv

-1stdv

Note: P/E 12m fwd vs. GBI yield

GBI/MSCI EM

Source: FactSet, Bloomberg, SEB

Over time the market discounts EM stocks and localdebt at a ratio of 1.25x. Currently the market tradesthese assets at 1.3x, i.e. very close to their long termaverage and well within a one standard deviation fromaverage corridor. This would imply that EM stocks and

local bonds are traded close to equilibrium.

As regards relative price performance our version ofthe Fed indicator has generally been able to tell thedirection of markets relative pricing. It signalled in

2005 that substantial value existed in EM equities. In thesecond half of 2007 it suggested that the bull run was welladvanced, with relative performance swinging back sharplyin favor of EM bonds in 2008. By end of 2008 the FEDgauge pointed to better value in EM equities vs bonds onceagain, but it took a few more months before started to letequities outperform EM bonds.

Subsequently however, relative performance between EMlocal bonds and stocks has been largely stable despite two

extreme readings from the Fed model indicator.

Overall, we conclude that the rather blunt tool for gaugingmarket timing offered by our EM Fed model valuationapproach, recommends a largely neutral weightingbetween EM equities and (local) bonds according to aportfolios normal risk distribution.

How do we trade itAs risks abate and the recovery goes on though notwithout obstacles our general macro view favours EMcurrencies and suggests stocks to outperform bonds.However, partly due to the more advanced EM businesscycles, and also because of a generally low valuation of EM-bonds, we continue to see them outperforming developed

market bonds. Although we see a number of potential riskslooking forward (see p6), we regard the current risk rewardbalance as rather favourable. From various localperspectives, we see a multitude of relative tradeopportunities arising from a number of countries differentresponse to challenging inflation pressures and themarkets assessment hereof. Several FX and EM bondtrading recommendations with an investment horizon ofthree to six months are presented in the strategy section on

p20 of this report.

AllocationCurrently holding a bullish absolute view on EM-stocks, wewould like to favour these in an intra-EM asset allocation.At the same time, little has happened to the long standingstrong undervaluation of local EM-bonds. Hence, the idealallocation would include quite a large share of these bonds,especially if hedged by negative exposure against DM

bonds to secure against positive global growth surprises.Our relative Fed-model inspired indicator of historical EMequity-to local bond valuation is currently in neutral.Coincidental or not, our similar measure of historical EM-bond to DM-bond valuation (see p13) also stands near

long-term averages.

In sum, for the strategic allocation, we think its likely thatmost readers would find their allocation into EM-bonds tosmall. But in the tactical perspective, our positiveassessment on the business cycle and absolute EM stockreturns point to a larger than usual share of equities in the

EM portfolio. We recommend assuming the currency risk.


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12


Fixed IncomeEM bonds have outperformed in line with ourforecast in the previous EMXAdue to acombination of a general decrease in EM localyields and EM currency gains vs. the USD.

Negatively, we have seen a less favorable marketassessment on EM sovereign credits as shown bya widening of the EM hard currency bond EMBIyield index over DM yields.

Bond Indices in USD

90

95

100

105

110

115

120

125

130


EM local bonds

DM Governments

US Treasuries

EM hard ccy bonds

Index2010-01-01=100

Source: Bloomberg

Much of the decrease in yields has been paced by arecent positive development in US Treasuries,probably driven by a moderation in global businesscycle expectations.

High inflation strategy paid offOur long term dominant strategy of runningoverweight positions in high inflation countries has

been well rewarded since our last EMXA in February.During this period, the market has once againbenefited investors willing to bear diversified localinflation risks. Although this could be taken as furtherevidence of the markets approval of monetarypolicies, significant inflation pressures persist. Withvigilance still justified, risk premia probably remain inlocal EM bonds, a situation very positive for futurelong term outperformance of debt from high inflation

countries, although of course not without risks.

90

110

130

150

170

190

210

230

250

Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

Index/PortfolioValue

GBI-EM

GBI-EM InflationStrategy

Emerging Market Bonds Inflation StrategyMontly Sep-2005 to April-2011

Some weaker credits underperformedWe expressed caution regarding weaker credits when theMENA crisis began in the course of publishing our previousEMXA report. Our call was well directed with, for example,Turkish credit spreads in hard currency wideningsignificantly. We recommended taking down exposures toTurkey relative to an otherwise fairly index-neutral SEB EMbond-basket. In all however, our basket underperformed,both relative to EM and DM bond indices, partly as a resultof its shorter duration.

SEB EM Bond Portfolio 2011 February 21 to May 20

SEB

weight Yield

Duration

years

`= i~=K rpa=K

Poland 15% A- 5.5% 4.1 MKTB MKRB NKOB

Hungary 7.5% BBB- 6.6% 3.6 PKPB NKUB RKOB

Iceland 5% BBB- 2.7% 0.4 JPKVB NKPB JOKTB

S. Africa 7.5% BBB+ 7.2% 3.3 JNKNB NKOB MKNB

Turkey 2.5% BB 9.2% 3.0 JNMKUB JOKPB JNOKVB

S. Korea 15% A 3.9% 3.2 OKTB JMKRB OKNB

Indonesia 5% BB+ 6.5% 3.0 QKRB NKSB SKNB

Malaysia 12.5% A- 3.4% 2.9 OKPB MKSB OKVB

Brazil 15% BBB- 12.7% 1.7 OKSB PKTB SKQB

Mexico 15% BBB 6.3% 4.1 SKUB JNKMB RKTB

Average 100% BBB+ 6.4% 3.1 OKNB MKUB OKVB

m~==cJON=

Rating

S&P

(LT-FC)

Inflation management keyInflation pressures remain strong in many EM economies.We expect them to be met by an increased willingness byauthorities to allow currencies to appreciate, a viewexpressed in the last EMXA and already partly vindicated.Holders of local bonds have benefited twice, directly fromtheir unhedged currency positions, and indirectly from thecooling effect on the economy which eased pressure on

monetary policy. Continued rate hikes and currencyappreciation are still needed with threats from food and oilprices about to be replaced by inflationary pressures fromclosing output gaps. Fiscal policies that aim to increaseinvestments and productivity rather than spending shouldnow also be rewarded.

Target relative valueWhile we forecast continued interest rate hikes, we are farfrom bearish on EM bonds. Bond markets, even in EM arespeculative and hikes are at least partly discounted. We soargued in the general section, showing the recent decrease

in yields which has occurred despite continued rate hikes.At local level, we see good relative value in several cases, to

which we will return in the strategy section.

EM ahead of DM in the business cycleWe observe however that DM economies are continuing torecover from deep business cycle lows, a developmentusually accompanied by higher bond yields. EM economiesare further ahead in the cycle, which should suggest a less

certain outlook for EM yields.


13/36

13


0

10

20

30

40

50

60

70

80

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

0

10

20

30

40

50

60

70

80

AdvancedEconomies

EmergingEconomies

Industrial Production Indices (total year 2000 = 100)monthly 1991 to Nov 2010

Source CPB, Neatherland's

bureau for

economic policy analysis

Growth expectations a key driverHowever, EM and DM market yields are following each

other fairly closely. We have seen a strong tendencyfor EM yields to move in the same direction as those inDM.

Bond Indices in USD

90

95

100

105

110

115

120

125

130

Jan-09 Jul-09 Dec-09 Jul-10 Dec-10

80

90

100

110

120

130

140

150

160

EM

bond(GBI-EM)

DM Governments

EM local bonds

DM

bonds(Citi)Jan2009=100

Source: Bloomberg

For each basis point DM yields have changed, those inEM have tended to change by about the same amount.Global growth expectations are clearly an importantdriver behind market pricing for both DM and EMbonds.

May, 2011 2Q, 2011 3Q, 2011 4Q, 2011 2Q, 2012 4Q, 2012

EMEA

Poland 4.25 4.25 4.50 4.50 4.75 5.00

Czech 0.75 0.75 1.00 1.25 2.00 2.50

Hungary 6.00 6.00 6.00 6.00 6.25 6.50

Turkey 6.25 6.25 7.00 7.75 8.25 8.25

S. Africa 5.50 5.50 5.50 6.00 6.50 6.50

Romania 6.25 6.25 6.25 6.25 6.75 7.00

Russia 3.25 3.50 3.75 4.00 4.75 5.00

LatAm

Brazil 12.00 12.25 12.75 12.75 12.75 12.25

Mexico 4.50 4.50 4.50 5.00 5.50 6.00

Asia

China 6.31 6.56 6.56 6.56 6.56 6.56

Korea 3.00 3.25 3.75 4.25 4.25 4.00

Taiwan 1.75 1.88 2.00 2.13 2.25 2.38

Malaysia 2.75 3.00 3.25 3.50 3.50 3.50

Thailand 2.75 3.00 3.50 4.00 4.00 4.00

India 7.25 7.75 8.25 8.25 8.00 7.75

Indonesia 6.75 7.00 7.50 7.50 7.50 7.50


SEB forecasts of policy rates for Q2-Q4 2011 and Q2,Q4 2012, %

We might ask whether or not local factors should have astronger impact on EM bonds. If so, lower EM yields couldbe justifiable as EM economies are ahead of DM in the cycleand curves eventually flatten as a business cycle highdevelops. At the same time, it would not be unnatural forEM bonds currently to be highly responsive to changes inglobal growth expectations. All else being equal, higherthan expected global growth would severely exacerbate theinflation burden on EM policymakers.

Historical relative EM-DM valuation neutralTaking currency fluctuations (and differences in portfoliodurations) into account, a weaker but still fairly strongcovariation is apparent between EM and DM debt marketindices (both valued in USD). EM return sensitivity to DM israther strong, with EM-returns (both positive and negative),having a tendency to be double as large as coincident DMreturns. Banking on this fact we establish an historical

valuation indicator. Any deviation from EMs tendency toshow twice as big (positive and negative) returns as DM isshown in increases or decreases in the index. As it turnsout, this index currently stands close to its long-termaverage, indicating an historically neutral DM vs. EM bondindices valuation.

SEB EM/DM historical trend indicator

0.8

0.9

1

1.1

1.2

1.3

2003 2004 2005 2006 2007 2008 2009 2010 2011


EM expensive

EM cheap

Long-term star outperformance set to continueIn the longer term, and even from the 3-6 monthperspective discussed here, we still expect continued EMlocal bond outperformance.

EM Yield Indices

6

6.5

7

7.5

8

8.5

9

9.5

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

1

1.5

2

2.5

3

3.5

4

4.5

Treasuryyield%p.a.

GBI-EM yield

5y Treasury yield

GBI-EMyield%p.a.

Source: Bloomberg


14/36

14


The fact that local EM bonds are close to their longterm trajectory of doubly outperforming DM bondsindicates after all that this trend remains unbroken.Another way of considering this phenomenon is toobserve the ratio of local EM bond yields to Treasuryyields which too remains within its historical range,especially since 2008. EM yields are more than three

times those in DM.

Also, EM currencies are tending to appreciate againstthe background of our own positive currency outlook.Since the beginning of 2003, GBI-EM has generated anaverage return of 15% in USD terms while CitigroupsWorld Bond Index, covering the DM universe, hasaveraged 7%. Measured in terms of excess return, i.e.after carry costs, EM bonds have therefore produced

an exceptionally strong outperformance.

Bond Indices in USD

50

100

150

200

250

300

350

2003 2004 2005 2006 2007 2008 2009 2010 2011

50

100

150

200

250

300

350

DM Governments

EM local bonds

Source: Bloomberg

We, together with a wide range of universityacademics, have tried to identify the cause of this

outperformance which appears inconsistent with theidea of efficient markets. In finance it goes under thename Uncovered Interest-rate Parity puzzle. Whilewe have no name for it, we have neverthelessdiscussed it previously. Probable reasons for suchpersistent and strong outperformance include, in ourview, the domestic bias of DM investors, market fearsof inflation risks, and a preference for avoiding lower-rated securities. We expect any investor able toovercome these obstacles to enjoy very strong risk-adjusted long-term returns.

Recovery bullish? Hedge and overhedge!Nevertheless, as DM economies are still recoveringfrom deep business cycle lows, higher DM yields arelikely. SEB also expects such an increase, as discussedin our latest edition of Nordic Outlook. Barring anysharp increase in risk aversion, we see no reason toexpect a breakdown in the tight connection betweenEM and DM yields anytime soon. We thereforerecommend hedging any exposure to EM yields withan opposite position in DM. In addition, for eachdollars worth of exposure to currency unhedged EMlocal bonds, we would suggest shorting the double in

DM.


15/36

15


CurrenciesThe main EM currency drivers will be carry,central bank activism and fundamentals. Weexpect monetary policy normalisation tocontinue. With rates already much higher in EM

than in their developed counterparts, carry willgenerate further EM FX gains. Central banks willalso tolerate more FX appreciation to dampeninflation and alleviate global imbalances.Although the GDP growth advantage of EM willdecrease next year, they will still benefit if, as weexpect, fundamentals become investmentdeterminants. EM FX appreciation will be morepronounced in coming months, partly due tocontinued strong liquidity. Hence we see goodvalue in an EM Asia basket (long CNH, KRW andMYR vs. short GBP, JPY and USD), we favour TRY

and RUB and recommend a long PLN/HUFposition.

During the period since our previous report inFebruary, 15 large EM currencies have appreciated by2.8% against the USD.

15 EM currencies, equal weigth. 100=1 Jan. 2004

EM FX spot vs. USD


jan

10

apr jul okt jan

11

apr

100.0

102.5

105.0

107.5

110.0

112.5

115.0

117.5

Ind

ex

100.0

102.5

105.0

107.5

110.0

112.5

115.0

117.5

In nominal trade weighted terms (NEER) theperformance was stable in late 2010 and early thisyear but the latest data (April) show an appreciation of1.3%. The recovery since the Great Recession has,however, only come two thirds of than half way

leaving plenty of room for further appreciation.

15 EM currencies, equal weight. 100=2005

EM FX NEER


06 07 08 09 10 11

87.5

90.0

92.5

95.0

97.5

100.0

102.5

105.0

87.5

90.0

92.5

95.0

97.5

100.0

102.5

105.0

Obviously, a return to pre-Lehman levels is not a giventarget. But, taking into account that EM passed thefinancial crisis in such a good way could be an indicationthat a further increase in NEER towards the 2006-2008

levels can be achieved without reaching stretched levels.

When we published our previous report, we recommendedretaining a 50% hedge ratio for EM currency exposure withreference to the adverse risk reward balance. On April 1,with some positive news and a resumption of positiveweekly fund flows to EM, we lifted the hedge andrecommended assuming full FX risk. While this strategy hasbeen satisfactory, EM currencies have appreciated lessthan we expected. Furthermore, long EM FX positions werechallenged by the sharp loss in EUR/USD and commodityprices during the first half of May.

Managing challengesSignificantly however, EM currencies have performedreasonably well under such circumstances. In our view,EUR/USD developments have more reflected euroweakness in response to increasingly dovish ECB rhetoricthan a strong dollar which would be more problematic foroften USD-funded EM positions. Considerable squaring ofcrowded positions has, of course, also occurred involvingEM currencies although, in the main, it was commoditiesthat were adversely affected. Most likely this has beenwhere the size of speculative positions had become mostly

stretched. For example, the scale of speculative long oilpositions has decreased by 1/5 of the recent high but stillremains long. At the same time, the short USD position hasalmost eased by half while its yen counterpart has becomelong. Long positions in, for example, MXN and RUB haveeased by 1/5 and 3/5 respectively compared to their recenthighs.

While many riskier positions (to which long EM currencyexposures are still referred) have been USD-financed, wenote a lower correlation between EUR/USD and, forexample, stocks, commodities and EM currencies than infor instance in the period preceding the Lehman crash.

Nevertheless, USD value is important and requires specialconsideration.

Major FX trends weaker USD near termIn our view, the key to the US dollar outlook lies with theFed. Given the continuing slowdown in the US economysince Q1 and its large twin deficits, we expect the centralbank to maintain its exceptionally loose monetary policy forsome time yet. We believe EUR/USD will recover early Maylosses and return towards 1.50 over the summer. However,as QE2 draws to a close, and the Fed ceases to reinvestloans and interest payments maturing this autumn, the

currency will recover. We expect such a development tooccur without any major impact on either interest rates or


16/36

16


the liquidity situation. By January 2012 the Fed willbegin hiking fed fund rates, we forecast to 2.0% byend-2012.

We expect the USD to recover after weakening fairlyconsiderably against many major currencies. We

forecast USD/EUR of 1.40 and USD/JPY of 88.00 byend-2011. However, the dollar outlook is ambiguous.We believe the currency will recover ground againstmany majors while depreciating further againstfundamentally strong currencies with supportiveinterest rates.

Initiation of the Feds hiking cycle will, however,terminate a long period of very cheap USD liquidity.While Japan will maintain its zero interest rate policyand the Yen probably replace the US dollar as afunding currency, the withdrawal of cheap USD

liquidity should ease pressure both on commodityprices and on capital inflows to EM. We expect thisdevelopment to be the key characteristic of activitynext year, by which time EM currency diversificationwill have increased.

Key EM FX drivers aheadIn our view, the key EM currency drivers over the next3-6 months will be as follows:

1. Carry

2. Central bank activism and

3. Fundamentals.

In the following analysis, we discuss why they are likelyto be important determinants of market activity andhow they will affect different EM currencies.

1. CarryCarry trades were adversely affected by the Japaneseearthquake which resulted in increased FX volatilitiesrendering positions less attractive. Then, afterrecapturing investor attention once again, they werehurt by the sharply lower EUR/USD and decreasingcommodity prices in early May. As already argued,however, we expect carry to become a key driver onceagain. We identify two preconditions to helping carryreassume this role. Firstly, we believe risk appetite will

remain supportive.

SEB Carry Indic & Risk Appetite Index

SEB Carry indicatorSEB_RAI_Median100

0

05 06 07 08 09 10 11

70

80

90

100

110

120

130

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

Secondly, we expect volatility to continue at current levels

or even decrease slightly further.

EM FX volatility and VIX

VIX indexEM FX 3M implied volatility. Average of 12 EM


jan

10

mar maj jul sep nov jan

11

mar maj

7

8

9

10

11

12

13

14

15

Percent

10

15

20

25

30

35

40

45

50

The graph below illustrates three months carry against theUSD annualized for a number of EM currencies. To little

surprise, BRL and TRY are at the top of the league. Notealso that the actually carry earned on especially the NDFcurrencies may differ substantially from the policy rates inthe respective countries. Two striking examples of this areBrazil where carry is around 8% compared to the currentpolicy rate of 12%. In China, investors currently get anegative carry of 1.5% annualised since the NDF market ispricing in some appreciation of CNY vs. USD (too little in

our view).


17/36

17


Carry %, 3m vs USD, Annualized

-4

-2

0

2

4

6

8

10

IDR

BRL

TRY

MXN

RUB

HUF

ZAR

KRW

PLN

MYR

CNY

Carry%

Source: SEB, Bloomberg

An analysis of risk adjusted carry confirms that EMcurrencies ought to be strong winners if carrybecomes a driving force in FX markets. All 10currencies vs. the USD in our sample have a Sharperatio exceeding 0.2, a level often referred to as aminimum for carry trading. The average Sharpe ratiofor these 10 EM currencies is 0.56 with BRL and TRYscoring well again but with IDR in the top of the league

according to the latest data.

Risk adjusted carry

0.0

0.5

1.0

1.5

IDR

BRL

TRY

MXN

RUB

HUF

ZAR

K

RW

PLN

MYR

Sharpratio

Source: SEB, Bloomberg

As a comparison, three of most commonly tradedcarry currencies among the majors, AUD, NZD andNOK currently have Sharpe ratios of 0.26, 0.14 and0.14 respectively against the yen.

2. Central bank activismSince last autumn, EM central banks have moreactively managed their currencies. Their doing soreflects concerns that the combination of vast

differences in GDP growth and interest rates on theone hand and a QE-induced abundance of globalliquidity on the other could cause EM currencies to

appreciate too far, too fast. Currency markets werecharacterised last October as being the subject of an FXwar. Subsequently, many EM central banks haveintervened regularly to prevent the market from having itall their own way. This strategy has operated together withnew capital restrictions mainly in Emerging Asia and LatinAmerica. Central bankers were largely successful, covertlyensuring EM FX did not appreciate further in NEER terms ineither late 2010 or early this year.

In our previous report we highlighted a likely change inbehaviour by central banks as headline inflation hadaccelerated to a point where further FX appreciation wouldbe tolerated to restrict imported price pressure.Prospectively, we expect this preferential balance to bemaintained given probable further high near-term headlineinflation, and also because markets are refocusing on coreinflation which will continue to rise from low levels for

longer with output gaps in many cases now filled.

Thousand billions

FX reserves in SDR

Developing Countries Industrial CountriesSource:IMF

00 01 02 03 04 05 06 07 08 09 10

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

SDRs

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

The existence of global imbalances also implies that theFX war will return to the news later this year. Pressure onChina and other EM surplus economies to takeresponsibility for restoring a more balanced globaleconomy is likely to intensify ahead of the G20 summit inCannes on November 3-4. Several Asian DevelopmentBank representatives have highlighted the merits of a jointEM Asian revaluation. While we agree, it remains to be seen

whether such policy coordination will in fact materialise.

3. FundamentalsFundamentals include the rate and structure of GDPgrowth, the internal and external macroeconomic balance(i.e. fiscal and current account balances), public andexternal indebtedness, as well as the demographicsituation, the status of the banking system, FX reserves andnet investment positions.


18/36

18


The panel of charts below serves to illustrate some of

these factors on an aggregate level:

Percentage change yoy

OECD and EM GDP growth

Source: IMF and SEB

85 90 95 00 05 10

-4

-2

0

2

4

6

8

-4

-2

0

2

4

6

8

OECD

Emerging Markets

Percent

Strong fundamentals underpin currencies as they

generate supportive flows and limit the risk ofunpleasant surprises. Over the next 3-6 months,representing the investment horizon of the present

report, we expect these factors to be key drivers ofbusiness flows (including trade and FDI) and investmentdecisions (through portfolio flows) influencing currency

markets.

EM fundamentals are stronger than those of developed

markets on many accounts. This applies in general, EM Asiais best in class. Having said that, it is important to notethat various EM countries provide significant scope forfurther improvement in terms of optimizing their fiscal,monetary and exchange rate policy mix. As we highlight onp6, we are concerned by evidence of complacency

regarding continued structural reforms.

What has been done has in many cases been impressive,conferring immediate positive benefits. However, the taskremains incomplete. Democratic reforms need to be rootedand invigorated, and institutional reforms improved. At the

same time, we also see scope for improvements incorporate governance and combating corruption.

SEB EM FX forecastsOur analysis of individual currencies in the frameworkdescribed above generates the following forecasts:

j~=OM b=OnNN b=PnNN b=QnNN b=OnNO

mik PKVO PKUU PKUO PKTR PKTM

erc OSV OSR OSR OSR OSR

`wh OQKR OQKO OQKM OPKS OPKP

olk QKNN QKMU QKMR QKMM QKMM

fph OQU ORM OQM OOM OMM

or_ QMKM PVKR PVKO PUKR PTKP

or_ L_ ^ph PPKR POKR POKR POKR POKM

or_ OUKO OSKT OTKM OTKR OTKT

r^e TKVV TKVR TKVR TKVR TKVR

qov NKRV NKRQ NKRM NKQU NKQR

w^o SKVN SKTR SKTR SKUM SKUM

_oi NKSO NKRU NKRR NKRT NKRT

juk NNKS NNKR NNKQ NNKP NNKM

`kv SKQV SKPU SKOU SKOM SKMP

pda NKOQ NKOO NKON NKOM NKOM

hot NMUP NMRM NMPM NMOM VVM

qta OUKU OUKP OUKM OTKS OTKQ

qe_ PMKP PMKM OVKS OVKQ OVKO

fko QRKMQQKO QPKT QPKR QOKU

fao URPS UQRM UQMM UQMM UPMMjvo PKMN OKVU OKVO OKVM OKUR

broLrpa N KQ O NKQU NKQR NKQM NKPR

rpaLgmv UNKT UOKM UQKM UUKM VOKM

sK=rpa

pb_=bj=cu=~

sK=bro

We therefore expect most EM currencies to perform wellduring the forecast period, particularly in the coming

quarter when:

high headline inflation will encourage centralbanks to accept stronger currencies

global liquidity will remain strong and

the USD will continue as a familiar fundingcurrency.


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19


Extending the horizon through to the end of this year,we see the possibility of many EM currenciesappreciating by around 5% against their tradedcurrency with ISK, TRY and KRW at the top of theleague followed by CNY and PLN having the bestpotential for nominal appreciation. At the bottom innominal terms we have UAH, HUF and IDR.

EM FX risksObviously, our forecasts are subject to various risks

including:

a more pronounced cyclical set-back

a faster/sharper tightening of global liquidity

earlier and more disorderly than expectedcontinuation of the European debt crisisand/or

a renewed sharp increase in oil prices.We discuss these risks in more detail on p6. Othersinclude positioning remaining biased towards manyEM currencies, and volatilities in general beingrelatively low, albeit less so than before the correction

during the first half of May.

and opportunitiesThe best opportunities in the EM currency space, inour view, are described in detail in the Fixed income

and FX trading strategy section on p20.


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20


Fixed income and FX TradingStrategiesIn our previous report we recommended a defensivepositioning bias given the challenging risk rewardbalance prevailing at that time. We advocated anintra-EM reallocation towards more liquid and morehighly rated instruments. We also suggestedmaintaining a 50% currency risk hedge but on April 1,we lifted that hedge to assume full currency risk.

Looking forward, based on our macro scenario asdescribed above and in view of the recent correction insometimes crowded positions, our investmentstrategy is to seek the potential gains from longpositions in EM bonds and currencies. In our opinion,the opportunities offering the best risk reward over

the next 3-6 months are as follows:

1. Long Turkish local bonds with open TRY risk

2. Long Polish 5s vs. Hungarian 3s with open FXrisk (long PLN/HUF)

3. Long Russian Eurobonds in rouble unhedged

4. Increase risk in SEB EM local bond portfolio,keep FX risk open, hedging IR risks with shortDM yield positions

5. Short EUR/ISK offshore, Place in HFF

6. Long long-end Croatia in USD, 2015 maturity

in EUR, both vs DM7. Long Lithuanian short end in Euros

8. Long EM hard currency bonds vs. DMcorporates

9. Long an EM Asian basket of CNH, KRW andMYR against USD, GBP and JPY

10. Sell USD/CNH

11. Retain EM FX basket

In the first five recommendations we suggestassuming risk on local government bonds and the

currency combination. Recommendations 6-8 concernhard currency papers while the last three proposalsinvolve pure FX positions. In the following analysis we

set out our key arguments and risks.

Long Turkish local bonds with open TRY riskWhen last winter arrived, the Turkish economy wasperforming very strongly. Q4 GDP was well aboveexpectations; up 9.2% and 8.9% y/y. FinMin Simsekexpects Q1 growth of 9.0%. We maintain our aboveconsensus 2011 forecast of 5.8%. Rapid growthobviously supports government finances with fiscal

data so far this year most encouraging. Significantly,spending controls have been maintained in the run-up

to elections in June.

GDP

Investmentan

dconsumption

However, high GDP growth is subject to two importantcaveats, particularly as it is predominantly driven bydomestic demand rather than exports. Firstly, imports haveincreased. After yet another disappointingly large currentaccount deficit in March, the full year deficit appears likely

to amount to 8% of GDP. The fact that an expensive oil billexplains a large part of the trade deficit provides someconsolation but with portfolio inflows needed to cover thevast majority of the deficit, this is clearly a cause ofconcern.

USDbn

The second caveat is inflation. Headline inflation hit a 40-year low of 4.0% y/y in March despite strong domesticallydriven growth and soaring global commodity prices. A verygood harvest last year is a key explanation. Going forwardhowever, base effects on local food prices are becomingchallenging. We believe the countrys high levels of

economic activity have strained resources so much thatinflationary pressure appears inevitable. We thereforeexpect headline inflation to increase towards 7% by year-

end.


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Percent

This will obviously provide a challenge for the centralbank which has been engaged since late last year inmaintaining an unorthodox policy mix of interest ratecuts and reserve requirement increases to restrictcapital inflows and dampen credit driven demand and

imports which adversely affect the external balance.To some extent, the authorities have succeeded inmaintaining a relatively inexpensive currency, butcredit growth has so far only shown limited signs ofslowing. In our opinion, this policy mix will be verydifficult to maintain with inflation set to exceed itsyear-end target of 5.5% as early as the summer. Weexpect rate hikes to be resumed. With only limitedsupport from fiscal policies in helping tighten policieswe now forecast that the policy rate will be increasedby 150bps from 6.25% currently to 7.50% by year-end?. We believe that once the central bank has

reverted to orthodox monetary policies, it willfrontload subsequently measures to dampen futureinflationary expectations.

While this should help inflation return to target in2012, such rate hikes will obviously support thecurrency, particularly with carry a key driver in FXmarkets. We therefore expect USD/TRY to fall to 1.48by year-end. A strong lira will prove problematic forthe central bank given Turkeys high current accountdeficit. We therefore expect more active interventions.Also, even if sterilisation comes at a significant cost,

increasing FX reserves will provide useful insuranceagainst future setbacks in risk appetite and

withdrawals of liquidity.

USD/TRY

REERIndex

Consequently, our forecasts show the liras potential to beamongst the best over the rest of the year, especiallydiscounting carry. Prospectively, we recommend holdingTurkish government bonds. We prefer shorter maturities astheir yields are as high as longer term bonds. For longbonds to breakeven against their shorter term counterpartswould require a rate path involving rate reductions early inthe cycle which appears unlikely. Due to high yields even inthe very shortest end some marginal exists against hawkishsurprises in rate policy. Also, three other factors willsupport bonds despite rate hikes. Firstly, we believe thereturn to orthodox monetary policymaking will succeed indampening inflation expectations. Secondly, we expect theAKP government to win the June 12 election which willreassure the market. Finally, we anticipate positive newsfrom rating agencies during the second half of the yearwith a transition to an investment grade rating increasingly

likely.

Turkish yield-curve

7

7.5

8

8.5

9

9.5

10

10.5

11

0 5 10 15

Maturity, years

Yield,%

p.a.

Yield 21-May 2011

1-month annulizedroll-down returns

Source, Bloomberg

Regarding flow statistics, a significant share of Turkishgovernment bonds has been driven offshore as a probableresult of RRR hikes. Foreigners have been quite prepared tobuy them at low prices from forced sellers. As moreforeigners seek to capitalise on this opportunity, pricesshould begin to increase. However, most of the potentialfor Turkish paper lies in a reduction in risk premia from apossible normalisation of monetary policy and RRR

requirements.For a hedge to a positive TRY exposure, we would sell USTreasuries, given orderly historical correlations. We alsoobserve that the most recent TRY softness has comedespite a strong development in Treasuries, which couldindicate current attractive relative TRY value.


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Turkish Currency and U.S. Yield

1.35

1.4

1.45

1.5

1.55

1.6

1.65

Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

USDTRY

0

0.5

1

1.5

2

2.5

3

Yield,%p.a.

Turkishlira

5y

Treasury

Source: Bloomberg

Long Polish 5s vs. Hungarian 3s with open FXrisk (long PLN/HUF)Polish authorities have singled themselves out asmore open minded towards currency appreciationthan almost all other EM. The central bank hassupported its own currency while recently theGovernment declared that EUR 13-14bn in EU fundswill no longer be exchanged directly with the centralbank but on the open market, a move which willprovide substantial support for the zloty. It will alsoalter the balance of risk as the FinMin is likely toincrease market supply of euros during periods of risk

aversion and zloty sell-offs. This reinforces our viewsexpressed in Currency Strategypublished on May 10,in which the zloty appeared as one of the highestscoring currencies, benefiting from a supportiveassessment of monetary policy, economicfundamentals and flows. We expect EUR/PLN to tradeat 3.75 by the end of the year. In REER terms, the zlotywill probably lag its peers.

Index100=15Se

p.2008

Despite different opinions concerning the linkbetween the zloty supportive conversion of EU fundsand the central banks interest rate policy, the latest

message from Governor Belka is that open marketconversion is not a substitute for policy rate hikes, aview which lends further weight to our bullish zloty

outlook. However, we do not think it entirely true. It simplydoes not make sense for a central bank targeting inflationwithin a fairly open economy to ignore the exchange ratescontribution to the decision whether to tighten or easemonetary conditions. Consequently, following theannouncement that the full amount of EU funds will beexchanged in the open market, we have reduced ourforecast year-end policy rate from 4.75% to 4.50%.Essentially, we regard our decision to do so as supported bythe knowledge that if the zloty fails to appreciate, forwhatever reason, more rate hikes are likely to occur.

P

ercent

April inflation rose further to 4.5% and is likely to remainaround this level throughout the year. As this is well abovethe 2.5% +/- 1% target a hawkish policy is warranted. Ourforecasts assume that this strategy will probably succeedwith average inflation falling to 2.8% during 2012 despite

our above consensus GDP forecast.

An important risk for the zloty is the expected revision ofthe countrys balance of payments data. If the continuouslylarge negative errors and omissions data represent under-reported imports which have then to be corrected, thecurrent account deficit could double from last yearsreported 3.3% of GDP. While we have been emphasisingthis risk for several years it has only recently become ofinterest to the market. Although it will not come as a greatsurprise we expect such news to have at least a temporaryadverse effect on the zloty.

What we have seen from polish short bonds and the zlotythis year is a trading pattern consistent with the policymessage. A strong zloty and lower yields (compared toGermany) have gone hand in hand. Short term deviationsfrom this pattern have so far suggested tradingopportunities, some of which we have reported in our morefrequent communications (e.g. EM FI Market Views, May13).


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3

3.1

3.2

3.3

3.4

3.5

3.6

Mar-04 Mar-18 Apr-01 Apr-15 Apr-29 May-13

spre

ad%p.a.

3.85

3.9

3.95

4

4.05

4.1

4.15

E

URPLN

2-yr yield spread

EURPLN

From a longer term perspective, we are bullish on boththe yield and the currency, recommending 5yr localcurrency bonds with full currency exposure.

In order to hedge such a position, we would targetHungarian paper, inspired by the current record of

Hungary's government led by Fidesz. Despite recentrelative stability, the government's short-sighted fixesto its long term budget problem do not reassure us.The underlying deficit remains around 5%, a fairlyvulnerable situation given a debt/GDP ratio of around80%. Although short term measures to socializeprivate pensions and introduce corporate crisis-taxeson companies have resolved the governmentsliquidity problem, solvency is likely to remain an issue.

What are the options next time the market questionsthe viability of Hungarian finances?

Hungary has come in from the cold. As the market hasendorsed the structural reform programme it has alsoaccumulated new positions. Foreign ownership ofHungarian government bonds has risen rapidly back topre-Lehman levels.

In our opinion, this has created the basis for apotential stop loss rally should confidence once againdeteriorate. This situation is further supported by thefact that the transfer of second pillar private pensionfunds to the state will adversely affect liquidity.Attention should therefore be paid to the

implementation of structural reforms. By July 1,parliament will have passed several additional laws. Inaddition, no proven solution to homeowners troubleshas yet emerged with foreign currency loans in sight.

While overall this implies several risks for the forint,we also note two supportive factors. Firstly, thecurrent high interest rate (the policy rate was hiked by75bps late last year and early this to 6.0%) provides animportant cushion during periods of normal riskappetite and volatility. Secondly, the domesticeconomy remains burdened by deleveraging of the

large FX debt and, for several years, by very meagrereal wage developments. GDP growth is thereforehighly imbalanced with a large and competitive export

industry benefiting from strong economic conditions bothin German, and elsewhere. As a result, the current accounthas swung around, and is now posting a surplus. Also,substantial portfolio inflows have provided considerablesupport for the forint. Overall, we are neutral, forecastingEUR/HUF at 265 by year-end, while seeing risks as lying onthe upside as discussed earlier.

Hungarian 3-year local bonds appear expensive on thecurve and could be abandoned together with theassociated currency exposure, in favour of theaforementioned exposure to Poland. Assets in the twocurrencies have recently shown a significant correlation,especially during the worst periods of the recent crisis.

Currencies vs EUR

220

230

240

250

260

270

280

290

300

310

320

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

EURHUF

3

3.2

3.4

3.6

3.8

4

4.2

4.4

4.6

4.8

5

EURPLN

Hungarian forint

Polish zloty

Source: Bloomberg

Long Russian Eurobonds in rouble unhedged

Supply in Russian rubles appeared likely to fall to zero forthe remainder of the year after statements from FM Kudrinat the beginning of May in which he stated that Russiawould not seek further funding in international markets thisyear due to its high oil revenue and strong trade balance. Atthe time, it appeared as if the market needed to sharplyreduce its supply forecast, possibly increasing the yieldmomentum for Russian Eurobonds in Ruble. However,barely two weeks later the authorities announced a RUB40bn issue in the international 2018 bond.

Russian Eurobond ruble 2018

6

6.2

6.4

6.6

6.8

7

7.2

7.4

7.6

7.88

Mar-11 Apr-11 May-11

Yield%p.a.

Source: Bloomberg

Asregards secondary market pricing, Russia will probably paya price for trying to manipulate the market. Yields are nowabove levels prior to Kudrins unreliable announcement.


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24


Despite the now proven fact that demand can increaseif yields go too low, we still regard the issue asattractive due to a Russian ruble supportive flowsituation and otherwise limited investment vehicles.We see further support from a positivemacroeconomic situation with further potentialbenefits from fiscal stimuli ahead of forthcoming

elections.

Russian currency and U.S. Yield

25

27

29

31

33

35

37

39

41

43

Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10

RUBB

ASKindex

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Yield,%p.a.

Russian CCY basket

5y Treasury

Source: Bloomberg

The risk profile of the Russian Ruble is apparently theopposite of US treasuries as shown in the diagramabove. The Ruble is apparently and unsurprisinglybenefiting from increasing risk appetite and improving

expectations concerning the business cycle (i.e.through crude demand). Those are the same factorsthat usually are negative for Treasuries. Rather thanrecommending this position in a spread to hardcurrency bonds, we regard it instead as a stand aloneinvestment with a favourable negative correlation to

DM bond holdings.

Increase risk in SEB EM local bond portfolio,keep FX risk open hedging IR risks with shortDM yield positionsWe adjust our EM Bond basket towards lower credit

qualities as we see the MENA implications as nowbeing fully priced in. In line with our case on Turkeyabove, Turkish allocation is increased. We recommendholding the position with full currency exposureagainst an interest rate hedge of DM government

bonds.

SEB EM Bond Portfolio 2011May 20

SEB

weight Yield

Duration

years

new old

Poland 15% 15% A- 5.5% 3.9

Hungary 2.5% 7.5% BBB- 6.6% 3.3

Iceland 5% 5% BBB- 2.7% 0.2S. Africa 10% 7.5% BBB+ 7.2% 3.1

Turkey 12.5% 2.5% BB 9.2% 2.7

S. Korea 7.5% 15% A 3.9% 3.1

Indonesia 12.5% 5% BB+ 6.5% 2.9

Malaysia 7.5% 12.5% A- 3.4% 2.8

Brazil 15% 15% BBB- 12.7% 1.5

Mexico 12.5% 15% BBB 6.3% 3.8

Average 100% 100% BBB 7.0% 2.8

Rating

S&P

(LT-FC)

Short EUR/ISK offshore, place in HFFOffshore ISK has appreciated since the presentation of the

liberalization plan earlier this spring despite the countrysfailure to accept the Icesave agreement. While we are

cautious concerning the level at which offshore ISK will bepriced in the upcoming auction, we believe auctions willhelp stabilise the position once they succeed in matchingbidders and sellers. At this point it is unclear whether thefirst auctions will represent a positive or negativedevelopment for offshore ISK, or even if any significantvolumes will be serviced during early auction rounds. Notethat Sedlabanki has indicated gradualism in theliberalization process as well as for the ISK price

developments.

Once solid price indications are available in connection

with the upcoming Sedlabanki ISK hard currency auctions,offshore and onshore rates should gradually convert. Basedon our positive long-term outlook for the Icelandiceconomy, and given also the current soft real exchangerate compared to historical levels, we expect offshore ISKto appreciate from levels reported during the firstsuccessful auctions. Sedlabankis first currency auction isdue June 7.

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Jan-10 Jul-10 Jan-11

realyield,%p.a.

HFF ISK 2014

Source: Bloomberg

Housing Finance Fund 2014 Bond


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25


Apart from pure short term paper, we also still see

good prospects in the HFF 14 bond, which due to

its favourable standing in the Icelandic currencyregulations has made strong gains since we firstrecommended it in February this year.

Long long-end Croatia in USD, 2015 maturityin EUR, both vs DMCroatian 10-year bonds in USD trade at a Z-spread toTreasuries of over 275bps despite relatively lowCroatian government debt of around 55% of GPD(Bloomberg). Their rating is BBB-. In our view it alsoappears as if the market needs to take into accountthe possibility of Croatia signing an EU accessiontreaty before the end of the year. Further, Croatianbonds in USD are cheap vs. their EUR-denominatedCroatian counterparts as the latter trade near the

Hungarian curve, and the former well above. Also,compared to the Hungarian EUR curve, the shorterend of the Croatian curve appears too steep,underlining the attractiveness of the Croatian EUR2015 issue.

Long Lithuanian short-end in eurosWhile Baltic economic growth continues to acceleratewe think the regions economies are much safer thistime when it comes to risk of being trapped in theboom-bust scenario. Growth is now more sustainableas it is driven by higher competitiveness rather than

borrowing and slow recovery of domestic demand ispreventing from forming new bubbles. In Lithuaniafiscal outlook continues to improve helping to adjustpublic sector disequilibrium. According to FinMinLithuanian GDP growth forecast has been increased to5.8% (above our forecast of 4.0%) for this year. TheFinMin now estimates that the public sector deficitwill fall from 7.1% last year to 5.3% this year, which

seems realistic in our view.

Lithuanian bond spreads vs. main markets have beennarrowing since the beginning of the year driven bythe general trend prevailing in CEE markets as well asa successful Lithuanian Eurobond issue in March. Thecountrys CDS levels have since March also decreasedsignificantly from 250 to 200bps. We see limitedscope for further big reductions in Lithuania

seb report: still good value in emerging markets

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