Emerging Markets 2014 Outlook - Deutsche BankEmerging Markets Foreign Exchange Economics Rates Credit Date 5 December 2013 Diverging Markets Emerging Markets 2014 Outlook Taimur Baig

Deutsche Bank Markets Research

Emerging Markets

Economics Foreign Exchange Rates Credit

Date 5 December 2013

Diverging Markets

Emerging Markets 2014 Outlook

Taimur Baig Marc Balston Robert Burgess Gustavo Cañonero Drausio Giacomelli Michael Spencer

(+65) 64 23-8681 (+44) 20 754-71484 (+44) 20 754-71930 (+1) 212 250-7530 (+1) 212 250-7355 (+852 ) 2203-8305

________________________________________________________________________________________________________________

Deutsche Bank Securities Inc. Note to U.S. investors: US regulators have not approved most foreign listed stock index futures and options for USinvestors. Eligible investors may be able to get exposure through over-the-counter products. DISCLOSURES ANDANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

Special Reports Diverging Markets

Rates in 2014: Refocusing on EM Fundamentals

Sovereign Credit in 2014: Back in the Black

FX in 2014: Diverging Currencies

EM Performance: Too Much Ado About Technicals

Asia’s Frontier Economies: Plenty of Alpha

Brazil: Overview of 2014 Presidential Elections

US Manufacturing and Mexican Growth

Foreign Demand for EM Local Currency Debt

5 December 2013

EM Monthly: Diverging Markets

Page 2 Deutsche Bank Securities Inc.

Key Economic Forecasts

2013F 2014F 2015F 2013F 2014F 2015F 2013F 2014F 2015F 2013F 2014F 2015F

Global 2.8 3.7 3.9 3.1 3.5 3.4 0.0 0.0 -0.2 -3.3 -2.9 -2.5

US 1.8 3.2 3.5 1.6 2.5 2.3 -3.0 -2.6 -2.7 -3.8 -3.1 -2.0

Japan 1.6 0.7 1.3 0.3 2.7 1.5 0.8 1.1 2.1 -9.5 -8.0 -6.6

Euroland -0.2 1.2 1.4 1.5 1.4 1.5 1.8 1.4 1.3 -2.9 -2.4 -2.0Germany 0.5 1.5 1.4 1.7 1.6 1.8 7.1 7.0 7.1 0.1 0.2 0.4France 0.2 1.3 1.9 1.1 1.5 1.3 -1.7 -1.5 -1.3 -4.1 -3.3 -2.9Italy -1.8 0.6 0.5 1.5 1.5 1.5 0.6 1.3 1.8 -3.1 -2.9 -2.9Spain -1.5 0.5 1.3 1.7 1.1 1.2 1.2 1.5 1.8 -6.5 -5.3 -4.0Netherlands -1.1 0.4 1.2 2.8 1.8 1.8 12.8 11.7 12.3 -3.9 -3.3 -3.0Belgium 0.1 1.2 1.6 1.2 1.4 1.6 -0.5 0.5 0.5 -3.0 -2.9 -2.7Austria 0.4 1.4 1.8 2.1 1.7 1.8 3.2 3.5 3.5 -2.1 -1.8 -1.6Finland -1.0 0.9 1.5 2.4 2.0 1.9 -0.8 -0.4 0.7 -2.7 -1.8 -0.7Greece -4.3 0.8 2.0 -0.6 -0.4 0.0 0.0 1.0 2.0 -4.5 -3.4 -2.5Portugal -1.7 0.8 1.3 0.6 0.9 1.1 0.5 1.5 2.0 -5.4 -4.4 -3.3Ireland 0.5 2.0 2.0 0.8 1.1 1.3 3.5 4.0 4.0 -7.4 -4.9 -2.8

Other Industrial CountriesUnited Kingdom 1.5 2.5 2.0 2.7 2.2 2.0 -3.5 -3.2 -2.8 -6.0 -4.8 -4.1Sweden 0.7 2.3 2.5 0.1 1.1 2.0 6.5 6.0 6.0 -1.5 -1.0 0.5Denmark 0.2 1.8 1.5 0.7 1.5 1.9 6.3 6.1 6.0 -2.0 -1.8 -1.5Norway 1.8 2.4 2.6 2.3 2.6 2.0 12.5 12.0 11.5 11.0 10.5 10.0Switzerland 1.9 2.0 2.0 -0.1 0.5 1.0 12.5 12.1 11.8 0.7 0.8 1.0Canada 1.7 2.8 2.8 1.1 1.9 2.4 -2.7 -2.5 -1.8 -1.4 -0.9 -0.3Australia 2.7 3.7 3.6 2.3 2.2 2.1 -2.4 -2.1 -1.7 -1.8 -1.7 -0.9New Zealand 2.7 3.2 2.4 1.1 1.9 2.3 -4.6 -3.9 -6.0 -1.7 -0.3 0.3

Emerging Europe, Middle East & Africa 2.2 2.9 3.5 4.8 4.5 4.7 0.7 0.2 -0.4 -1.1 -0.8 -1.6Czech Republic -1.2 1.7 2.2 1.4 0.9 2.0 -0.6 -1.1 -2.5 -3.1 -2.7 -2.6Egypt 2.1 3.0 4.2 6.9 8.6 10.5 -2.1 -0.4 -2.8 -14.7 -13.2 -14.3Hungary 0.7 1.8 2.0 1.8 1.7 2.8 1.2 1.0 0.6 -2.9 -2.9 -2.7Israel 3.6 3.7 4.2 1.6 2.0 2.2 1.6 1.9 2.1 -3.6 -3.0 -2.5Kazakhstan 5.3 4.8 5.2 6.0 5.6 6.3 1.3 2.0 1.5 5.3 4.8 3.3Poland 1.4 3.0 3.9 1.0 2.3 2.7 -1.4 -1.6 -2.5 -4.8 4.0 -3.1Romania 2.2 2.6 2.6 4.1 2.3 3.2 -1.6 -3.1 -3.0 -2.5 -2.2 -2.2Russia 1.5 2.4 2.8 6.7 5.2 4.7 1.7 1.7 1.0 -0.6 -1.1 -1.3Saudi Arabia 3.7 4.3 4.3 3.8 3.6 3.5 16.4 9.8 8.0 11.9 7.7 7.4South Africa 1.9 2.9 3.5 5.7 5.1 5.3 -6.6 -5.6 -5.0 -4.1 -4.0 -3.5Turkey 3.7 3.4 4.4 7.5 6.4 6.8 -7.5 -6.5 -6.0 -2.3 -2.3 -2.3Ukraine 0.3 1.5 2.0 -0.4 1.4 2.9 -10.2 -7.5 -7.0 -4.0 -4.5 -4.2United Arab Emirates 5.1 3.1 3.4 1.5 2.5 2.5 17.9 14.1 13.0 9.7 7.1 7.4

Asia (ex-Japan) 5.9 6.9 6.8 3.5 3.9 4.0 1.5 1.5 1.1 -3.0 -2.8 -2.5China 7.7 8.6 8.2 2.6 3.5 3.2 2.4 2.2 1.9 -2.0 -1.8 -1.5Hong Kong 3.2 5.0 4.5 4.1 3.5 3.2 -0.9 3.7 2.7 2.8 3.2 3.5India 4.3 5.5 6.0 6.3 5.5 6.3 -3.4 -3.0 -3.5 -7.5 -7.3 -7.0Indonesia 5.5 5.2 5.5 7.0 6.7 6.5 -3.9 -3.3 -2.8 -2.2 -2.4 -2.6Korea 2.8 3.9 3.6 1.1 1.8 2.8 5.7 4.5 3.6 -0.7 -0.1 0.1Malaysia 4.8 6.0 5.8 2.1 3.0 2.9 3.6 4.5 6.3 -4.2 -3.8 -3.3Philippines 7.0 6.8 7.0 2.9 4.1 3.3 4.0 4.1 4.4 -2.0 -2.4 -2.2Singapore 3.5 3.5 4.2 2.3 2.8 3.5 14.7 15.5 14.5 7.3 6.9 6.8Sri Lanka 7.2 7.5 7.5 7.0 7.0 7.4 -4.1 -3.1 -2.7 -5.8 -5.5 -5.0Taiwan 1.8 3.5 3.4 0.8 0.9 1.2 10.8 9.4 8.1 -3.0 -2.0 -1.1Thailand 3.0 4.2 5.0 2.2 3.2 2.4 -0.3 0.2 -0.6 -3.0 -3.2 -3.3Vietnam 5.3 5.8 6.3 6.6 7.3 9.8 3.2 2.0 -3.1 -6.0 -6.2 -5.5

Latin America 2.3 2.6 3.1 9.0 9.9 8.9 -2.4 -2.3 -2.5 -3.5 -3.8 -3.7Argentina 2.4 1.6 2.8 24.9 28.5 23.6 -1.2 -1.6 -2.0 -3.6 -3.8 -3.6Brazil 2.2 1.9 1.7 6.2 5.8 5.4 -3.6 -3.2 -3.5 -3.2 -3.8 -3.4Chile 4.3 4.2 4.5 1.7 2.8 3.0 -3.2 -3.8 -3.2 -0.9 -0.5 -0.4Colombia 4.0 4.3 4.5 2.6 3.1 3.6 -2.6 -2.7 -3.0 -2.4 -2.3 -2.2Mexico 1.2 3.2 3.6 3.7 3.8 3.7 -1.4 -2.0 -2.2 -2.9 -4.0 -3.6Peru 5.2 6.0 6.5 2.5 2.7 2.9 -5.0 -5.5 -4.5 1.0 0.6 0.5Venezuela 1.5 0.5 3.5 40.0 47.5 43.0 1.7 4.3 4.2 -14.3 -11.5 -13.5

Memorandum Lines: 1/

G7 1.3 2.3 2.5 1.4 2.3 2.0 -1.2 -0.9 -0.7 -4.3 -3.5 -2.6Industrial Countries 1.2 2.2 2.5 1.4 2.1 2.0 -0.7 -0.6 -0.5 -4.0 -3.3 -2.4Emerging Markets 4.5 5.3 5.4 4.7 5.1 5.0 0.7 0.6 0.1 -2.7 -2.5 -2.5BRICs 5.6 6.4 6.4 4.3 4.4 4.3 0.4 0.4 0.0 -3.2 -3.2 -2.9

Consumer prices (% pavg) Current account (% GDP) Fiscal balance (% GDP)Real GDP (%)

1/ Aggregates are PPP-weighted within the aggregate indicated. For instance, EM growth is calculated by taking the sum of each EM country's individual growth rate multiplied it by its share in global PPP divided by the sum of EM PPP weights.

5 December 2013


Deutsche Bank Securities Inc. Page 3

Table of Contents Diverging Markets EM economies and asset markets have disappointed, leading to a growing perception that better opportunities lie elsewhere. This is too simplistic. Some economies will continue to struggle but growth elsewhere will remain relatively strong, albeit below past peaks. Investment appetite for EM may also be lower than in recent years. This could see some markets overshoot to the downside in the near term as expectations adjust. But there is still sufficient value in EM to justify a material allocation in global portfolios over the longer term. Spotting the divergence within EM will be the key to extracting it. ............................................................................................................................................................................ 04

Rates in 2014: Refocusing on EM Fundamentals Closer to their historical norm, we expect term premia in EM curves to track more closely with growth potentials and inflation trends in 2014. Accordingly, we expect country specifics to continue to play an important role in performance. Overall, we find that the cushion to absorb a potentially faster pace of global growth is more limited in the short end and belly, expecting EM curves to bear-flatten as normalization proceeds and volatility subsides. ........................................... 15

Sovereign Credit in 2014: Back in the Black While EM assets are likely to face continued headwinds in 2014, we believe the dramatic negative shift in the wider perception of EM debt cannot be repeated in 2014 given the return of risk premium. With continued taper risk, we start the year with a neutral overall exposure, but believe EM sovereign spreads have potential for moderate tightening, offsetting a rise in US yields, offering about 6% return in 2014........... ................................................................................ 20

FX in 2014: Diverging Currencies Despite still being exposed to a tapering/guidance related hurdle we see a better potential for EMFX as an asset class in the upcoming year. While EMFX will probably continue to be a shock absorber to global risks, the prospects of a more benign economic backdrop should not only help EMFX but evidence the nuances between EM economies that are likely to grow in 2014........... ........................................................................................................................................................... 34

EM Performance: Too Much Ado about Technicals We find little evidence of technical bottlenecks determining EM performance – both of domestic and external sources. Instead, this seems to originate in cyclical – fundamentals-related – weakness in demand rather than secular portfolio shifts. ...................................................................................................................................................................................... 39

Asia’s Frontier Economies: Plenty of Alpha We focus on eight selected frontier economies of Asia that hold promise for a better tomorrow, not just for their population but for investors seeking alpha in an increasingly correlated world. Most of these economies, because of their early stages of development and lack of market depth, are by and large uncorrelated to global markets, thus offering a useful investment strategy ..................................................................................................................................................... 45

Brazil: Overview of 2014 Presidential Elections Barring a significant deterioration in economic conditions, the most likely scenario for next year’s elections is that President Dilma Rousseff will be re-elected due to her high approval ratings, low unemployment, extensive welfare policies, and her party’s powerful political structure. While we believe some policy adjustments will be inevitable (especially on the fiscal front), we expect Rousseff to maintain strong government intervention in the economy, and do not anticipate significant progress in structural economic reforms during her second term........... .................................... 49

US Manufacturing and Mexican Growth Manufacturing activity has recovered more slowly in Mexico than in the US throughout late 2012 and 2013, partly explaining subpar GDP growth in Mexico recently. Using manufacturing disaggregate data for both countries, we find that those activities characterized by the highest correlation between the two countries grew more slowly in the US in 2013. Furthermore, we estimate that if the recovery of US manufacturing had been generalized across activities this year, manufacturing output south the border would have been approximately 4% larger. Such broad base growth is expected for 2014, likely adding 70bps of GDP growth to the Mexican economy. ............................................................................. 54

Foreign Demand for EM Local Currency Debt Foreign holdings of EM local currency debt have increased 3-fold in the past 4 years, adding USD500bn of additional investment. This increase has been driven by the emergence of global local currency bond funds, but in recent months appetite for such funds, as indicated by mutual fund flows, appears to have reversed. In this report we look beyond the EPFR flow data to understand the global dynamics of non-resident demand. We examine the data which is available from each country on non-resident bond holdings ........................................................................................................................ 57

5 December 2013



Diverging Markets

We have witnessed a dramatic shift in the perception of EM as an investment destination. After many years during which EM was touted as an outperformer, there is now a perception that better opportunities lie elsewhere.

There are several, related, factors which have contributed to this shift:

— Growth has weakened, especially in the larger economies, just at the time when expectations of growth in DM have been improving;

— Capital flows to EM slowed sharply on fears of Fed tapering, exposing vulnerable external positions in a number of cases;

— Several countries have seen large scale protests as growth has not kept pace with popular aspirations that were raised during earlier phases of rapid expansion;

— EM asset markets have underperformed.

We believe that investors’ perceptions have been exacerbated by cyclical factors, but structural bottlenecks should not be discarded – especially in the larger economies. It is becoming increasingly inappropriate, however, to base investment in the asset class on sweeping judgments of economic outperformance or excess risk premium. Differentiation has increased.

The differences relative to developed markets are no longer large relative to the variation within the asset class. The future of EM will be one of divergence within these markets rather than one of collective outperformance or underperformance.

Key to such divergence will be the paths taken in adjusting to rising global interest rates. With the possible exception of Ukraine, this is highly unlikely to trigger a classic EM crisis. It will, however, be a painful process for those countries with large external financing needs, though India is now relatively better positioned to weather this storm.

In the years to come, there will be a premium on reform as tailwinds that favored EM over the last decade fade. Asia remains best placed to deliver high growth, albeit not as rapid as in the recent past. Chile, Colombia, Peru, and Turkey, should enjoy relatively healthy expansions. Mexico and much of central Europe, which have been among the poorest performers in recent years, are set to see growth accelerate. A little further down the line, we could also see brighter days in Argentina if elections in late-2015 lead to a change of policies.

Others, including Brazil, Russia, South Africa, and Venezuela, will struggle to deliver tough reforms and their economic performance will reflect this.

Given this outlook, we expect appetite for EM investment to be lower going forward than in recent years, but offering sufficient value to justify a material allocation in global portfolios. As the shock waves from the crises in developed markets dissipate, and as fund flows become less dominant, the correlation between EM (local currency) fixed income and DM fixed income should decline, increasing the value of EM as a diversifier once again.

In the near term, however, as investors re-calibrate their expectations for the performance of the asset class valuations could continue to overshoot to the downside. This is already taking place in currencies, the natural shock absorbers that actually render EM less fragile, and in sovereign credit.

Introduction: the past and present of EM

After many years during which EM was touted as an outperformer, there is now a perception that better opportunities lie elsewhere. Circumstances that led to a golden age for EM will not be repeated. Economies are closer to maturity, most of the low hanging fruits of reform have been picked, and the external backdrop has become more challenging. Growth has slipped accordingly. Asset market performance has disappointed. Does this simply represent the difficult teenage years for EM or is it symptomatic of a deeper malaise?

The Golden Age of Emerging Markets The decade leading up to the 2008 financial crisis were transformational years for emerging markets, characterized by several unusually favorable developments:

The great moderation and years of robust expansion in the US provided a tremendously strong foundation for the global economy.

The establishment of the single market and single currency in Europe provided a second powerful engine for growth and reform, especially for emerging European countries that joined an enlarged European Union.

Within EM, the widespread adoption of macroeconomic stabilization policies following the crises of the 1990s and early 2000s tamed inflation and brought public finances under control. Fixed

5 December 2013



exchange rate regimes were ditched. Ability to borrow in local currency increased.

The emergence of China and, especially, its integration into the global trading system was a hugely positive supply shock for the world.

The associated super cycle in commodities provided a fillip for previously struggling natural resource producers.

Favorable demographics further underscored EM’s advantage over DM.

Lastly, and most recently, cheap and plentiful external financing following unprecedented monetary expansion in core markets has cushioned the slowdown in global activity.

The broadening appreciation of such factors helped to fuel an unprecedented increase in investment into emerging asset markets. Nowhere has this been more evident than the boom in EM fixed income markets in recent years. Dedicated EM debt mutual funds, for example, now manage well over USD 300bn of assets compared to a pre-crisis peak of USD100bn. Foreign holdings of Mexican local currency bonds have risen by USD 110bn over this period, a pattern that has been replicated to varying degrees in Brazil, Malaysia, Poland, Russia, South Africa, Turkey, and beyond.

The future will be more challenging These tailwinds have faded and, in some cases, turned into headwinds. We see six key challenges for EM in this regard:

Global growth will be stronger than it is today but below the peaks seen from 2003-07.

The cost of external financing will increase as the Fed and other major central banks slowly start to withdraw monetary stimulus.

A possible multi-year dollar upswing will challenge the competitiveness of some EMs.

Demographics will turn less favourable, more imminently for some countries, such as Russia, than others.

Commodity prices may be well supported at current levels but are past their peak.

Growth models within EM are past their sell by date in some cases, with their excessive reliance on demand vs. supply.

Exiting demographic windows

1940

1960

1980

2000

2020

2040

2060

2080

FRA USA RUS CHN BRA TUR MEX IDN IND ZAF

Exit year

Exit year shows the point at which countries exit the "demographic window " when the working age population is most prominent, defined (by the UN) as the period when the proportion of children falls below 30 percent and proportion of people over 65 is still below 15 percent.

Source: UN, Deutsche Bank

Growth in EM is already fading, especially in the larger economies. While growth reached 10% during the immediate post-crisis rebound, it has decelerated to 5% over the last couple of years. Against this backdrop, meeting the demands of newly aspiring populations will be more difficult. Social tensions are to be expected and the political environment will become noisier. Public protests, such as those recently witnessed in Brazil, Russia, South Africa, and Turkey, are likely to become a more regular occurrence.

This more challenging environment is already weighing on the performance of emerging asset markets. Relative to most other asset classes, emerging FX and fixed income markets sold off more aggressively during the summer when tapering fears were at their most acute and rebounded less strongly as these fears dissipated. Benchmark indices for both local currency and hard currency debt, for example, remain down around 5.5-6% this year. This has left many investors in

The inflows to EM debt funds have been disappointed

-10

0

10

20

30

Jan 10 Jan 11 Jan 12 Jan 13

Return on inflows of hard ccy funds%

-15

-10

-5

0

5

10

15

Jan 10 Jan 11 Jan 12 Jan 13

Return on inflows of local ccy funds%

Note: Each bubble represents a month of inflows to EMD funds, with the size of the bubble being proportional to the amount of inflow (in USD) and the y-axis indicating the cumulative average fund performance since the inflow occurred.

Source: Deutsche Bank

5 December 2013



EM sitting on losses or only marginal gains. We estimate that less than 40% of the mutual fund inflows to EM local currency assets since the start of 2010 are in the money, with less than 20% having cumulative gains in excess of 5%. For EM hard currency investment, the picture is only a little better: 56% of inflows are in-the-money, with 33% above 5% cumulative gains.

While portraying EM as a single asset class has always been overly simplistic, it used to be broadly sufficient given the powerful collective forces that drove performance during their golden age. The distinction between EM and DM was significant enough that the details could be ignored. This no longer applies: the differences within EM and DM are now more significant than the distinctions between the two groups.

The future of EM is thus likely to be one of diverging performance. Higher US interest rates will raise the bar for some and perhaps even trigger a crisis in the odd case. Others will sail through largely unscathed. Some countries are emerging from deleveraging and are poised to enjoy significant acceleration activity. Others overly reliant on cheap credit or high commodity prices need to undertake painful reforms to avoid further deceleration in growth. Social discontent may be the catalyst they need for change. These are the factors that will determine the divergences in performance and to which we now turn, starting with long-term growth prospects.

Diverging growth prospects

In aggregate, we estimate that the potential growth rate of EM will decline from a peak of 6.5% prior to the crisis to about 5% over the next five years, driven primarily by a deceleration in the larger EM economies. This is disappointing and explains much of the current pessimism towards EM. If we exclude the BRICS economies, however, the drop in growth is much less dramatic, from a peak of 4.2% to around 3.6% over the next five years.

Within EM, however, the pattern will be far from uniform. Reform priorities differ from country to country. In a few cases, there are still lingering first generation macroeconomic stabilization issues that need to be addressed. Russia, for example, needs to complete its transition to inflation targeting. Others, such as Brazil, Indonesia, and Turkey, have broadly the right frameworks in place but have not always implemented them effectively, resulting in episodes of high inflation. At the other end of the spectrum, Argentina and Venezuela have not even hinted at fighting inflation.

Among the larger EM economies, however, the priorities lie mostly in the area of structural reforms. China, for example, has relied on capital accumulation and the absorption of surplus rural labor into more productive activities in urban areas. Very high rates of investment have inevitably resulted in diminishing returns. The labor force will also start declining within the next few years. Maintaining high growth rates will therefore require much greater efficiency in the use of capital and labor. This will in turn require deregulation and a shift from state-owned to private enterprise.

Commodity producers will no longer be able to ride the super cycle in prices that made consumption-led growth an easy option. Greater investment is needed to foster faster productivity growth and diversification into other areas of economic activity. Some, including Russia and South Africa, will also need to encourage more investment in natural resources just to maintain their comparative advantage in these areas. Few have made much progress. Among major EM commodity

Mind the gap: trend growth in EM and DM

G7

EM

BRICS

Non-BRICS EM

0

1

2

3

4

5

6

7

8

9

1980 1985 1990 1995 2000 2005 2010 2015

Trend GDP growth %

Source: Haver Analytics, IMF, Deutsche Bank

EM commodity producers fail to diversify

BRA

CHL

IDN

RUS

ZAF

40

60

80

100

120

2000 2002 2004 2006 2008 2010 2012

Manufacturing exports as % of total goods exports (2000=100)

Source: Haver Analytics, Deutsche Bank

5 December 2013



producers, manufactured goods, for example, account for a lower share of total exports today than they did a decade ago.

What of the prognosis for reforms? Asia remains best placed to deliver high growth, albeit not as rapid as in the recent past. Chile, Colombia, Peru, and Turkey, should enjoy relatively healthy expansions. Mexico and much of central Europe, which have been among the poorest performers in recent years, are set to see growth accelerate. Others, including Brazil, Russia, South Africa, and Venezuela have not signaled any sense of urgency in responding to this new reality .

Potential growth rates in EM

0

2

4

6

8

10

12

CH

NU

KR IND

RU

SH

UN

PO

LA

RG

BR

AKO

RZA

FTU

RM

AL

CH

LC

OL

THA

PH

LM

EX IDN G7

EM

2003-07 2014-18

Potential growth (%)

Countries ranked by change in change in potential growth (lowest to highest)


High or higher growth While China will not return to the double-digit growth rates of the past, it should be able to sustain growth rates in excess of 7% for the rest of this decade. The deregulation of interest rates will raise the cost of capital and weigh on growth. Allowing capital to be reallocated away from a state sector to the private sector, on the other hand, should allow productivity growth to be maintained. Financial deregulation and the opening up of protected sectors to private investors, both domestic and foreign, will be needed to deliver this. The reforms announced last month go a long way in this direction. The improving outlook in the US and Europe should also help the process of adjustment to a somewhat lower but more durable growth trajectory.

Recent reforms in India are also likely to pay dividends. Despite an economic slowdown and a fairly unfavorable political environment, the government has implemented an impressive range of reforms, including: fuel price reform and fiscal consolidation; energy sector reform, especially tariff liberalization; the unlocking of numerous projects stuck at various stages of regulatory and administrative approval; opening up

various sectors, especially retail, to more foreign investment; and capital account liberalization. Additional reforms are underway, including an ambitious deregulation of the banking sector. Regardless of the nature of coalition that governs India after elections next year, economic performance will likely be better.

Outside the big two in Asia, the low hanging fruits of reform appear most evident in Indonesia. The recent economic slowdown has been mainly cyclical and a function of loose macroeconomic policies, which led to overheating and worsening of external balances. Recent steps to tighten policies are thus welcome. Blessed with a large and young population, a rich commodity base, stable democracy, a thriving civil society, improving governance, and low leverage (the combined debt of public sector and households is less than 50% of GDP), the economy is ripe for an acceleration in growth provided the right policies are deployed to encourage investment. Regardless of the outcome of next year’s election, it is likely that reforms in the mining sector and labor market will resume and should further support growth.

Elsewhere in Asia, Malaysia, with the recent conclusion of elections, has a fairly unimpeded half-decade window to carry out reforms to reduce its dependence on the commodity sector, embrace high valued added manufacturing, reduce public sector intervention in the corporate sector, and consolidate fiscally. The latest budget offers some hope in this regard. The Philippines is keen to boost its infrastructure for both manufacturing and tourism, and in that respect the key reform would be to set up regulation and operating mechanism for public-private partnerships. Thailand could also offer good returns given its productive manufacturing and labor base, thriving tourism and agriculture sectors, and a well anchored macroeconomic policy framework. But it would first need to deal with seemingly perennial political unrest and upgrade its infrastructure where there has been a gap between announcements and implementation.

In EMEA, we see the challenges in Turkey as mostly cyclical in nature. Favorable demographics, a well-diversified export sector, and relatively low levels of leverage should support growth over the medium term, though participation in the labor market remains low (especially among women) and excessive reliance on foreign savings will leave the economy prone to boom and bust cycles. The year ahead may be difficult given the twin challenges of Fed tapering and important domestic elections. But thereafter the economy should be able to sustain growth rates comfortably in excess of 4%.

In central Europe, after years of underperformance, much of the region (Hungary being an exception) is primed for a relatively strong upswing. The drag from

5 December 2013



years of fiscal consolidation and deleveraging in the private sector is now starting to fade, confidence is returning, and domestic demand should respond accordingly. Competitiveness has improved as manufacturers have successfully plugged into the German supply chain, leaving them well placed to take advantage of strengthening global and European recoveries. Vulnerabilities have also been reduced as balance sheets have been rebuilt and external positions strengthened, leaving the region more resilient to rising US rates.

Competitiveness gains in central Europe

CZE

HUN

POL

ROM

80

100

120

140

160

Sep-2007 Sep-2009 Sep-2011 Sep-2013

Share of German export market (September 2007 = 100)


Mexico has been the market destination of choice in Latin America over the last year. Despite strong fiscal and monetary institutions, deep local pension markets, and a liberal trade regime, performance in recent years has been lackluster, partly due to US weakness. A new administration, however, has already delivered labor market, financial, and fiscal reforms. Proposals to allow greater private investment in the energy sector are set to be passed by the end of the year and would be another step in the right direction given Mexico’s abundant natural resources. Together with a pick up in the US, this should support moderately stronger growth in Mexico.

Elsewhere in the region, Chile, Colombia, and Peru have already delivered significant reforms over the past decade or two. They have seen some slowdown in growth recently and remain relatively dependent on commodities but are still delivering solid productivity gains and should remain the fastest growing economies in the region.

Low or lower growth Brazil has relied for too long on consumption-led growth. This was sustainable so long as commodity prices were on an upward trend. Financial deepening, from a low base, also helped. But these tail winds have faded. Potential growth has probably already dipped

below 3% and will remain there if nothing changes. Low investment, among the lowest in EM at less than 20% of GDP, is the main constraint to higher growth. There are various reasons for this. The lack of a proper regulatory framework for infrastructure projects has also taken a heavy toll on long term investment. Public investment in infrastructure has been squeezed by higher spending on public wages and social transfers. The latter has discouraged savings while high corporate tax rates to pay for this spending have weighed on private investment. Public debt dynamics are still favorable: little or no adjustment in the overall fiscal position would be needed to keep debt on a sustainable path. Reforming the tax regime or the social security system against this backdrop should therefore be possible. In our view, however, the likelihood of such changes, even after elections next year, is still low – for ideological reasons.

Russia has made significant strides on macroeconomic reforms, which have helped to reduce inflation to historically low levels and maintained a buffer of oil savings. But experience elsewhere shows that this will not be enough and indeed potential growth is probably not much more than 3% right now. Like China, resource allocation needs to become more efficient, which will necessitate a reduction in the role of the state, including in the banking sector. Investment also needs to increase, which will require a better investment climate, better governance, and more transparency. Russia must also deal with the challenges of an ageing population, which will bite sooner than in all other major EMs. Plans are in place in each of these areas, which have delivered some results: Russia joined the WTO last year and this year and reached the top 100 in the World Bank’s Doing Business survey this year. But implementation has been hesitant and is likely to remain so.

Strong and weak performers in Latin America

ARG

BRA

CHI

COL

MEX

PER

VEN

18

20

22

24

26

15 20 25 30 35 40 45

Gross investment (% GDP)

Government primary expenditure (% GDP)

Stronger performers


5 December 2013



Despite its strong institutions and first rate local capital markets, structural impediments have also weighed on both growth and the external accounts in South Africa. Public infrastructure has suffered from years of lack of investment, resulting in power shortages and a lack of capacity in the port and rail systems. These are being addressed. Significant new power generating capacity is set to come on stream late next year, for example. But it will be some years before these bottlenecks are fully resolved. There are few grounds for much optimism beyond this. Labor markets are not functioning properly, resulting in strikes and high wage settlements that are in turn limiting employment growth, eroding competitiveness, and discouraging investment. Despite significant public spending (higher than in the US), the education system is delivering outcomes that are among the worst in the world.

Education outcomes in EM

1

2

3

4

5

6

7

SGP

KOR

UKR IDN

CH

N

RU

S

PO

L

THA

PH

LTU

R

CO

L

AR

G

MEX

BR

A

ZAF

Quality of maths and science education

Best

Worst

South Africa

Source: World Economic Forum – The Global Competitiveness Report 2013-14, Deutsche Bank

Hungary will likely see a moderate cyclical recovery but its longer-term prospects remain constrained by the excesses of the past. The stock of public and private debt has fallen but remains onerous at over 230% of GDP. It is running small current account surpluses and modest fiscal deficits. But without much faster growth, which would in turn require a more supportive business climate, it will require years of tight policies to reduce debt levels to more comfortable levels.

Venezuela has spent most of its commodity windfall and emerged with little to show for it. After years of increased state intervention in the economy financed by high oil prices and debt, the country now finds itself saddled with excessive regulation, inefficient state companies, and a rigid exchange rate regime. With President Maduro seemingly fully committed to maintaining this “Bolivarian Revolution” of deceased President Chavez, this will likely mean low growth, high inflation, and rationing of basic goods. Debt service remains manageable, but on a clear deteriorating path.

Argentina has followed a similarly myopic path over the last decade, using commodity income to finance consumption while deterring investment. Recent mid-term elections, however, confirm a new social preference for more balanced policies. General elections are still nearly two years away. But with vast relatively unexploited natural resources and an economy that is basically unleveraged, there are reasons to be optimistic about the longer-term outlook if the electorate turns its back on the last decade of failed policies.

Adjusting to the end of easy money

If the factors discussed above will play out over the next several years, the near-term economic performance of EM will be determined as much by how its economies adjust to rising US rates and the end of easy money. The impact on global liquidity conditions may be partially offset by continued aggressive monetary expansion by the Bank of Japan and, potentially, the ECB if it feels the need for another long-term refinancing operation. Nevertheless, past and recent experience suggests that adjusting to higher US rates will be a bumpy ride for many – emerging and developed.

There are two main features of EM economies that make them potentially sensitive to rising global interest rates: first, reliance on external financing flows, which are likely to become both less abundant and more costly; and second, high leverage levels in some cases, in either the public or the private sectors, which will see debt service costs rise as interest rates increase.

We had a fire drill over the summer when fears of Fed tapering first surfaced. After an initial wave of selling that largely reflected market positioning, attention quickly shifted towards fundamentals. The so-called fragile five EM economies (Brazil, India, Indonesia, South Africa, and Turkey) that were characterized by

EM Basic Balances

-8

-6

-4

-2

0

2

4

6

8

10

TAI

KOR

HU

N

PH

L

CZE

RU

S

CH

N

RO

M

CO

L

CH

L

BR

A

MEX

THA

PO

L

IDR

ISR

IND

UKR

TUR

ZAF

% GDP

Basic balances are the sum of the current account balance and foreign direct investment. Source: Haver Analytics, Deutsche Bank

5 December 2013



large external imbalances and high inflation generally saw the biggest corrections in their currencies and local rate markets.

Should we expect the same pattern repeat itself as and when the Fed finally does begin to taper its asset purchases? We have already seen a significant adjustment in asset prices. Currencies in the fragile five, for example, have recovered a little in recent weeks but still look moderately cheap relative to our measures of longer-term fair value.

Currency valuation in the fragile five

-15

-10

-5

0

5

10

15

BRL TRY IDR INR ZAR

Apr

End Nov

Misalignment (vs. productivity‐adjusted PPPs)

Overvalue

dUnd

ervalued


On the other hand, we have seen relatively little reduction in foreign exposure to local currency EM debt markets. EM debt mutual funds have experienced significant and ongoing outflows, but these investors represent a relatively small part of the overall foreign investment. Institutional funds meanwhile began adding exposure once again as soon as July. The share of foreign ownership of Brazilian local currency debt

markets has actually hit new peaks in recent weeks. Even in Turkey, which has been in the eye of the taper storm, the share of foreign holdings of domestic debt securities is barely 2ppts below its May peak.

The fragilities that led to underperformance in the first place have also not changed all that much in the last few months although we would expect to see some more differentiation within the fragile five.

The change of governor at the Reserve Bank of India and a greater emphasis on tackling inflation has gained some credibility. The external accounts are also improving and we expect the current account deficit to dip to 3% of GDP next year.

Monetary policies in Brazil, Indonesia, and Turkey, have also been tightened. Real policy rates are still very low in Indonesia and Turkey, however, despite relatively robust domestic demand and credit extension. Fiscal policy has been loosened further in Brazil ahead of elections.

South Africa’s vulnerabilities reflect structural weaknesses rather than loose macroeconomic policies. As such, they are less amenable to a quick fix. Public infrastructure investment will continue to boost imports for the next year or two but is necessary to support long-term growth. More worrisome is the performance of exports, where high wage settlements, strikes, and low investment, have undermined any competitiveness gains from the weaker rand.

Currencies will likely come under further pressure if capital flows remain soft or weaken further. This is highly unlikely to trigger a payments or solvency crisis of the kind that once characterized EM. Currency mismatches are generally small and certainly much lower than in the past. Even in Turkey, where the short FX position of companies has increased in recent years to about 20% of GDP, this is offset by the long FX position of households. Weaker exchange rates will not therefore blow up balance sheets in the way that we have seen in past major EM crises.

The process of adjustment may nevertheless be painful in terms of growth, especially if domestic liquidity conditions need to be tightened further to keep inflation in check. The large stock of foreign holdings of local currency debt in these markets is another source of potential risk. While foreign investors proved relatively “sticky” during the summer, a further round of selling could put upward pressure on yields and squeeze growth.

Only Ukraine today has the features of a classic EM crisis with a fixed and overvalued exchange rate, a current account deficit that exceeds any in the fragile five, currency mismatches, and very limited reserves to defend the currency. The reduced availability and rising

Foreign ownership of local currency debt is not far

from the peak

0

100

200

300

400

500

600

700

800

Mar 09 Mar 10 Mar 11 Mar 12 Mar 13

Sum of all foreign holdings

AUM of EMD LC mutual funds

USD bn


5 December 2013



cost of financing will likely require substantial domestic adjustment and significant external financial assistance. But Ukraine will be viewed as an exception and a crisis there will not lead to a reappraisal of the rest of EM.

Overall, EM sovereigns appear least vulnerable. As is well known, EM sovereign credit metrics are generally healthy, especially when stacked up against most developed markets. Government debt levels in EM are still only about 40% of GDP on average, barely one-third of the level in G7 countries, and not much higher than before the global financial crisis. There are just a handful of EM countries that have seen their debt ratios increase by more than 10% of GDP (Ukraine, Malaysia, South Africa, Hungary, Poland, and Venezuela) in the last five years. But only in Hungary has this taken government debt to levels that might be deemed obviously excessive.

Government debt in EM

0

20

40

60

80

100

120

140

UKR

MYS

ZAF

HU

NP

OL

CH

LTH

AC

HN

MEX

KOR

RU

SB

RZ

CO

LP

HL

TUR

IND

IDN

AR

G

EM G7

2007 2012

% GDP

Countries ranked by the change in government debt (highest to lowest)


At the same time, most countries have also been able to take advantage of favorable financing conditions to lengthen the average maturity of their debt. Once more, only a handful of countries saw the average maturity of their debt shorten over the last few years and in these cases maturities were either already long and/or debt levels low. Again, Hungary stands out as having seen its debt level rise significantly from an already elevated level while the maturity of that debt has shortened further to less than four years.

Government debt maturities in EM

0

2

4

6

8

10

12

14

16

CH

L

RU

S

HU

N

AR

G

IDN

MYS

PO

L

BR

Z

KOR

CO

L

TUR

IND

THA

MEX ZA

F

PH

L

2007 2012

Average remaining maturity (years)

Countries ranked by the change in average maturites (shorter to longer)


Private debt levels, however, have increased more rapidly over this period. Total credit to the non-financial sector, from both bank and non-bank sources, increased from 72% of GDP on average in 2007 to over 90% by early 2013. Our view, therefore, is that it will likely be at the level of corporate and household debt that the normalization of interest rates will probably be most problematic. Across the three EM regions, the risks appear greatest in Asia. Not only are debt levels there much higher, averaging 130% of GDP versus about 80% in EMEA and 40% in Latin America, but also they have generally risen much more in Asia than in the other regions, especially in China and Korea (and more so for companies than for households).

Private debt levels in EM

0

20

40

60

80

100

120

140

160

180

200

220

CH

N

HU

N

KOR

BR

Z

TUR

THA

PO

L

MYS IND

RU

S

IDN

MEX

AR

G

ZAF

2007

2013

Credit to non‐financial private sector (% GDP)

Source: BIS, Deutsche Bank

5 December 2013



Implications for EM investment performance

Since late May, mutual fund investors have steadily and consistently withdrawn money from EM fixed income. Strategic institutional investors have thus far held firm, but there is evidently a re-assessment of EM excess return potential taking place. The outcome of this could have a profound impact on the performance of the asset class for over the medium term. So, how should we look at the excess return potential of EM fixed income?

Structural drivers of excess returns In simplistic terms, we can think of the investment case for EM relying upon structural macroeconomic drivers that deliver trend outperformance (versus DM), and short-term cyclical factors (macro, technicals, and valuation) which result in oscillations around this underlying trend, with frequent overshoots to the upside and downside. At present there is a great deal of focus on near-term factors, such as the timing of a Fed tapering, and the impact that it has on capital flows and currencies. We would view these as part of the short-term cyclical factors. Nevertheless, as discussed, there is also a re-assessment of the trend potential of EM that is ongoing and impacting performance of the asset class.

In terms of the macro-economic drivers, over the medium-term, three factors ultimately dominate: productivity growth relative to the trade partners, the real interest rate premium over developed markets and improving sovereign balance sheets. Economic growth

is obviously a key factor underpinning all three, but it is useful to split the three up given their specific impact on the various ways of investing in EM.

First, the more rapid growth of productivity supports the real appreciation of currencies. This obviously impacts any investment in local currency assets. Higher real rates lead to a direct outperformance of local currency fixed income assuming constant real exchange rates. Finally, improving sovereign balance sheets lead to stronger credit ratings and tighter spreads for sovereigns (and often also for corporate borrowers as the country risk premium declines) and hence outperformance of hard currency debt. The charts below illustrate the evolution of these three variables in recent years.

Note that when we consider ‘EM’ in aggregate in our analysis, we weight the component countries/markets according to the main benchmarks against which most global fixed income investment is managed.

In all three cases the recent dynamics of these drivers are not as powerful as they were in the 2002-07 period. In the past couple of years, annual relative productivity growth has slowed to just 0.8% from an average of 3.0% in 2005-07. Sovereign ratings migration has also slowed, with effectively no improvement in average credit quality, compared to an average pace of improvement of 0.25 rating notches per year in 2003-07. The one aspect that remains robust is aggregate real rates. While real rates are not as high as they were at the start of the 2002-07 period, relative to US real rates they remain at the high end of the range of the past decade.

The structural drivers of EM outperformance are not as powerful as during the 2002-07 period

95

100

105

110

115

120

125

2005 2007 2009 2011 2013

Per-capita PPP GDP vs US

As a proxy for productivity, we construct indices

of relative per-capita PPP GDP between

individual EM countries and the US. These are

then aggregated to provide a global EM index

using the weights of the GBI-EM Global

Diversified.

-2

0

2

4

6

8

2004 2006 2008 2010 2012 2014

Real rate differential vs US

Individual country real rates are constructed on

the basis of DB’s EMLIN sub-index yields minus

ex-post y/y inflation. From this we subtract 5Y

TIIPS yield. Country real rates are aggregates

using the weights of the GBI-EM Global

Diversified.

9

10

11

12

'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13

Average credit rating of EM sovereign USD debt

We take the average sovereign ratings from

Moody’s S&P and Fitch and then construct an

aggregate based on the weights of DB’s EM USD

Sovereign index. On the scale above 9

corresponds to BBB/Baa2, 10 to BBB-/Baa3, etc.


5 December 2013



The decline in the pace of relative productivity growth is at the heart of the shift in attitude towards EM. However, it is not universal. Latin America has slowed to 0.3% from 3.8%, EMEA to 0.2% from 1.5%, but in Asia the slow-down has been more modest, falling to 2.4% from 3.0%. This pattern can also be seen in the differential behavior of real exchange rates, with the trend in both Latin America and EMEA stalling after 2007, but continuing to appreciate until more recently in Asia.

Regional real exchange rates and productivity

differentials

Latin America

90

100

110

120

130

140

2005 2007 2009 2011 2013

Productivity (proxy) differential

Real exchange rate

EMEA

90

100

110

120

130

140

2005 2007 2009 2011 2013

Asia

90

100

110

120

130

140

2005 2007 2009 2011 2013* Real exchange rates are re-based such that Dec-2004 = 100

Productivity differentials are re-based so that there is no average misaligment between the two series over the entire period.


The likelihood of broad acceleration in relative productivity growth across EM seems low. As such,

and with real yields hovering at around 2% above the US, there seems little justification to assume significant outperformance by EM in the coming few years. Absent a benign economic shock at the core, which seems highly unlikely, reforms will likely be the key to changing this picture, by reinvigorating growth. As discussed above, the outlook is mixed with growth set to remain relatively high in some cases, to recover from low levels in others, but to remain low or fall further elsewhere. These divergences should be reflected in the long-term performance of asset markets within EM.

What does this mean for the medium-term performance potential of EM fixed income? Can we derive an expectation for returns using as a basis our sober assessment of macroeconomic prospects?

Local currency fixed income: In simple terms, over the medium-term, an investment in local currency fixed income should deliver a USD return from two sources: (i) real appreciation of the currency relative to the dollar, fueled by productivity gains and (ii) an excess return from the relative real rate differential.

The chart below illustrates the trade-off between these two variables: excess real rates (current 5Y) on the y-axis and growth differential (DB forecast for next 2-years as a proxy of productivity) on the x-axis for a range of EM local markets.

Drivers of long term value in local markets

BR

CL

CO

CZ

HU

ID

IL

MX

MY

PE

PH

PL

RU TR

ZA

KR

TH

NG

RO

GBI

-1

0

1

2

3

4

-2 -1 0 1 2 3 4

Real rate differential vs US, %

2014-15 growth differential vs US, %

Dark blue points represent major local markets (GBI-EM Global Diversified weights > 5%) Diagonal lines represent constant values (0, +1.5%, +3.0%) of real rate differential + 0.4 x growth differential. Source: Deutsche Bank

Empirically we find that a coefficient of 0.4 for the relationship between real exchange rates and per-capita PPP GDP (our proxy for productivity). We can use this coefficient to see the trade-off between growth and real rates. For instance, we estimate the trend

5 December 2013



excess return for an investment in domestic currency fixed income to be approximately RealRateDiff + 0.4 x GDPDiff. This relationship is shown by the diagonal lines on the chart, illustrating excess returns of 0%, +1.5% and +3.0%.

While there is a fairly wide dispersion of expected returns in the sample, it is interesting that all but two of the major markets have excess returns between 1.1% and 2.0%. For the GBI-EM (the most widely followed benchmark) we obtain an excess return of +2.0%. Given that this is a USD return in excess of US nominal rates, it can be thought of as somewhat analogous to a credit spread.

Despite a wide range of forecasts, excess returns for

many major EM markets lie in the 1.5-2.0% range

0

+0.5

+1.0

+1.5

+2.0

+2.5

+3.0

+3.5

+4.0

+4.5

+5.0

Nig

eria

Bra

zil

Per

u

Co

lom

bia

Turk

ey

Ind

on

esia

Chile

Mex

ico

GB

I-E

M

Ru

ssia

Po

lan

d

Hu

ng

ary

So

uth

…

Mal

aysi

a

Thai

lan

d

Rom

ania

Ph

ilip

pin

es

Sou

th K

ore

a

Isra

el

Cze

ch …

Expected excess return, %


Is this sufficient to persuade the USD500+bn of strategic institutional money currently invested in the market to remain put? We think it should be. Considered in the context of other fixed income opportunities an excess return of 200bp over US nominal rates is material (basically double where real US rates are priced to settle in five years!). Furthermore, considering the substantial uncertainty that remains regarding the future prospects for the global economy, retaining a degree of diversification, and a foothold in what still represents approximately 50% of the global economy, is surely prudent. Lastly, USD 500bn remains a very small proportion of the global fixed income investment set.

Sovereign Credit Assessing the excess return potential of sovereign credit is somewhat more straightforward than for local currency fixed income. The competing asset class(es) are more obvious: developed market corporate credit. The extent to which EM sovereign credit has underperformed DM corporate credit during 2013 is quite remarkable and, as far as we are concerned, not

justified by fundamentals. Historically EM sovereigns traded tighter than equivalently rated DM corporate credits. This was arguably justified during the time in which EM sovereigns were on a strong, secular upgrade path. However, in recent years, with the pace of upgrades slowing substantially, such a premium was no longer justified. However, the pendulum has now swung in the opposite direction; EM sovereigns are trading cheaper than similarly rated DM corporate credits. This discount is not justified by fundamentals. There is admittedly a risk of a rating downgrade for some high profile sovereigns, but fundamentally, balance sheets of EM sovereigns remain extremely healthy. Furthermore, with the market becoming increasingly diverse (the EMBI Global now consists of 60 different sovereign credits), the performance of idiosyncratic high yielders (such as Venezuela and Argentina) is having a much-reduced impact on the performance of the rest of the market.

EM sovereign spreads imply a rating 1 notch below the

actual

A

A-

BBB+

BBB

BBB-

BB+

BB

BB-2003 2005 2007 2009 2011 2013

Average credit quality of EM sovereign USD debt

As implied by the spread at which it

trades

Actual rating


The premium offered by EM over DM corporate credits provides a cushion, while EM rating migration pauses. However, if EM countries seize the nettle of reform as we discussed earlier, then it could trigger a renewed re-rating of the asset-class. In this sense, persistently positive growth differentials, albeit lower than in the recent past, should also help. Given the underlying strong balance sheets, this could happen relatively abruptly, albeit not in the immediate future.

While external risks remain high and currencies the shock absorber, we see credit (sovereigns and also selected corporates) as the safest entry point (cyclically). Structurally, the upside local markets offer remains quite attractive – even if diminished.

Marc Balston, London, 44 20 754 71484 Robert Burgess, London, 44 20 754 71930

Drausio Giacomelli, New York, 1 212 250 7355 Gustavo Cañonero, New York, 1 212 250 7355

Taimur Baig, Singapore, 65 64 23 8681

5 December 2013



Rates: Refocusing on EM Fundamentals

The re-establishment of term premium that started in 2013 is advanced and is now more comparable to historical norms. It is obviously insufficient to absorb possible bouts of volatility that could accompany tapering and potential testing of forward guidance.

With more premia embedded in longer tenors across both EM and DM, we expect term premia to track more closely with growth potentials and inflation trends in 2014. Accordingly, we expect country specifics to continue to play an important role in performance.

We find that the cushion to absorb a potentially faster pace of global growth is more limited in the short end and belly of most EM curves. We favour payers in Turkey and Israel but favour receivers in Poland. We see residual value in receiving in Hungary, while in South Africa the value in the front end is now sizeable. In Asia we like paying the front end of the Malay curve versus Thai, as well as paying the front end of Korea and Taiwan (maintaining a steepening bias).

There is a significant gap between current and ‘neutral’ policy rates, yet only a modest growth upturn in the years ahead is priced by the mid-sector of EM curves. On account of attractive valuation, low carry burden and high beta to US rates, we find paying the ‘belly’ of the 2s5s10s butterfly attractive in Mexico, Czech Republic and (less so) Hungary.

As normalization proceeds and volatility subsides, we expect EM curves to bear-flatten in 2014. The Turkish curve stands out as a good candidate for bear flattening. We also like flatteners in South Africa and Israel, while favouring (bull)-steepeners in Russia. In LatAm, we favour flatteners in Mexico and Brazil and, less so now, steepeners in Chile. In Asia we recommend buying bonds in India, receiving in the long end of Singapore vs. US, but paying Hibor-Libor spread. Still in Asia we like paying spreads in China, Malay vs. Thai rates, 2Y/5Y Korea IRS outright and 2Y/5Y Taiwan spreads.

Inflation premium also seems subdued. We find the inflation premium too low in Turkey and favour linkers vs. nominal bonds in Brazil and Chile.

Re-pricing: Part II

EM local markets started 2013 under booming inflows and at very tight valuations despite prospects of acceleration in global growth throughout the year. In several “high-yield” markets, long-dated tenors barely offered enough compensation for inflation. In some

cases, long-dated real yields turned negative as inflows built. As we end the year, valuation and flows are still on opposite sides, while the outlook for the US economy is brighter again. However, now real yields are back firmly in positive territory – even if still low by historical standards in most cases. Despite better valuations, however, outflows from local markets persist, although at a much slower pace than in the summer months.

Interest rate differentials vs. the US have recovered as USTs sold off. The chart below presents the spread between the market-weighted average of EM and similar-duration US real yields (5Y sector). The two charts cover not only “traded” real yields, but also a more comprehensive sample of nominal bonds deflated by inflation expectations in countries where linkers are non-existent. The yield differential in favour of EM ranges from 200-400bp and it is now hovering around almost 350bp in the broader sample.

Interest rate differentials recover despite UST sell-off

100

150

200

250

300

350

400

Dec 08 Nov 09 Oct 10 Sep 11 Aug 12 Jul 13

Spread of EM 5Y (deflated) real yields vs.US 5Y TIIPS, bp

0

2

4

6

8

2005 2007 2009 2011 2013

LatAm vs. TIPS EMEA vs. TIPS

LatAm and EMEA 5Y linkers' yield index vs. US 5Y TIPS (%)

Source: Deutsche Bank, Bloomberg Finance LP

5 December 2013



This suggests that concerns about persistent outflows and the absence of EM premium over developed markets may be exaggerated – especially in LatAm. Under DB’s baseline scenario for policy rates and US rates (3.25% for UST10Y), we expect the EMLIN index to return 4% this year vs. -8.7% so far in 2013. This compares with -2% we forecast for UST in 2014.

In our view, the re-establishment of term premium that started in 2013 is advanced.1 From the negative levels of early 2013, term premia are now more comparable to historical averages (or higher). They are obviously insufficient to absorb possible bouts of volatility that could accompany tapering and potential testing of forward guidance. However, with more cushion priced in longer tenors across both EM and developed markets, we expect them to track more closely growth potentials and inflation trends in 2014. Accordingly, we expect country-specifics to continue to play an important role in performance.

Although the global economy is improving, growth risks remain two-sided, as 2013 reminded us repeatedly. This will likely translate into range trading for longer tenors. However, we find that the cushion to absorb a potentially faster pace of global growth is more limited in the short end and belly of most EM curves, as we discuss in the following sections. There is still a substantial gap between current and “neutral” policy rates, while the mid-sector of EM curves prices in modest growth upturns in the years ahead. Inflation premium – though positive across EM – also seems subdued.

These may prove adequate should global growth continue to recover gradually, but limited monetary policy premium and the possibility that forward guidance is tested (especially if the US accelerates as we expect) suggest that local yield risks remain exposed to further re-pricing in the year ahead – possibly not as sharply as in 2013 at current valuations, however. We expect EM curves to bear-flatten in 2014 once the dust settles.

EM specifics: Assessing curve premium The short end: Testing “forward guidance” The ability of EM central banks to commit to keeping policy rates low for a prolonged period of time is limited, in our view. Not only are output gaps lower, but also inflation risks are higher. In only a few cases (including Chile, Russia, Israel, and CE3) are inflation expectations hovering below (by only a small margin) or at the target.

1 US 10Y5Y is trading above 4.5%, which is consistent with growth and inflation prospects of 2%. The re-pricing in 2013 has amounted to about 150bp and the bulk of it stemmed from the re-pricing in term premium. In our view, UST pricing should follow more closely steady-state inflation and growth.

In most emerging economies, labour markets are not far from full employment and we have found no (structural) systemic change in these economies’ linkages to developed markets. As we discuss in a separate piece2, we believe that most EMs are on the cusp of acceleration in growth. Several important countries such as Brazil, South Africa, Turkey, Russia, and India will likely lag for structural reasons, but they already face persistently high inflation nevertheless.

Under this backdrop, is “monetary policy premium” adequate? We find it to be low under our baseline scenario of return to trend growth – even if gradually so. In the charts below, we compare market pricing, our estimates of “neutral” policy rates and the basic elements of a Taylor rule to assess “monetary policy premium”. In the first two charts, the horizontal axis gauges the time it takes for yields as implied by the forwards to meet our estimates of neutral policy rates. We note that since these curves price some term premium, this probably underestimates the implied time to achieve neutrality. The charts compare this “time to convergence” with our estimates of output gaps and the differential between inflation expectations and targets.

Assessing “monetary policy premium”

USD

ZAR

ILS

BRL

CLP

COP

MXN

EUR

CZKHUFPLN

RUB

TRY

KRW

INR

‐2.0

‐1.5

‐1.0

‐0.5

0.0

0.5

1.0

1.5

2.0

0 12 24 36 48 60 72

Expected inflation in excess of target (%)

Convergence time to "neutral" priced in (months)

receivers

payers

USD

ZAR

ILSBRL

CLP

COP

MXN EUR

CZK

HUF

PLN RUB

TRY

KRWINR

‐6

‐5

‐4

‐3

‐2

‐1

0

1

2

0 12 24 36 48 60 72

Output gap (%)

Convergence time to "neutral" priced in (months)

receivers

payers

Note: 1. We include India for completeness, even though the current policy rate is higher than our estimated neutral rate. Convergence time is plotted as 0 months. 2. In Turkey, Korea and the Czech Republic, forwards do not converge to our estimated neutral policy rates within 72 months. Source: Deutsche Bank

2 See “Diverging markets, in this publication.

5 December 2013



India, Russia, CE3, and Chile lead in terms of monetary policy “cushion”, with inflation hovering below target and negative output gaps. These are followed by Israel and Colombia. Among those, receivers in Poland seem to stand out on lower inflation risks per carry.

In contrast, there is less “central bank premium” in Brazil, Turkey, and – to a lesser extent – South Africa. In these countries, there is less room to manoeuvre given higher inflation and smaller gaps. The signals are more mixed in Mexico, where inflation and output gaps have opposite signs. The same is true in Korea, but in this case the time to convergence to neutral is quite long, suggesting upside risks to yields. Turkey stands out as the most mispriced of these markets, in our view: Not only is inflation too high and the output gap too low, but also the curve prices too slow a normalization path.

Among the high-inflation countries, while temporary easing in inflation pressures may bring small cuts in Russia, shorten the cycle in Brazil and extend the SARB’s pause – thus attracting short-term receivers – we caution that inflation in these countries has an important inertial component – especially in Brazil. With underlying inflation running well above headline in Brazil, achieving neutrality requires overshooting neutral rates.

Looking beyond the intra-EM differences, the overall time to convergence seems excessive. Even where premium is highest, it would still take about 40 months to convergence. Historically, business cycle upturns have closed these gaps in shorter time frames. “Low for long” may be credible in countries such as Israel, Chile, and the Czech Republic, which do not show any imminent pressure points on inflation and capacity utilization, but the time priced to “neutrality” (more than four years) still suggests that risks are biased to higher rates even in these cases.

We favour payers in the short end of Turkey and Israel, receivers in Poland, and tactical receivers in Hungary, Russia, and South Africa. In LatAm, Brazil stands out as the best front-end receiver (amid high volatility, however) followed by Colombia and Chile. As disinflation runs its course in Asia, we like paying the front end of the Malay curve versus Thai as a trade on divergent inflation/policy outlooks. Long time to convergence contrasts with more growth-sensitive markets in North Asia; we thus favour paying the front end of Korea and Taiwan (maintaining a steepening bias).

The belly: A mild business cycle priced in Forward guidance and scepticism surrounding global growth may extend the life of short-end receivers. Even under this dovish scenario, however, the value proposition in mid sector of EM curves is questionable, in our opinion. The delayed normalization priced may

be adequate for developed countries that still face the leftovers of debt overhang. Arguably, a subdued upturn is likely in the case of the BRICS, where credit cycles and policy expansion post-crisis were also severe – yet not as deep as in developed markets. For most emerging economies, however, growth normalization appears within reach over the next year or two. The chart below plots the gap between 2Y, 3Y ahead and 2Y spot vs. the neutral rate – the current policy rate gap.

Only a few EM curves offer positive premium for receivers (notably Brazil, India, Russia, and Mexico). In contrast, we see value in payers across several countries such as Turkey, Korea, Europe, the Czech Republic and the US. Not surprisingly, Turkey again stands out.

Pricing a subdued cycle in the years ahead

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Where do we find the best protection trades against possibly stronger business cycles? As we have highlighted 3 , despite their negative carry, 2s5s10s butterflies are rather depressed across several EMs, trading through pre-May levels in some cases, while displaying a high correlation with global risk proxies (namely the slope of the US volume curve). This suggests that butterfly payers can be used as proxy hedges for a potential surge in front-end rates volatility, whether predicated on stronger-than-expected pick-up in activity or risks regarding the unbundling of tapering and forward guidance.

We look for butterfly payers that combine attractive valuation, lower carry burden, and the highest beta to US rates front end volatility (DGX index) as a proxy of the perceived strength of the global cycle. We favour the highest “payout” in the sense of the highest potential upside vs. lowest carry and drawdown.

The chart below indicates that paying the belly in 1:2:1 2s5s10s butterflies in Mexico, Czech Republic, and

3 See “Trading Pre-Taper Anxiety”.

5 December 2013



(less so) in the US combines potential upside (y-axis) and significant exposure to a stronger cycle (x-axis), while having relatively low carry burden (r-squares and 3M carry in bp are expressed as the first and second numbers in the brackets).

Butterflies: Where to pay

(USD 88%,‐15)

(EUR 72%,‐4)

(MXN 84%,‐8)

(CLP 49%,‐4)

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In EM, we favour paying the belly in Mexico, Czech Republic and less so in Hungary as defensive trades. In Asia we favour paying 5Y outright in China and also the belly in Korea and Taiwan.

The long end: Looking beyond tapering Extending the analysis of the previous sections, we now look at premium in longer tenors. To do so, we again compare “neutral” vs. forwards4. The vertical axis in the chart below shows this “excess term premium” embedded in the forwards. The horizontal axis presents the “monetary policy premium” (the difference between what is priced in 2Y, 3Y forward vs. 2Y spot and the “policy rate gap” – the distance from “neutral”). The chart segments EMs into four quadrants, according to these premia.

Comparing term premium and monetary premium to gauge the relative value between the longer and shorter tenors of EM curves, the chart below suggests that EM value is concentrated in bear-flatteners. This is consistent with our view that premium is higher in the longer end of EM curves with little cushion for a faster pace of economic recovery in the shorter tenors. This is also in line with tapering being the most imminent risk, while forward guidance is yet to be tested.

Again, Turkey stands out as the best candidate for bear-flattening. Korea appears as a clear short-end payer, but with no clear curve trade. Mexico and Russia show value in receiving, but while Russia bodes well

4 We use 3Y forwards as our starting date as we believe that this time frame reduces potential mis-pricings related to differences in monetary policy paths. We use the average 2s10s slope during 2004-08 (before the crisis) as a proxy of “neutral”, comparing it with the slope 3Yforwards.

for bull-steepening (which could be triggered by possible easing), Mexico shows more value in the longer end (bull-flattening). Hungary, South Africa, and Israel seem too steep, with value concentrated in longer tenors.

Pricing long-term growth, after term premium

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Brazil also stands out as too steep. Fiscal risks and a central bank that prefers to chase inflation risks combined with election uncertainty that could mount into 2Q/3Q bodes for caution, but at over 13% (and 14%+ in forwards) we find nominal rates in Brazil outright too high and the curve too steep. We expect the central bank to continue to tighten – cornered by high inflation – even if gradually so. Fiscal slippage seems to be peaking. However, rates and FX will likely be most volatile in Brazil as elections (not market stability) look to be an absolute priority for this government.

In EMEA we favour flatteners in Turkey, South Africa and Israel, while favouring steepeners in Russia. In LatAm we like flatteners in Mexico, Brazil and see residual value in steepeners in Chile. We also continue to favour receiving the long end in Mexico versus the US. In Asia we recommend buying 5-7Y bonds in India, receiving in the long end of Singapore vs. US, but paying Hibor-Libor spread. Still in Asia we like paying 2Y/5Y IRS spreads in China, Malay vs. Thai rates, 2Y/5Y Korea IRS outright and 2Y/5Y Taiwan spreads

Nominal bonds or linkers? Inflation across EMs has been low except in cases where central banks have been negligent. However, the benefits of lower food prices and lacklustre global growth will likely start to fade during 2014 under our baseline scenario. Subdued oil prices could provide a reprieve, but these prices have been subsidized (and lagging) in many important emerging markets. Also, as discussed above, output gaps are not nearly as high as

5 December 2013



in developed countries. In addition, central banks will likely err on the side of higher inflation than lower growth. Moreover, in many important markets such as Brazil, Turkey, and South Africa, inertia seems to have pushed the baseline level up.

Inflation premium (defined as breakevens – consensus inflation) is negative in Chile, Colombia, and Israel (see chart below). This is in line with inflation risks, which we deem low especially in Chile if oil prices recede in 2014 as we expect. Liquidity may be binding in Israel and Colombia, but – in Chile – linkers are most liquid and – at negative premium – they seem an attractive defensive trade. We also favour long breakevens in CLP.

In South Africa, premium seems adequate, given our view of persistent economic slack and some currency appreciation. Yet, in Brazil, it just looks too high. Underlying inflation is running near 8% so that sub-100bp of premium seems low – especially given the risk of additional BRL weakness. In Turkey, liquidity is also a hurdle for linkers. Besides, food prices are running a little above trend and will probably correct downwards; domestic liquidity conditions are now finally being tightened, which should also help. In both cases, however, there are risks to the upside, primarily from the potential for further exchange rate weakness. Thus, we find the premium to be too low.

Assessing inflation premium

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We favour linkers vs. nominal bonds in Brazil, Chile, and Turkey – liquidity permitting.

Final remarks: Technicals and other idiosyncratic risks Technicals remain mostly an external risk, in our view. Although in some cases amortization increases substantially in 2014, the outlook for net supply (supply in excess of redemptions) seems manageable – and actually benign in several countries. The chart below shows the net financing picture in 2014 (y axis) vs. the net financing picture in 2013 (x axis), both expressed relative to GDP (%). Except for CZK and MXN, the outlook for net supply seems benign.

The external technical risk remains potentially quite high. As the last chart shows, foreign holding of local debt has increased despite the outflows from local markets over the past year. In Hungary, Poland, South Africa, Mexico, and Malaysia, foreign holdings remain substantial and in excess of 30%. Historically, foreign investors (a source of long-term savings via insurance and pension funds) have been important anchors for the extension of local curves. They have been quite resilient to several monetary policy shocks, but it would be premature to discard the risk of a more substantial rotation away from fixed income.

Our baseline view is that the global economy simply cannot afford such a marked reallocation, as it is still quite leveraged. The Fed’s own reluctance to validate more aggressive re-pricings of US fixed income seems to concur with our baseline view. However, these are unusual times. Even if significant outflows do not materialize, investors should remain prepared for bouts of hedging – either via paying swaps or buying USD – as was the case throughout 2013.

Supply risk contained

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Foreign holding: Resilient, but still the wild card

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Sep‐12 Highest Sep‐13% of outstanding


Drausio Giacomelli, New York, +1 212 250 7355 Guilherme Marone, New York, +1 212 250 8640

Siddharth Kapoor, London, +44 20 7547 4241

5 December 2013



Sovereign Credit in 2014: Back in the Black

While EM assets are likely to face continued headwinds in 2014, we believe the dramatic negative shift in the wider perception of EM debt cannot be repeated in 2014 given the return of EM risk premium.

With continued taper risk, we start the New Year with a neutral overall exposure. However, as rate uncertainty recedes after the initial taper shock and Fed continues with its dovish guidance as we foresee, we believe EM sovereign spreads have potential of some moderate tightening, offsetting the rise in US yields and offering about 6% return in 2014.

We expect some moderate improvement in EM credit fundamentals overall in 2014, especially in the ‘fragile’ countries, but foresee continued negative ratings drift as in 2013.

We are not optimistic on the short-term outlook for funds flows, but we believe supply/demand balance is likely to be more supportive, as for the first time since 2007 we project principal and interest repayments to be slightly more than gross issuances.

In terms of credit differentiation, we apply our valuation model based on country-specific macro factors and adjust the results with impacts of current account balances – a main driver for credit’s rate sensitivity in 2013.

We recommend an overweight exposure to Colombia, Russia, Poland, and Hungary, underweight exposure to Brazil, Indonesia, and Ukraine, while maintaining a neutral exposure to the rest, notably Argentina, Venezuela, Turkey, and South Africa.

In relative value, we retain a cash curve steepening bias in the near term given rate uncertainty. The CDS/bond basis is settling in a tighter range currently but we look to trade a potential bounce in the basis as rate volatility recedes later in 2014.

Introduction

2013 has been a very significant year for emerging market sovereign credit. A perfect storm of factors transpired to push EM spreads to their cheapest levels in over a decade, relative to developed market corporate debt. The most important question facing us as we look forward to 2014 is whether this past year was a discrete adjustment, or whether appetite for EM sovereign debt has been so damaged that we face an extended period of underperformance.

With declining QE from the Fed and relatively lackluster aggregate economic growth, emerging markets assets are likely to face continued headwinds in 2014. However, these headwinds should not brew into a storm like in 2013. We expect a further rise in US 10 year yields, but for this to be constrained with 5Y-5Y forward around 4.5%. Furthermore, we believe the dramatic negative shift in the wider perception of EM debt cannot be repeated in 2014. Sentiment is already poor and expectations have adjusted downwards. These factors should put a limit on further underperformance of EM sovereign credit relative to developed market corporate. However, given the shock of 2013, we believe EM sovereign debt is not cheap enough to motivate the sharp reversal in fund flows which would be a necessary condition for a substantial spread compression relative to DM corporate.

As a result, while the major theme of 2013 was of the systematic underperformance of EM sovereign credit, we expect diversity within the asset class and divergent performance of individual EM credits to be the dominant theme of 2014.

2013 in perspective: a revelation of fading tailwinds

It has been a year to forget for EM sovereign credit In 2013, EM credit has been one of the worst performers among all asset classes, suffering a major re-pricing on the deterioration in EM’s relative fundamentals vs. the developed world and a dramatic shift in the perception of EM as an investment opportunity, triggered by the prospect of QE taper. Portfolio rebalancing due to rising interest rates, a topic that has been talked about throughout the year, has not materialized to the same extent (or in the same form) as expected for the general credit market, as inflows to both global investment grade and high yields have returned and both asset classes are seeing credit spreads at the tightest levels since 2007. Instead, rebalancing has been more pronounced in the form of unwinding of inflows into EM debt funds accumulated during previous years.

Year to date, EM sovereign credit, measured by the EMBI-Global benchmark, returned -7.5%, significantly underperforming Global IG (-1.3%) and in stark contrast with Global HY (+7%). Within E

Documents

Emerging Markets 2014 Outlook - Deutsche BankEmerging Markets Foreign Exchange Economics Rates Credit Date 5 December 2013 Diverging Markets Emerging Markets 2014 Outlook Taimur Baig