Emerging Markets Explorer - SEB Group · 2016-11-23 · 4 Emerging Markets Explorer SEB EM Forecasts FX Rates (end of period) Policy Rates (end of period) 06-Oct-2016 Spot 1M 4Q-16

Emerging Markets ExplorerA Rally with Risks

October 2016

Strategy — Carry back in vogue Macro — Slow recovery Watch — China, the Fed, and Trump

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Emerging Markets Explorer

CONTENTS

Executive Summary................................................................................................................................................................................... 3

SEB EM Forecasts ...................................................................................................................................................................................... 4

Macro Outlook: Carry Strategies Back in Vogue .................................................................................................................................. 5

Clinton vs Trump: Continuity vs unpredictability in relations with China and Russia ..................................................................... 8

Theme: Top Three FAQ on ASEAN ........................................................................................................................................................ 10

Theme: China’s rebalancing leads to slowdown ................................................................................................................................ 12

Country Section ....................................................................................................................................................................................... 14

Asia ............................................................................................................................................................................................................ 14

China .................................................................................................................................................................................................... 14 India ...................................................................................................................................................................................................... 14 Indonesia ..............................................................................................................................................................................................15 South Korea ..........................................................................................................................................................................................15 Malaysia ............................................................................................................................................................................................... 16 Philippines ........................................................................................................................................................................................... 16 Singapore ............................................................................................................................................................................................. 16 Thailand ................................................................................................................................................................................................ 17

Emerging Europe ...................................................................................................................................................................................... 17

Czech Republic .................................................................................................................................................................................... 17 Hungary ............................................................................................................................................................................................... 18 Poland .................................................................................................................................................................................................. 19 Russia ................................................................................................................................................................................................... 19 Turkey .................................................................................................................................................................................................. 20 Ukraine ................................................................................................................................................................................................. 20

Latin America ........................................................................................................................................................................................... 21

Brazil ..................................................................................................................................................................................................... 21 Mexico .................................................................................................................................................................................................. 21

Sub-Saharan Africa ................................................................................................................................................................................. 22

South Africa ......................................................................................................................................................................................... 22 Disclaimer ................................................................................................................................................................................................. 24

EDITOR

Per Hammarlund

CONTRIBUTORS

Mattias Bruér

Ann Enshagen Lavebrink

Olle Holmgren

Melody Jiang

Andreas Johnson

Karl Steiner

Sean Yokota

Disclaimer: See page 24

Contacts: See page 25

Cut-off date: 5 Oct, 2016

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Executive Summary

TOP PICKS

Brazil: The BRL is involves high risk, even by EM standards. However, with the economy set to grow next year, reforms

to be implemented, and yields around 10%–11%, the BRL is attractive. It remains one of favored long currencies in our FX carry trade model.

India: The INR looks set to weaken somewhat at the beginning of Q4 as measures introduced in 2013 to stabilize the

INR expire. The INR should strengthen from there due to attractive yield and stronger economy. The latter part of Q4 will be a good time to build long INR positions.

Indonesia: For rates, we prefer steepeners or paying the back end since we expect some recovery in economic growth

and inflation expectations to rise. We think receiving front end will also work as we expect another 25bps of rate cuts into 2017.

Russia: The recession is bottoming out and oil prices have stabilized, both of which will support the RUB. With yields

around 8%, the RUB is one of our favorite long carry trade targets.

MACRO OVERVIEW

Two factors look set to support EM risk appetite:

1. Persistently low interest rates in developed markets, and

2. A gradual slowdown in China, no hard landing.

THEME ARTICLES

The choice between Clinton and Trump is a choice between continuity and unpredictability in US relations with

emerging markets, and more specifically with China and Russia.

Top Three FAQ on ASEAN

1. Why is ASEAN gaining more attention? It’s looking better than China.

2. What’s your top pick in ASEAN? Indonesia.

3. What are the main risks in ASEAN? Economic overheating and global power politics.

China’s rebalancing leads to slowing headline GDP growth. The good news is that restructuring is taking place. The bad news is that China will decelerate in 2017.

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SEB EM Forecasts

FX Rates (end of period) Policy Rates (end of period)

06-Oct-2016 Spot 1M 4Q-16 1Q-17 2Q-17 3Q-17 Oct 6, 2016 Current RateNext

MPC4Q-16 1Q-17 2Q-17 3Q-17 4Q-17

vs. EUR Asia

PLN 4.30 4.35 4.25 4.20 4.20 4.15 China Lending 4.35 -- 4.35 4.35 4.35 4.35 4.10

HUF 305 310 305 305 303 302 Deposit 1.50 1.50 1.50 1.50 1.50 1.25

CZK 27.0 27.0 27.0 27.0 25.0 25.0 RRR 17.00 17.00 17.00 17.00 16.50 16.00

RON 4.46 4.45 4.45 4.40 4.35 4.32 South Korea 1.25 Oct 13 1.25 1.25 1.00 1.00 0.75

TRY 3.43 3.42 3.23 3.41 3.41 3.50 India 6.25 Dec 7 6.25 6.25 6.25 6.00 6.00

RUB 69.9 71.8 67.7 66.0 68.2 71.0 Indonesia 5.00 Oct 20 5.00 4.75 4.75 4.25 4.25

vs. USD Malaysia 3.00 Nov 23 3.00 3.00 2.75 2.75 2.50

RUB 62.4 63.0 61.0 60.0 62.0 64.0 Philippines 3.00 Nov 10 3.00 3.00 3.00 3.00 3.00

TRY 3.06 3.00 3.05 3.10 3.10 3.15 Thailand 1.50 Nov 9 1.50 1.50 1.25 1.25 1.25

PLN 3.84 3.82 3.83 3.82 3.82 3.74 Taiwan 1.375 Dec 15 1.375 1.375 1.130 1.000 1.000

HUF 272 272 275 277 275 272 Emerging Europe

CZK 24.1 23.7 24.3 24.6 22.7 22.5 Poland 1.50 Nov 9 1.50 1.50 1.50 1.50 1.75

UAH 25.90 26.00 27.00 28.00 28.00 28.00 Czech 0.05 Nov 3 0.05 0.05 0.05 0.05 0.25

ZAR 13.74 13.18 14.00 14.20 14.50 15.00 Hungary 0.90 Oct 25 0.90 0.90 0.90 0.90 1.50

KES 101.3 100.0 106.0 108.0 110.0 115.0 Turkey 1W repo 7.50 Oct 20 7.50 7.50 7.50 7.50 8.00

NGN 315 330 330 350 350 350 O/N Borrowing 7.25 7.25 7.25 7.25 7.25 7.75

BRL 3.22 3.18 3.00 3.10 3.25 3.40 O/N Lending 8.25 8.00 7.75 7.75 7.75 8.25

MXN 19.24 20.10 18.75 19.00 19.00 18.50 Romania 1.75 Nov 4 1.75 1.75 1.75 1.75 2.00

CLP 665 700 690 700 710 710 Russia 10.00 Oct 28 10.00 9.00 8.50 8.00 8.00

CNY 6.67 6.70 6.80 6.75 6.70 6.70 Ukraine 15.00 -- 15.00 14.00 14.00 13.00 12.00

CNH 6.70 6.70 6.80 6.75 6.70 6.70 Latin America

HKD 7.76 7.80 7.80 7.80 7.80 7.80 Brazil 14.25 Oct 19 13.75 13.25 12.75 12.00 11.50

IDR 12,995 13,100 13,500 13,200 12,800 13,000 Mexico 4.75 Nov 17 4.75 5.00 5.00 5.00 5.25

INR 66.6 66.5 68.5 67.0 66.5 66.0 Chile 3.50 Oct 18 4.00 4.25 4.50 4.75 5.00

KRW 1,111 1,130 1,180 1,130 1,120 1,110 Sub-Saharan Africa

MYR 4.13 4.00 4.25 4.20 4.15 4.10 S. Africa 7.00 Nov 24 7.00 7.25 7.50 7.50 7.50

PHP 48.2 48.5 49.0 48.5 48.0 47.5 Source: Bloomberg, SEB

SGD 1.37 1.37 1.41 1.39 1.35 1.34

THB 34.8 35.0 36.0 35.4 35.0 34.5

TWD 31.4 32.0 32.5 32.0 31.5 31.2

EUR/USD 1.12 1.14 1.11 1.10 1.10 1.11

USD/JPY 103.5 103 106 110 110 110

EUR/SEK 9.63 9.60 9.50 9.45 9.35 9.15

USD/SEK 8.60 8.42 8.56 8.59 8.50 8.24

Real GDP Consumer Price Inflation2013 2014 2015 2016 2017 2018 Target Latest SEB Forecasts

SEB EM Aggregate 6.4 4.7 4.0 4.2 4.7 4.8 2016 % y/y 2014 2015 2016 2017 2018

Asia Asia 2014 2015

China 7.7 7.3 6.8 6.6 6.3 6.0 China 3.0 1.3 Aug 2.0 1.4 2.2 2.5 2.5

India 6.4 7.0 7.3 7.6 7.8 8.0 India 5.0 5.1 Aug 7.2 4.9 5.4 4.7 4.5

Indonesia 5.6 5.0 4.8 5.0 4.9 6.0 Indonesia 4.5 (±1) 3.1 Sep 6.4 6.4 5.0 5.3 4.8

South Korea 2.9 3.3 2.6 3.2 3.3 3.0 South Korea 2.0 1.2 Sep 1.3 1.3 1.5 1.2 1.4

Singapore 4.7 3.3 2.0 2.2 1.9 2.8 Singapore -- -0.3 Aug 1.0 -0.5 0.4 1.0 1.5

Philippines 7.1 6.2 6.3 5.9 5.3 6.6 Philippines 3.0 (±1) 2.3 Sep 4.1 1.5 2.5 2.8 3.0

Malaysia 4.7 6.0 5.0 4.1 3.9 4.3 Malaysia 2.0–3.0* 1.5 Aug 3.2 2.1 2.8 2.5 2.6

Taiwan 2.2 3.9 0.7 2.3 2.6 1.7 Taiwan -- 0.3 Sep 1.2 -0.3 0.8 1.0 1.1

Thailand 2.9 0.9 2.8 3.3 3.5 3.5 Thailand 2.5 (±1.5) 0.4 Sep 1.9 -0.9 1.5 2.0 1.7

Emerging Europe Emerging Europe

Poland 1.3 3.3 3.6 3.6 3.5 3.4 Poland 2.5 (±1) -0.5 Sep 0.0 -0.9 -0.4 1.8 2.2

Czech Republic -0.5 2.7 4.6 2.6 3.0 3.0 Czech Republic 2.0 (±1) 0.6 Aug 0.4 0.3 1.0 2.5 3.0

Hungary 0.2 3.7 3.0 2.4 2.5 2.7 Hungary 3.0 (±1) -0.1 Aug -0.2 -0.1 0.9 3.0 4.0

Turkey 4.2 3.0 3.9 3.0 3.1 3.5 Turkey 5.0 7.3 Sep 8.9 7.7 8.2 7.5 8.0

Romania 3.5 3.0 3.8 3.7 3.3 3.5 Romania 2.5 (±1) -0.2 Aug 1.1 -0.6 0.1 2.4 2.9

Russia 1.3 0.7 -3.7 -0.4 1.0 1.5 Russia 4.0** 6.4 Sep 7.8 15.6 7.1 6.0 5.0

Ukraine 0.0 -6.6 -9.9 1.0 2.0 3.0 Ukraine -- 15.4 Aug 2.1 44.1 14.0 10.0 --

Latin America Latin America

Brazil 3.0 0.1 -3.8 -3.5 0.5 2.0 Brazil 4.5 (±2) 9.0 Aug 6.3 9.0 8.6 6.0 5.0

Chile 4.0 1.8 2.3 1.9 3.0 2.5 Mexico 3.0 (±1) 2.7 Aug 4.0 2.7 2.9 3.5 3.2

Mexico 1.4 2.2 2.5 2.0 2.5 3.0 Chile 3.0 (±1) 3.4 Aug 4.4 4.3 4.0 3.1 3.5

Sub-Saharan Africa Sub-Saharan Africa

South Africa 2.3 1.6 1.3 0.3 1.5 2.0 South Africa 3.0–6.0 5.9 Aug 6.1 4.6 6.4 5.8 6.0Source: IMF, OECD, Bloomberg, SEB *BNM forecast; **2017. Source: SEB, Bloomberg, Consensus Economics.

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Macro Outlook: Carry Strategies Back in Vogue

Low developed-market interest rates to persist

A gradual slowdown in China; no hard landing

The stage is set for EM to strengthen gradually

WHITHER THE EM RALLY?

A key market theme has been the recovery in EM assets

since January of this year. A couple of factors, first and

foremost, a hard landing in China and an unexpected jump

in US or euro-zone inflation, could drive the rally into

reverse. However, low global inflation and loose monetary

policies look likely to persist in most advanced economies.

In addition, while policy makers in China will reduce

monetary stimulus to cap excessive credit growth, they will

step up fiscal policy stimulus. As a result, the conditions are

in place for global risk appetite to remain strong and for the

EM rally to continue, albeit at a slower pace than during the

first half of the year. In an environment when commodity

and oil prices do not fall continuously, investing based on expected carry should generate good returns.

PLENTY OF ROOM TO MOVE HIGHER

Our EM FX index has risen by 10% since bottoming on

January 20 this year, while the MCSI EM equity index is up

by 33%. EM bonds have also rallied, with spreads against

US Treasuries narrowing from more than 500bps in January

to around 350bps in October. The rally mainly reflects

reduced fears of a hard landing in China, an unexpectedly

dovish US Fed, and depressed EM asset valuations. The

improvement in sentiment towards China is partly due to

reduced exchange rate volatility (following the introduction

of capital controls) and partly to stronger growth. Although

restrictions on financial account convertibility represent a

setback for China in its quest for a more market-based economy, they have helped restore confidence for now.

Signs of continued strong growth in China on the back of

significant monetary and fiscal stimulus have impacted

other EM economies. The Institute of International

Finance’s (IIF) coincident indicator suggests that EM growth

bottomed out in January and February reaching a level

consistent with real GDP growth of 4.7% in August.

Increasing confidence in China’s growth outlook has also

boosted commodity prices, which, in turn, has helped

stimulate demand for EM assets, especially equities and currencies.

After hiking in December 2015, the US Fed became more

dovish in January, causing capital flows to favour EM,

almost three years after the 2013 “Taper Tantrum”. The

hunt for yield has resumed. After EM currencies depreciated

by 27% (against a basket comprising the USD, EUR, JPY,

CHF and GBP) and EM equities fell by 37%, valuation levels became very attractive.

Several indices may now be approaching resistance levels.

Technical analysis of the MSCI EM equity index suggests it is

only 2–3 percentage points away from a key resistance

level. Similarly, some EM currencies, for example the BRL,

are no longer cheap in real effective terms. However, just as

markets became oversold, a rally above fair value should be expected.

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CHINA RISKS STILL LURK

Worries about a hard landing in China have not

disappeared, but simply been deferred. The country’s

credit-fuelled stimulus risks exacerbating overcapacity and

indebtedness among state-owned companies in the

medium-to-long term. Another worry is Beijing’s desired

shift away from the use of monetary policy (which has

driven construction) to fiscal policy and its effect on

commodity prices. Nevertheless, we believe that the bottom

reached in January will last for at least another year and that

a potential correction lower from current levels should be

temporary. Beijing will not risk market volatility by

tightening monetary conditions too fast, especially not so

close to the leadership transition in one year’s time,

suggesting that the construction and real estate sectors will

continue to grow and provide a floor under commodity prices.

Leverage remains a key concern. Debt in EM continues to

grow, driven primarily by increased borrowing by non-

financial corporates in China and Saudi Arabia in 2016. One

mitigating factor in the case of China is that the bulk of new

loans are denominated in RMB. In addition, leverage is

rising the fastest in state-owned enterprises (SOE), which

can count on government support. Nevertheless, over time, the growth in debt needs to slow.

LOW GLOBAL RATES DESPITE A US HIKE IN DECEMBER

While the Bank of Japan may not add to its quantitative

easing program, it is still considering ways to loosen

monetary policy. Similarly, the ECB is a long way from

tightening its monetary policy, despite recent tapering

comments. With the US Fed unlikely to hike before

December, we believe present conditions will ensure capital

continues to flow to EM and the rally to continue over the

coming 3–6 months. Nevertheless, the single most

significant threat to EM is a sudden jump in US inflation,

prompting the FOMC to take a considerably more hawkish stance.

Policymakers are now signalling an eagerness to resume

gradual monetary policy normalization. Notwithstanding

disappointing economic data, Janet Yellen claims that the

Fed is seeing definite evidence of the economy expanding

more strongly. As such the case for an increase in the

federal funds rate has strengthened. Reading the tea leaves

of the September FOMC meeting a couple of phrases stand

out. The statements that the monetary policy stance is

appropriate “for the time being” and that near-term risks to

the outlook now appear roughly “balanced” strongly

suggest that the Fed expects to hike in December. Three

officials dissenting in September in favour of a rate hike in

combination with a large majority of analysts expecting at

least one hike in 2016 also suggest that a rate hike is

around the corner. As such, given our baseline economic

scenario where growth picks up in H2, the Fed is very likely to hike rates in one of the upcoming meetings.

With respect to the timing of the next rate increase, the

December meeting looks most likely. The November

meeting is just days before of the US elections and has no

press conference attached to it. At the December meeting,

the Fed can hike rates while at the same time sending

dovish signals using both words and forecasts. The Feds

current rate forecast which is one 25 bp hike in 2016, two

hikes in 2017 and three hikes in 2018 is just 25 basis points

above our own forecast with respect to end-2018. The

market is currently pricing in a better than even chance of a

December hike and remains very sceptical about the

prospect of a series of rate hikes. A very gradual increase in

rate should avoid causing a sharp reversal in EM risk appetite.

Another thing to consider is that Janet Yellen’s first term as

the Fed chair ends in February 2018. While Hillary Clinton is

likely to nominate Yellen for a second term, Donald Trump

certainly isn’t. Many Republicans have been Fed sceptics for

years, calling for a more rule-based approach to monetary

policy. If Trump nominates someone that favours such

ideas it could certainly have monetary policy ramifications.

Classic Taylor rules, for example, are suggesting that

monetary policy normalization already should have gotten

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well underway even when taking the downtrend in the real neutral rate into account.

The election may also have implications for monetary

policy. A President Trump or a President Clinton may both

imply tighter monetary policy over time. While many of the

current economic proposals are unlikely to become law,

especially if the government powers remain divided, there

are reasons to expect more expansionary fiscal policy, the

flip side of which may tighter monetary policy. In the short-

term, however, Donald Trump winning the presidency in

combination with a Republican sweep in Congress would

likely be a risk-off event, at least initially. While not our base

case, it would strengthen the USD and potentially delay the Fed from hiking in December.

INVESTMENT STRATEGY

The improvement in the growth outlook in EMs, relatively

high yields compared to mature markets, and still-cheap valuations have brought back the carry trade.

The correlation between EM currencies and global risk

appetite is well documented and has been particularly

strong over the past year. As the relationship is coincident,

current levels of RAI can unfortunately not be used to

forecast future EMFXI. However, by forming a view on the

future development of RAI one gains a perspective on the

likely development also of EMFXI. Furthermore, deviations

between the indices may be used to spot correction opportunities.

Lately the indices have been very closely aligned but

starting Sep 23 a discrepancy is noted with EMFXI rising

while RAI heads slowly lower. If this development continues

it is a clear warning sign for the budding rise in EM

currencies, while if RAI turns around and also seeks higher

levels, the EM currency strengthening receives further support.

The more straight-forward carry strategy (going long the

three highest yielding currencies and against the three

lowest yielding ones) have returned more than 11% since January, according to SEB’s EM FX carry model.

Per Hammarlund, Mattias Bruér and Karl Steiner

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Clinton vs Trump: Continuity vs unpredictability in relations with China and Russia

Our main scenario is that Hillary Clinton will be the next US

president and we forecast a 70% probability of a Clinton

win. However, events between now and Election Day could

still propel Donald Trump to victory. Here we review how a

Clinton or Trump victory could affect US relations with

China and Russia with a focus on trade policy and

sanctions. Trade policy has uncharacteristically risen to a

top issue in the 2016 presidential election campaign and

both candidates have used a large dose of economic

populism and promised to protect American jobs from

“unfair” foreign competition. Since the year 2000, around 5

million US manufacturing jobs have been lost. Nevertheless,

a Clinton presidency would imply limited changes to current

policies, while a Trump presidency could result in a sharp

departure from status quo, not least in regard to China.

Consequently, we spend a large part of this article

discussing the ramifications of a Trump victory for US policies towards China.

CHINA

Relations between the US and China have become

increasingly tense due to China’s growing presence in the

South China Sea and more recently increasing irritation in

the US over trade issues. The next US president will face a

challenging task in managing the relationship with China. A

central point is the Trans-Pacific Partnership (TPP). The TPP

is a multinational trade deal negotiated by the Obama

administration and 11 other countries, but excluding China.

The agreement contains measures to lower both tariffs and

non-tariff barriers to trade. The TPP is currently awaiting

ratification and is pending approval in the US Congress. The

agreement would bring substantial benefits to the US

economy and a failure to implement it would increase

China’s influence in Asia and risk pushing US allies in the

region toward China. Neither of the presidential candidates

supports the TPP. However, the election campaign has

made it clear that Trump has more radical proposals on

trade policy than Clinton and a Trump presidency would mean much higher uncertainty.

Trump

Trump has taken a particularly aggressive and populist

stance towards China, arguing that millions of US jobs have

been lost due to China’s trade barriers. He has promised to

raise tariffs on Chinese imports to 45% and to declare

China a “currency manipulator” on his first day in office.

Focus lies on trade policies, but Trump has also signaled

that he intends to ramp up US military presence in the South China Sea.

What possibilities would Trump have to slap tariffs on

Chinese imports? Quite good, actually. There are a variety

of broadly written statutes under which a US president can

act to impose tariffs or quotas. For example, according to

the Trade Act of 1974, the president can impose tariffs in

retaliation for an undervalued exchange rate, barriers to

market access or other hinders to US exports. If tariffs were

imposed there would be substantial negative effects on

various US firms and states. Trump would face court

challenges and possibly also attempts by Congress to

amend the statutes. However, such measures would take

time and be difficult to achieve. According to a study by the

Peterson Institute of International Economics, Trump would

need a period of at least a year or two to implement his policies unilaterally vis–a-vi China.

Another question is whether Trump would actually follow

through with his threats, or if he would rather use them as

bargaining chips in negotiations. Based on his election

campaign, he could claim a political mandate to impose

sanctions and his aggressive approach indicates some

follow-through. Trump has held protectionist views for a

long time. However, recent speeches suggest that Trump

may have moderated his stance and that he would listen to

economic advisers, implying that the most radical

proposals, such as the US withdrawing from the WTO,

would be scrapped. At a minimum, with a Trump presidency

there would be no hope of ratifying the TPP and a fair

chance of tariffs on Chinese imports. Trump could also ask

the Treasury to declare China a currency manipulator, but this would have little immediate impact.

China’s exports to the US are equivalent to close to 4% of

GDP and depending on how tariffs are designed they could

have a material impact. However, several factors diminish

the potential impact. Firstly, China is the dominant supplier

of many of the most important goods that the US buys from

abroad, making it difficult to channel demand away from

Chinese suppliers. Secondly, retailers in the US would be

able to absorb some of the tariffs by reducing their margins.

Thirdly, China is likely to retaliate. One response would be

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to allow the yuan to weaken, diminishing the impact of tariffs.

Clinton

During the election campaign, Clinton has been forced to

move closer to Trump’s aggressive stance on trade issues.

Clinton negotiated the TPP as secretary of state but seems

to have changed her mind regarding the agreement. Lately,

she has even said that she opposes the TPP in its current

form. However, Clinton supported Obama’s free trade

efforts during his first presidential term and unlike Trump

does not have a history of opposing free-trade. A Clinton

victory would likely mean that trade agreements remain in

place. There would probably also be a chance of ratifying

the TPP despite Clinton’s stance during the presidential

campaign. She could argue that side agreements have been

negotiated and that the provisions of the TPP have been

improved. The most likely outcome in a Clinton presidency

is a focus on improved enforcement of existing trade laws

and on preventing abuse by trading partners. Clinton has

promised to strengthen enforcement by expanding the US team that monitors trade.

RUSSIA

Russia’s relations with the US had started to deteriorate

already before the conflict with Ukraine broke out, as Russia

has sought to expand its power and international clout.

Besides Ukraine, there are a number of factors such as the

Magnitsky Act, Russia’s decision to grant residency permit

to whistleblower Edward Snowden and the handling of the

civil war in Syria that have soured relations between Russia

and the US. US sanctions on Russia are a result of the

annexation of Crimea and conflict in Eastern Ukraine and a

lifting of sanctions has been tied to a return of Crimea to Ukraine.

While Trump has taken an aggressive stance towards China,

he has a much friendlier attitude towards Russia and has

argued that improved relations with Russia could help the

US defeat ISIS. Trump has said he would consider removing

sanctions and has made several remarks that should delight

Russia and Putin. For example, in July Trump argued that he

would not come to the defense of a NATO ally that hasn’t

paid its expected contribution. Trump has also said that he

would consider recognizing Crimea as Russian territory. In

an apparent signal of tolerance of Russia’s aggression in Eastern Europe, Trump has also praised Putin’s leadership.

Trump’s business relations in Russia have sparked

controversy and there is a lot of uncertainty regarding this.

Some have suggested that these links could affect Trump’s

policy making if he would be elected president. In the event

of a Trump presidency, chances of the US lifting sanctions on Russia would improve.

Clinton has a much more frosty relationship to Russia and

has described the relationship between the US and Russia

as “complicated”. She has also described Putin as a “bully”.

If Clinton becomes the next US president as expected, we

will stick to our view that US sanctions will remain in place for the foreseeable future.

Andreas Johnson

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Theme: Top Three FAQ on ASEAN

QUESTION 1: WHY IS ASEAN GAINING MORE ATTENTION?

ASEAN is gaining attention because it’s looking better than

China. First, ASEAN provides better growth potential than

China. China is clearly slowing and will do so for the next 5-

10 years. ASEAN’s growth is accelerating and countries like

Philippines are now growing faster than China. Vietnam is

coming back (6.7% growth in 2015) as well as up and coming Myanmar (7%).

Second, China has become more expensive relative to

ASEAN. China’s success and rapid growth has increased

monthly average wages to $613 USD, compared to Malaysia

at $651, Thailand $391, Philippines $215, Indonesia at

$1831. Producing out of ASEAN has become much cheaper

and corporates are moving production facilities to ASEAN.

Third, China has started looking outward as the domestic

economy is more stable and growth matures. The easiest

and most logical place to invest would be its neighbors in

ASEAN. Of course, this has had negative impact with

tensions rising in South China Sea. But the economic

attention and investment flow have increased into ASEAN from China.

Fourth, China’s demographics are turning more negative

relative to ASEAN. The chart below shows the dependency

ratio, which is the ratio of the number of people who are

typically not working (below 15 and over 65) vs working

(age 15-65). China’s dependency ratio started to rise, which

means China’s non-working population is increasing. Less

workers lead to slower growth. For ASEAN, this will stay

stable until 2020 and will rise much slower compared to

China (China’s dependency ratio increases faster because of the “one-child” policy).

___________________________ 1 Data from International Labor Organization (ILO) from 2013.

QUESTION 2: WHAT’S YOUR TOP PICK IN ASEAN?

We like Indonesia the best based on two reasons. First,

Indonesia is investing more and somewhat moving towards

China’s high growth model. ASEAN used to have a high

investment and high growth model until it ran into the Asian

Financial Crisis in 1997/98. Since then, investment has

been low but Indonesia is finally starting to invest more and

will grow faster. Second, Indonesia has a clean balance

sheet with low debt. It can borrow and leverage up to

finance the high investment growth model. Of course,

there will be bumps along the way with external shocks.

However, over the 5-10 year time horizon, we think Indonesia is positioned best to be our top pick in ASEAN.

QUESTION 3: WHAT ARE THE MAIN RISKS IN ASEAN?

We’ll divide the main risks into economic and political. On

economics, the main risk is growing too fast that can lead to

imbalances and overheating. In a world of negative interest

rates and excess liquidity, ASEAN looks attractive to

international investors and inflows can happen rapidly.

Many of these economies have under-developed capital

11


markets and risk management infrastructure. Money can

go into unprofitable investments and lead to bubbles. The

risk is that ASEAN bites off more than it can chew. The

central banks need to be prudent and raise interest rates appropriately as the economy heats up.

On politics, we are not as worried about populism and

scenarios like Brexit taking shape because it is already

happening. President Jokowi’s win in Indonesia was largely

the people voting for a commoner over the ruling elites.

President Duterte’s victory in Philippines is similar.

The main risk is that ASEAN getting more attention is a

double edged sword. The competition between the two

superpowers, US and China is being played out in ASEAN

where they are trying to win influence. Unfortunately, the

next step is that China and US may start meddling in

domestic politics to get their person in office. This is usually

not favourable to the people in ASEAN and can be a catalyst for division.

Sean Yokota

12


Theme: China’s rebalancing leads to slowdown

REBALANCING TO CONSUMPTION HAPPENING

China has often been criticized by the international

community for its high investment and low consumption

growth model. However, as you can see from the charts

below, the rebalancing is starting and in recent months, fixed asset investment growth has taken another leg lower.

The government is taking notice and making noise. In May,

the state council sent out 9 investigatory teams to 18

provinces to carry out special inspection into the

investment slowdown. Also in July, the cabinet unveiled

detailed measures to support investment, including

widening financing channels for firms and establishing new equity funds.

However, we don’t think these measures will make a big

difference and the slowdown in investment will continue.

The good news is that restructuring is taking place. The bad

news is that China’s slowdown will accelerate going into

2017 and put downward pressure on things like commodity

prices. Here are three reasons why we think investment will slow going forward.

MORE PRIVATE ENTERPRISES MEAN THEY FOLLOW PROFIT OUTLOOK NOT WHAT GOVERNMENT SAYS

First, the increase in private sector enterprises relative to

state owned enterprises (SOEs) comes with short term

costs. The chart below shows the number of private

enterprises jumping in the last 15 years and dominating the

number of SOEs. Having more private enterprises mean

that they won’t increase investment just because the

government tells them to. They invest in line with the profit

outlook and not to appease the government. This makes it

more difficult for the government to create instant stimulus.

You see this clearly in the chart where the economy

collapsed post the Lehman crisis in 2011 and the number of

private sector enterprises dropped by going out of business

(and some extent to number of foreign firms). On the other

hand, the number of SOEs didn’t budge. The private sector

responds to the economy and economic outlook. Private

firms don’t see the profit outlook improving and are slowing investment.

DOMESTIC INVESTMENT WILL SLOW DUE TO OUTWARD INVESTMENT

Second, more businesses will invest overseas and not in

China. Businesses are experiencing the slowdown in growth

and it makes sense to invest in places where the economic

outlook is better. Furthermore, the currency weakness can

fuel outward investment. As you can see from the chart

below, RMB weakness coincides with increase in outward

investment. It’s difficult to tell the causality as to whether

weaker RMB led to more outward investment or outward

investment is causing RMB weakness. Regardless of the

trigger, when currency weakness starts, businesses tend to

increase outward investment. Furthermore, some

businesses increase outward FDI to mask sending money abroad to speculate on further currency depreciation.

13


REAL ESTATE INVESTMENT GROWTH WILL FADE

Third, real estate investment will decline. Real estate

investment accelerated at the beginning of the year and

peaked in April, with government’s removal of austerity

measures. However, the growth in property prices has

increased too fast due to loose monetary policy and the

government has reverted to tightening measures again. We

are already seeing property prices decelerating and this should slow real estate investment growth going forward.

CHINA TO SLOW DOWN TO 6.6% IN 2016 AND 6.3% IN 2017

Investment slowdown is a natural cost of the economy’s

rebalancing towards consumption and services and we

expect the downward trend to remain into 2017. This will

drag the economy slower and we’ll see a slowdown

beginning in Q3 GDP. While this is negative for China and

commodities short term, the rebalancing is positive long term and reduces the risk of a hard landing.

Sean Yokota

14


Country Section

Asia

China

Macro: The economy will continue its slow grind lower from

6.8% in 2015 to 6.6% in 2016 and 6.3% in 2017.

Manufacturing and heavy industry will be the main drag on

growth as the government rebalances towards less capital

and debt intensive services and consumption. The Achilles’

heel of China’s economy is the total debt at around 250%

of GDP and how to grow without reliance on debt.

President Xi will move forward with lower growth as a cost

to avoid a debt crisis in the future. The tolerance of how

low growth can go will depend on the development in the

labor market. The government believes that generating 10

million jobs a year will keep the labor market stable. The

increase in the service sector has cushioned the slowdown

but the economy will keep decelerating. Service sector job

growth has been concentrated in people starting their own

business. This helps achieve job growth targets but salaries

at small businesses are typically lower than working in a

factory. The lower income growth will be reflected in lower GDP growth.

Monetary policy will become slightly tighter. Policy was

loosened previously to support growth in construction and

the manufacturing sector. Property has been the best

sector and now prices are rising over 30%yoy in major first

and second tier cities. The government will tighten to

prevent reverting to the old borrow and grow model that

can increase hard landing risks. Administrative measures in

the property market started in March such as requiring

larger down payments on mortgages. That hasn’t worked

well and more measures will be passed. The government

adjusts by regulation and window guidance and thus interest rate levels will not change.

FX/Rates/Equity: CNY will depreciate slightly to end 2016

at 6.80. Relative fundamentals with weaker China growth

vs an accelerating US economy and a rate hike by US will

weaken CNY. CNY will become a cyclical currency like all

other currencies and we don’t see a recovery in CNY until

economic fundamentals accelerate. On rates, we want to

receive or hold government bonds since we expect no

change for this year but more cuts in 2017. Also interest

rates need to remain low to smoothly roll over short term

wealth management products. The government will start

running larger fiscal deficits, reaching 3-4% of GDP but

with lack of high quality bonds, demand will be strong

enough to keep long rates stable. Low rates will put a floor

in equities but for the Shanghai Composite to break 5,000

again, it will need better fundamentals, which is again an economic acceleration.

India

Macro: India is taking over China as the high growth

economy at 7.6% in 2016 and 7.8% in 2017 compared to

7.3% in 2015. The economy will continue to improve from

lower inflation that has almost halved from over 10% to

6%. Lower inflation is supporting consumption and that is

spilling over to higher production and investment. We

expect inflation to remain low and allow RBI to deliver

50bps of cuts in the policy rate to 6.00%, which will further

support growth in 2017. Furthermore, Prime Minister Modi

has finally delivered on reforms with passage of the Goods

and Services Tax which allows for greater productivity gains

for corporates by reducing red tape. It should also make

states compete for investment by providing better hire/fire

requirements and preferential treatment in acquiring land.

The reforms go into effect in early 2017 so we will not see real impacts until 2018.

The main risk to India is the weak banking sector that is

carrying non-performing assets. However, the recent

passage of the Bankruptcy Law allows the banks to write-

off those assets and frees the balance sheet to make new

15


loans, which will also be supportive for the economy. Again, implementation will be in 2018.

The central bank and monetary policy has been overhauled.

The inflation targeting has recently been cemented into law

and the previous system where the governor alone made

the interest rate decision has been replaced by collective

decision making in a six-member monetary policy

committee. The choice of Urjit Patel succeeding Raghuram

Rajan as governor signals continuity and we expect no

major changes in the direction of monetary policy nor a weakening of central bank independence.

FX/Rates/Equity: Going into year-end 2016, we expect a

mild weakening in INR to 68 from higher US interest rates

and increase in outflows due to expiration in measures

passed in 2013 that stabilized the currency. But, that

should be the peak and INR should strengthen from there

due to attractive yield and stronger economy. Also, despite

50bps in cuts, RBI will keep real rates positive to support

the currency. 4Q will be a good time to build long INR positions.

For rates, we prefer to receive the front end, since we

expect more rate cuts and for the curve to steepen since we

expect economic growth to regain traction and push up the back end.

The equity market should continue to do well with

monetary easing and economic recovery. Foreign flows are

returning as investors exit underweight emerging market

equity exposure. We also believe that domestic buying will

increase as they see a better growth environment coupled with low inflation.

Indonesia

Macro: Indonesia’s growth should finally accelerate to

5.0% in 2016 and 5.6% in 2017 compared to 4.8% in 2015.

Growth has been declining since 2011 from the fall in

commodity prices where Indonesia is heavily exposed. We

think commodity prices are reaching a trough and should

not drive growth lower from here. Another growth driver

was credit growth but that has more than halved since

2013, slowing down investment and consumption.

Indonesia still has low debt and can leverage up, unlike

China. However, the weakening currency has forced the

central bank to keep tighter policy and that has stalled

credit growth. With a more stable currency, the central

bank has been able to reduce interest rates by almost

225bps and that will get the credit cycle started again and

push growth higher in 2017. Lastly, the credibility of

President Jokowi and the government was recently boosted

by appointment of Dr. Sri Mulyani Indrawati as Finance

Minister. She will keep spending in check and more importantly improve tax collection.

The main risk is a sharp rise in US interest rates and yield.

As a current account deficit economy and recipient of

global capital flows due to its high attractive yield, rising US rates can lead to rapid capital outflow.

FX/Rates/Equity: IDR will depreciate into end of the year

towards 13,900, compared to 13,100 currently like everyone

else from expected US rate hike. The government is

choosing growth over currency to grow the manufacturing

sector. With the fall in commodity prices and exports,

manufacturing needs to be the new growth engine and a

weaker currency will help develop this sector. Also, the

government is cutting interest rates to increase domestic demand, again with the cost through a weaker IDR.

For rates, we prefer steepeners or paying the back end since

we expect some recovery in economic growth and inflation

expectations to rise. We think receiving front end will also work as we expect another 25bps of rate cuts into 2017.

The equity market has been a top performer in 2016 and is

one of the most expensive in Asia. It may underperform

other Asian markets but with interest rate cuts and healthy economy, equity prices should continue rising.

South Korea

Macro: Korea has shifted from 5% to 3% growth economy.

As a manufacturing power house, the slowdown in global

trade and global demand weighs on growth. Furthermore,

Korea’s private sector debt is one of the highest in the world

and prevents corporates and households to borrow and

grow. Bank of Korea has set a policy that will require

households to deleverage and will keep growth limited.

Lastly, Korea is heavily reliant on Chinese demand and will

be impacted by the structural slowdown in China. Growth

will rebound slightly to 2.8% in 2017 from 2.6% in 2016 and

2015 on the basis of slightly better global demand and some relaxing in property measures.

Korea’s risk is to the downside in the next 12 months with

increased tensions with China. Relations between China

and Korea have been very healthy but recently it has taken

a 180 degree turn with Korea installing self-defense missiles

on the North Korean border. China sees this as another

16


step by US to contain China and will likely fight back with

unannounced sanctions against South Korea. China is South Korea’s biggest trading partner and can be damaging.

FX/Rates: Korean Won (KRW) will weaken following the

rest of Asia towards 1200 by year end compared to 1110

currently. The large current account surplus and capital

inflows have helped Korea but they can both turn with

tensions with China rising. Korea will cut interest rates to

support growth but it is reaching a limit at 1.25% and we only expect a 25bp cut in 2017.

The equity market should underperform. Interest rate cuts

will provide some support but Korea is shifting to a mature

economy with limited upside in growth and asset prices and

will become less attractive. Furthermore, competition is

increasing from Japanese companies focusing on market

share (under-cutting prices) and Chinese companies moving up the value chain.

Malaysia

Macro: Malaysia’s economy is expected to slow to 4.1% in

2016 from 5.0% in 2015 but recover to 4.2% growth in

2017. Prime Minister Najib gave cash hand-outs 3 years ago

to influence the last election and he will be reversing them

in 2016, which will weigh on growth. In addition, exports

are slowing since Malaysia is a major exporter of palm oil

and natural gas. The lower commodity prices will also

reduce tax revenues and slow public and private investment.

Political risk has increased over scandals on the

government owned 1MDB strategic investment company

that may have misallocated funds and struggled to meet

debt obligations. Default risk has subsided from sales of

assets to China but Malaysia’s governance structure are still

under question and putting pressure on PM Najib’s political

position. It seems that Najib has eliminated his critics and will hold on to his position but the situation is still fluid.

FX/Rates: MYR was the worst performing currency in 2015

from a perfect storm of rising US yields, lower commodity

prices reducing the current account surplus and political

risk. In 2016 MYR has been the star driven by the recovery

in commodity prices. Going forward, MYR will weaken into

year-end with lower commodity prices from a China

slowdown but the bulk of the weakness is finished. The risk

is foreigners still owning half of the government bond

market and inflows will not increase as US yields become

more attractive, China stops accumulating FX reserves and

buying Asian bonds. Interest rates will be reduced by 50bps

to 2.50% to help growth in a low inflation environment and credit growth at all-time lows.

Rates will fall and receiving in the front end makes sense.

Backend should be avoided since we don’t expect growth

but fiscal situation may deteriorate from lower revenue related to lower oil prices.

Philippines

Macro: The economy’s trend growth has increased from 4-

5% to above 6%. Former President Aquino’s cleanup of

public debt, improved governance and lower inflation

environment have worked. In the short run, growth should

accelerate to 6.7% in 2016 compared to 6.3% in 2015 but

should ease back to 6.4% in 2017. Monetary stimulus of

100bps cuts and a rise in public investment into the

Presidential election have boosted growth. With the

election over, the positive effects will wear-off and lead to a

mild slowdown in 2017. The risk to the economy is to the

upside since the new President Duterte may keep public

investment high at the beginning to kick start his

Presidency since many lower income households are feeling

left out of the increase in GDP trend growth. The flip side is

that President Duterte keeps increasing fiscal stimulus and

the structural adjustment President Aquino implemented gets reversed.

FX/Rates: PHP underperformed going into the Presidential

election due to the event risk but it has gained post the

election. The current account surplus has fallen from

slower remittances due to slower global economy but

remains solid. The rise in foreign direct investment has also

secured long term inflow which will support the currency.

The currency should outperform in the region. Also, the

Philippines will be supported by higher interest rates and

we think it will be one of the first economies to hike rates in late 2017.

Singapore

Macro: Singapore is similar to China and has chosen to

slow the economy to improve the quality of growth. The

government has also slowed immigration to reduce the

concern over inequality. This has led to a fall in trend

growth from 5-6% to 2%. Going forward, we don’t expect a

big change in this strategy. Furthermore, as a small, open

economy, Singapore’s growth will remain subdued along

17


with the global economy. Growth will reach only 1.8% in 2016 and 2.0% in 2017.

We think the domestic economy will be tough because

Singapore inherits much of the rise in US interest rates and

crimps the property market. Most mortgages are flexible

rates and the impact is felt very quickly by households and

reduces consumption. We are getting some relief with rates

falling from 1.75% to 0.6% due to a more dovish Fed but

that can easily turnaround into 2017 and weigh on the domestic economy.

The upside risk to Singapore is a shift in government policy

to favor growth. We are looking for loosening in the

property market as a signal for the shift. The easiest

adjustment is to remove the stamp duty that was placed on home sellers.

FX/Rates/Equity: SGD should stay around the 1.35-1.45

range in the next 12 months vs USD. The MAS has moved to

neutral policy with 0% appreciation slope in its currency

policy. With headline inflation declining, MAS should still

have an easing bias. Core inflation remains higher at 1%

but we think it’ll follow headline inflation over the long run.

However, unless we get a more aggressive move from the

Fed, policy will remain unchanged for the next 12 months.

The equity market should remain subdued with an

uncertain interest rate environment and weak economic outlook.

Thailand

Macro: Thailand’s economy has been on a roller coaster

since the Global Financial Crisis in 2008 followed by

adverse weather and political instability. Since 2015 the

economy has been more stable at around 3% growth but a

step lower than the 5% growth rate it enjoyed before 2008.

As long as we have political stability, the economy will be

growing at 3% in 2016 and 2017. Politically, the recent

approval of the constitution is a positive step towards

normalization. Public investment should be positive as the

military has full authority to allocate funds and it wants to

support the economy so that the election scheduled for November 2017 moves smoothly.

With political stability and relaxation of visas for China,

tourists have stormed back to Thailand; supporting the

economy. Tourism spending shows up as exports of

services and the current account surplus has ballooned to

over 10% of GDP. Furthermore, this has trickle down

effects where it supports incomes for small and medium sized enterprises and increases consumption.

Foreign direct investment has slowed with weaker

economic growth and political issues but it has been more

stable than we had expected. Thailand still is an attractive

location to invest in since it is efficient and infrastructure is

relatively strong. Also, wages are not rising as fast since

Thailand has relaxed immigration laws that allows imports

of workers from lower income countries (e.g. Myanmar, Vietnam).

FX/Rates/Equity: Monetary easing has corrected over-

valuation in THB. THB will weaken towards 36 with a Fed

hike along with another 25bp interest rate cut by Bank of

Thailand. Low and subdued inflation provides room for

easing. However, post the Fed hike, THB should again

strengthen as inflows are expected to increase as global

investors look for yield. Also foreign investors are most

likely under-invested in Thailand due to the political

instability and money should flow back into Thailand’s equity market.

Emerging Europe

Czech Republic

The CZK is getting closer to experiencing a sharp and

sudden appreciation against the EUR. When the Czech

National Bank (CNB) removes the EUR/CZK 27.0 floor, the

pair looks set to plunge from 27.0 to 24.0 before settling

around 25.50. It may even touch as low as 23.0, last seen in

2008. The CNB has pledged to keep the floor until mid-

2017, but has recently indicated that it may extend the

18


policy further. However, we expect the CZK’s “Swissie

Moment” to come sooner than the central bank is indicating due to signs of a looming rise in inflation.

The EUR/CZK floor is an attempt to lift inflation, and with

imports equalling some 75% of GDP, a weak exchange rate

should help boost domestic prices. Comparing Czech

inflation to those in Poland and Hungary, it appears that the

CNB has been somewhat successful. Whereas both Hungary

and Poland have experienced deflation, the Czech Republic

has not seen prices fall. Nevertheless, inflation has been

stuck below 1% since 2014, reaching only 0.6% y/y in August 2016.

The key signposts of rising underlying inflationary

conditions in the Czech Republic are continued monetary

supply growth, a tightening labour market and strong wage

growth. In addition, both business and consumer

confidence are at their highest levels since 2008. With

unemployment at 4.2% — among the lowest levels in the

EU — inflation-generating private consumption will be the main driver of 2.6% growth in 2016 and 3.0% in 2017.

Nevertheless, all indicators are not pointing in the same

direction. Despite strong domestic demand, inflation has

not picked up due to virtually non-existent international

price pressures. With growth in both the EU and the US

disappointing, global inflation will continue to be subdued.

In addition, Czech PMI, industrial production, and retail

sales plunged in July following the Brexit vote. While the

manufacturing PMI recovered to 52.0 in September, it

remains vulnerable to the German business cycle. The

Czech economy is, like Poland and Hungary, strongly linked

to the German export sector, which saw sales drop by more than 5% in July, the largest fall since 2008-09.

The central bank is in a pickle. If it waits to remove the floor,

speculative capital will be pouring in, making an adjustment

later much more volatile than it would be now. In addition,

the CNB would take an exchange rate loss, as its swelling

reserves would be worth less in CZK terms. The longer it

waits, the bigger the cost. One strategy could be to lower

the floor gradually, but that would only feed speculation of further CZK appreciation.

The CNB will likely keep the floor for now as the CZK is not

out of line with the PLN and HUF exchange rates. The bank

is even considering cutting its policy rate into negative

territory, but MPC members have so far resisted, believing

that the cost is greater than the benefits. A short EUR/CZK

position is all about timing. As long as Czech inflation and

German export growth stay low, the CNB will keep the floor.

However, when they improve, the CNB has a strong incentive to remove the floor sooner rather than later.

Hungary

The Hungarian economy decelerated markedly in H1 2016.

The transition between two EU funding cycles has resulted

in a slowdown public investment. Net exports are expected

to continue supporting growth but the primary growth

driver will be consumption, benefitting from strong real

income growth. Employment continues to rise and

unemployment reached a record low of 5.0% in July. There have also been wage hikes in the public sector.

The central bank has not been close to the 3% inflation

target for several years. In August inflation was -0.1% y/y.

The policy rate is currently at a record low of 0.9% and we

expect the rate to remain at this level. The central bank

prefers to use unconventional policy measures rather than

touching the policy rate and in September cut the amount

of cash that banks can store at central bank deposits. The

intention is that funds should be shifted from the central

bank to the interbank or debt markets, reducing borrowing costs.

The HUF is among the best performing EM currencies in

2016 and there are several supporting factors. Hungary has

reduced external borrowing, there is a current account

surplus and the banking sector has deleveraged. Public

finances have strengthened. The currency has also gained

from Moody’s and S&P’s upgrade of Hungary to investment

grade in May and September, respectively, boosting inflows

into Hungarian assets. Going forward, most gains for the

19


HUF are likely to have happened already and the central bank wants to prevent excessive appreciation.

The referendum on EU refugee quotas on 2 October saw

98% of voters siding with the government’s refusal to

accept migrants under the EU’s quota system. While voter

turnout fell short of the required 50%, Prime Minister Orban

declared the result a victory. It is not clear what Orban will

do next but one possibility is that he will hold early elections in order to take advantage of the referendum’s momentum.

Poland

The PLN is trading at the weakest levels since 1990 in “de-

trended” real effective exchange rate (REER) terms. While a

further weakening is unlikely due to a strong

macroeconomic outlook, a sharp and substantial

strengthening of the PLN is not in the cards. We expect the

PLN to appreciate gradually, pushing down the EUR/PLN

pair to 4.25 in Q4 2016 and 4.20 in Q1 2017 on the back of

increasing global risk appetite and a slow economic

recovery in the EU. Nevertheless, risks are skewed towards

a weaker PLN due to potential domestic political surprises,

which could again push EUR/PLN up to between 4.40 and 4.50.

Real GDP looks set to expand by around 3% in 2016, again

one of the fastest growth rates in the EU, driven by strong

domestic demand. Poland is currently experiencing

deflation, and prices look set to fall by almost 0.5% in 2016.

Nevertheless, the National Bank of Poland is unlikely to cut

its policy rate further from the current 1.50% unless the

economy slows down sharply or the PLN strengthens

unexpectedly against its CEE peers, CZK, HUF, and RON.

The current account deficit has been reduced to a trickle

and will likely reach only 0.5% of GDP in 2016. Polish

industry is a supplier to the German export sector. The key

risk is weak German exports, which together with strong

Polish domestic demand could widen the current account

deficit and lower demand for PLN. However, so far, FDI fully

covers the current account deficit, although it has fallen lately.

The key downside risks are already mostly priced into the

PLN. The new proposal from President Andrzej Duda on

how to address the CHF-mortgage-loan problem is much

less onerous to banks than initially feared. The

constitutional crisis will rumble on through at least

December, when the term of the current chair of the

constitutional court, Andrzej Rzeplinski, ends and the

government can ensure the election of a new head that will

be more amenable to the government’s agenda. A lowering

of the retirement age, free medicine for the elderly, a new

retail tax are known political (budget) risks as is the planned

renationalisation of parts of the polish banking system.

Nevertheless, the main risk to Polish assets including the PLN is worsening politics.

Russia

The worst of the recession has now passed and slightly

higher oil prices are providing some support to the

economy. The recovery is primarily driven by industry;

industrial production and exports are recovering. It is more

difficult to see a turnaround in consumer facing sectors.

The inflation slowdown has helped to stop the fall in real

wages, but retail sales remain under pressure and are still

falling in year-on-year terms although the decline has

slowed. The recovery will be fragile and slow. We expect

GDP to fall by 0.4% in 2016 and to climb slowly in 2017 by 1.0%.

Parliamentary elections on September 18 saw United Russia

and Putin cementing the grip on Russian politics despite the

weak economy. The outcome implies that current economic

policies will remain in place. Fiscal policy will have to handle

the budget deficit and will primarily hurt public sector

investments since government tries to avoid cutting social

spending. The central bank is expected to continue cutting

the key interest rate as inflation decelerates but easing will be slow and gradual.

The parliamentary election will not improve relations

between Russia and the West and does not change our view

of the Western sanctions. Support for the sanctions has

20


eroded in various EU countries but the recent flare up in

tensions between Russia and Ukraine has reduced the

likelihood that the measures outlined in the Minsk 2

agreement necessary for lifting sanctions will be

implemented. We predict another extension of EU sanctions

beginning of 2017. The US has tied lifting of its sanctions to

a return of Crimea to Ukraine. This is highly unlikely and we

expect most US sanctions to remain in place for the

foreseeable future although a Trump victory in the US

presidential election would increase the probability of a lifting or easing of sanctions.

The RUB has been one of the best performing emerging

market currencies this year. Although the correlation

between the rouble and the price of oil has weakened due

to rising risk appetite driving capital to EM, the currency’s

fortunes remain highly dependent on energy prices. The

RUB has appreciated as oil prices have recovered. SEB

forecasts that the price of oil will average $50/barrel in H2

and we expect USD/RUB to strengthen slightly from current

levels to 61.0 at the end of 2016. At the end of 2017 we

expect USD/RUB to be 66.0. The two key risks to the rouble

is a renewed fall in the price of oil and increasing tensions

with the EU and the US. Volatility could be significant driven by changes in the price of oil.

Turkey

The TRY is facing increasingly strong headwinds, but will

not suffer a sharp selloff or crisis. We expect it to average

3.05 against the USD in Q4 (currently 3.05) and to 3.10 in

Q1 2017. Deviations from the average will present buying

and selling opportunities, when global risk sentiment turns.

The main risks for the TRY are on the downside. It may

suffer from tightening global liquidity, as well as domestic

political risk, and it is vulnerable because it is not particularly cheap.

The outlook for the TRY has soured since our last EM

Explorer from April 2016. The coup attempt on July 15 and

the ensuing purge of potential Gulenists in state institutions

and the corporate sector have cast a pall over the business

environment and raised doubts about the quality of the rule

of law. While it is too early to tell if the police and justice

system will be permanently undermined by the dismissal of

between 9,000 and 10,000 police officers and close to

3,000 members of the judiciary, unpredictability is weighing

heavily on investor sentiment. Equally importantly is the

slowing economy, a trend that was apparent already before

the failed putsch. Real GDP growth slowed to 0.3% q/q in

2Q 2016, and monthly indicators such as industrial

production, business confidence, and retail sales point to a

further slowdown in 3Q. We expect annual growth to reach

only 3.0% in 2016 and 3.1% in 2017, driven primarily by

government and private consumption. Investment and sluggish external demand will be drags on overall growth.

The economic slowdown is contributing to the central

bank’s easing bias. The bank started easing monetary policy

in March 2016. The TRY’s main Achilles heel remains the

reliance on short-term financing of its sizeable current

account deficit, estimated to reach 4.5% of GDP in 2016.

Falling interest rates will reduce carry and potentially

increase volatility as global risk appetite waxes and wanes.

The deteriorating growth outlook and political uncertainty

(regarding not only the purge of Gulenists and crackdown

on media, but also an executive presidency, the Syrian war,

and the Kurdish conflict), have prompted both S&P and

Moody’s to lower their sovereign ratings. The downgrades

have left Fitch alone among the big three to keep Turkey as

investment grade. We expect Fitch to follow the other two

in the coming six months. Although the downgrades are

largely priced in, they will add to the headwinds facing

Turkey, ensuring that there will be no quick rebound in markets.

Ukraine

Ukraine is past the acute crisis and the economy has

stopped contracting. In Q2, GDP growth was 1.4% in year-

on-year terms. Industrial production is recovering and

although retail sales are still falling in year-on-year terms

the drop has decelerated. Rebuilding in conflict-hit areas will contribute to investment going forward.

The recovery will be weak, however. GDP is expected to

grow by 1.0% in 2016. In 2017, growth will accelerate

cautiously to 2.0%. The recovery will be dependent on

continued structural reforms and support from the IMF and

the EU. In mid-September, the IMF approved the third

tranche of the four-year Extend Fund Facility program worth

USD 17.5bn. The tranche was disbursed following a

yearlong delay and was reduced to USD 1bn due to slow

implementation of reforms, primarily measures to curb corruption.

The government reshuffle and appointment of Volodymyr

Groysman as prime minister this spring has stabilized the

domestic political situation but several key reformers have

left and the contentious political environment means

government will struggle to deliver reforms. Going forward,

21


there is also a risk that a less acute economic situation and

a recovery in foreign exchange reserves will reduce

incentives to implement politically difficult reforms such as pension reform.

CPI inflation has decelerated sharply and was 8.4% in

August, compared to the full year average for 2015 of 48%.

The inflation slowdown and a more stable currency has

allowed the National Bank of Ukraine to cut its key interest

rate from an eye-watering 22% at the beginning of the year to the current rate of 15%.

The UAH has weakened since the start of the year and the

recent intensification of the conflict in eastern Ukraine has

weighed on the currency. Foreign reserves have recovered

but are still too small to allow the central bank to intervene

to support the UAH. The NBU continues to liberalise capital

controls but many restrictions still remain. The loosening of

capital controls can result in capital flight, weakening the

UAH but the primary risks to the currency are linked to the

domestic and foreign political development and to the

continuation of the IMF programme. We see the USD/UAH rate ending 2016 and 2017 at 27.00 and 28.00, respectively.

Latin America

Brazil

Signs are growing stronger that the economy has passed its

worst downturn. Industrial production and retail sales have

begun to rise cautiously on a monthly basis. Exports are

recovering and the current account deficit has decreased

substantially. Inflation has started to slow and this trend will

continue driven by low capacity utilisation and fading

effects from earlier hikes of regulated prices. GDP is still

falling in year-on-year terms but the decrease is

decelerating and we expect positive growth to return in 2017.

The domestic political situation has stabilised following

former president Dilma Rousseff’s permanent removal from

office. The new government under Michel Temer has

launched market-friendly and ambitious reforms but

ultimately it is implementation that will be decisive. The

reform focus lies on the very weak government finances

with a budget deficit of more than 10% of GDP.

Constitutional amendments and a pension reform are vital

for the austerity plan to succeed. Budget-cutting is critical

for monetary easing; the central bank has said that there is

no room for cuts unless public finances improve. Economic policy therefore has little scope to boost demand.

Both the stock market and the BRL have rebounded

strongly this year. Rising commodity prices, an

improvement in EM risk sentiment and expectations of

market friendly reforms are the most important drivers. The

real is one of the best performing currencies this year and

the central bank has intervened to try to stop the

appreciation since a strong currency is a threat to the

export-driven recovery. The permanent removal of former

President Dilma Rousseff has eliminated one of the key

risks to the real and the rally is expected to continue for a

little while yet. We expect the USD/BRL exchange rate to be

3.00 at the end of 2016. In 2017 the real will retrace part of

the gains as the great need for structural reforms are

unlikely to be met and the central bank starts cutting the key interest rate.

Mexico

The MXN has been the worst performer in our EM FX

universe year to date. In fact, it has been the only currency

to generate a negative return including carry. That

performance is contrary to our cautiously optimistic view in

our last Explorer in April. While the MXN will not continue to

weaken at the same pace as it has over the last couple of

years (the MXN fell by 35% against the USD between June

2014 and September 2016), a quick rebound similar to the

recovery of the BRL is unlikely. The MXN looks oversold, but

there is no obvious trigger that could initiate a reversal of

the trend. We expect USD/MXN to reach above 20.00

before the US election in November. Assuming that Hilary

Clinton wins, the MXN will retrace part of its recent losses, touching 18.75 in Q4 and 19.00 in Q1 2017.

22


The immediate cause of the recent depreciation of the MXN

is the rise of Donald Trump in polls for the November US

presidential election. His plans to build a wall along the

border with Mexico and to make Mexico pay for it sound

unrealistic. Nevertheless, even a scaled-down version

combined with tariffs on imports from Mexico would hurt

the Mexican economy, which sends some 80% of its

exports to the US. The effect that Trump has had on the

MXN is also visible in MXN option volatilities, which show

particular uncertainty around the election date. If Hilary

Clinton wins the election, as we expect, the Trump effect

will dissipate. The MXN will experience a sharp, short-term

rally as a result. However, due to the structural causes of the

MXN’s weakness and low carry, the rebound will not be the start of a new trend appreciation of the MXN.

The underlying reasons behind the depreciation of the MXN

— sluggish growth, a fiscal dependence on oil, corruption,

and weak rule of law — will not go away anytime soon. In

particular, the oil sector generate roughly 30% of

government revenue and with oil seemingly stuck around

$50/barrel, budget cuts are necessary. Hence, growth will

take time to recover, even if growth in the US picks up. The

failure so far to put public finances on a sustainable footing

prompted the S&P to revise the “Outlook” on its BBB+

sovereign rating to “Negative” from “Stable” in August. The

new finance minister, Jose Antonio Meade (who followed

Luis Videgaray after he resigned over Trump’s visit), has

pledged to achieve a primary budget surplus in 2017. If he

succeeds and if it coincides with the positive effects of

recent year’s structural reforms starting to show, it could

provide the trigger needed for a longer term recovery in the MXN.

Sub-Saharan Africa

South Africa

The ZAR has been on a long-term weakening trend since

June 2011. That trend will not be broken. The main drivers

behind the depreciation are sluggish growth, low

commodity prices, a political inability or unwillingness to

undertake macroeconomic reform, and deteriorating public

finances, and these factors will not go away. However, it has

appreciated by some 3% against the USD, over the past

year, and by a remarkable 23% since January 20, 2016.

USD/ZAR (currently 13.70) is trading near the “bottom” of

the trend channel, and may even briefly break below the

floor of the channel around 13.18–13.20. Low global

interest rates, a very cautious US Fed, and continued strong

growth in China (giving short-term support to commodity

prices and risk sentiment) should continue to bolster the

ZAR in the coming 1–2 months. Nevertheless, we expect the

ZAR to weaken gradually over the coming six months reaching 14.00 in Q4 2016 and 14.20 in Q1 2017.

The South African economy is facing a number of

challenges. The mining sector and export earnings are

being pressured by a long-term downward trend in

commodity prices. State-owned enterprises and utilities

need to be reformed. Growth is slowing to a trickle this year,

reaching only 0.3%, due to weak external demand growth

and low real domestic demand growth due to high inflation.

Growth is also held back by reduced fiscal flexibility and

structural bottlenecks in the mining and manufacturing

sectors. Market-friendly reforms such as those outlined in

the National Development Plan (NDP) are held back by a

socialist ideology dominant in the ruling ANC party, as well

as the risk of escalating social tensions. The ANC is losing

support among younger voters and will be reluctant to take

unpopular decisions. The student demonstrations in

September are a case in point, but labour relations also

have a history of violence. In addition, the ongoing power

struggle between the presidency, Jacob Zuma, and the

finance ministry under Pravin Gordhan, is weighing on

sentiment. Lack of progress on fiscal consolidation has lead

to rating downgrades, leaving South Africa at the cusp of

“junk”. While downgrades are probably not imminent as

gross government debt is still well below 60% of GDP, we

expect S&P and Fitch to downgrade their ratings to “BB+” over the coming year.

The South African Reserve Bank’s (SARB) hiking cycle has

taken a pause, leaving the main policy rate at 7.00%. As

long as global risk appetite remains favourable and the Fed

23


dovish, the SARB will stay on hold. Inflation has moderated

to just below 6% largely due to the strengthening of the

ZAR. Stagnant interest rates, weak macroeconomic

fundamentals, and now a relatively strong ZAR suggest that the potential for further appreciation is limited.

24


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Emerging Markets Explorer - SEB Group · 2016-11-23 · 4 Emerging Markets Explorer SEB EM Forecasts FX Rates (end of period) Policy Rates (end of period) 06-Oct-2016 Spot 1M 4Q-16