Emerging Markets: What has Changed

(from my colleagues Dr.Win Thin and Ilan Solot)

1) The Czech central bank (CNB) gave us some details about its intervention program

2) Tensions are escalating again with China’s new East China Sea Air Defence Identification Zone (ADIZ) initiative

3) Protests in Thailand are escalating

4) Brazil risks are tilting back towards the negative side

5) The yen-won cross seems to be in play once again

Over the last week, Taiwan (+3.5%), Mexico (+3%), and India (+3%) have outperformed in the EM equity space in local currency terms, while Indonesia (-1.5%), Russia (-1.5%), and Brazil (-1%) have under performed.

In the EM local currency bond space, Brazil (10-year yield up 24 bp), Turkey (up 22 bp), Russia (up 16 bp), and South Africa (up 12 bp) have underperformed over the last week, while China (10-year yield down 22.5 bp), Thailand (down 14 bp), and Colombia (down 12 bp) have outperformed.

In the EM FX space, INR (+0.7% vs. USD), PHP (+0.2%), and KRW (+0.2%) have outperformed over the last week vs. USD, while IDR (-2.2%), BRL (-2.2%), CLP (-2%), and RUB (-1.2%) have under performed.

1) The Czech central bank (CNB) provided some details about its intervention program. The bank has sold some CZK200 bln ($9.9 bln) so far, most of it just after they the announced the program on the November 7. Moreover, official comments stated that the bank will keep this program “at least to 2015.” The risk to EUR/CZK still seems to be skewed towards the upside for several reasons: (1) the CNB is committed to the EUR/CZK 27.0 floor for now, (2) there are no practical constraints to their execution capacity, and (3) some MPC members are rumbling about raising the floor further to 28.0.

2) Tensions are escalating again with China’s new East China Sea Air Defense Identification Zone (ADIZ) initiative. The ADIZ is a unilateral attempt to impose new rules on the airspace of the islands whose ownership is disputed, especially with Japan. China threatened to take “defensive emergency measures” against aircraft that fail to identify themselves in that airspace. Many observers are especially worried about the increased risk of an accident. To make matters potentially worse, a pair of American B52 bombers flew across disputed islands in the East China Sea on Tuesday. In what appeared to be a direct challenge to the Chinese claim, the Pentagon said that the flights were a long-planned training mission and insisted that the US would continue to operate in what it considers to be international air space.

3) Protests in Thailand are escalating. The usual political cycle seems to be repeating itself, and at this point, it is incredibly difficult to predict how disruptive they will turn out. The potential seems to be there for a repeat of 2010, when protests paralyzed the country for two months and resulted in a military crackdown with some 90 deaths. Furthermore, Bank of Thailand unexpectedly cut rates by 25 bp to 2.25%. As we noted in our recent report, inflation is low and the economic situation going into the political crisis has been deteriorating, so there is a case for cuts. The problem, however, is that a dovish surprise in the context of political turmoil and Fed tapering risks seems like a dangerous proposition. So either the central bank has softened its tolerance to a weaker currency, or they are confident in their ability to manage the speed of depreciation. In our view, both are risky assumptions given the potentially explosive political situation. This just reinforces our negative view towards Thai assets.

4) Brazil risks are tilting back towards the negative side. The Supreme Court has delayed until February 2014 its decision regarding bank compensation of depositors. In related news, local press is reporting that Petrobras may delay any decision on a new fuel pricing formula until after the elections next October. While these delays might allow Brazil to continue trying to muddle through, we do not believe investors are willing to give the country the benefit of the doubt now, especially as the fundamentals continue to worsen. October fiscal data came in worse than expected, and we believe ratings downgrades are only a matter of when, not if. The central bank hiked rates 50 bp to 10%, as expected. However, it changed the wording slightly which suggests that a 25 bp hike may be the next move in January instead of 50 bp.

5) The yen-won cross seems to be in play once again. Reported heavy intervention in USD/KRW by the BOK is probably a reflection of JPY/KRW breaking below the 10.50 level. We have been waiting for a trigger for the BOK to step up its intervention efforts, and this could be it. Even though there has been no real evidence that a weaker yen has impacted Korean exports, policymakers remain sensitive to it. After all, Japan is Korea’s second largest trading partner with total trade in 2012 of $105 bln – the first is China with nearly $250 bln in total trade. But more importantly, Korea’s exports compete with Japan on the global stage. We think the out performance of won is coming to the end and recommend using the currency in the short end of relative value trades.