Emerging Markets: What Has Changed

(from my colleague Dr. Win Thin)

1) EM remains resilient, suggesting potential for several quarters ahead of outperformance

2) China announced a doubling of the permissible band from 1.0% to 2.0% around the daily fix, and has since encouraged significant weakness

3) The Crimea referendum was overwhelming, with 96.6% voting to rejoin Russia

4) There were reports of re-weighting Colombia in the JPM bond index

Over the last week, Hungary (+5.5%), Russia (+4.8%), and Egypt (+3.9%) have outperformed in the EM equity space in local currency terms, while Peru (-2.7%), Hong Kong (-2.6%), and China (-2.5%) have underperformed.

In the EM local currency bond space, Ukraine (10-year yield -22 bp), Hungary (-17 bp), and Russia (-13 bp) have outperformed over the last week, while Philippines (10-year yield +35 bp), Brazil (+29 bp), and Sri Lanka (+22 bp) have underperformed. To put this in better context, the 10-year UST yield rose 13 bp over the week.

In the EM FX space, COP (+2.2% vs. USD), RUB (+1.2%), and PLN (+0.9% vs. EUR) have outperformed over the last week, while CNY (-1.5%), ZAR (-1.3%), and PHP (-1.2%) have underperformed.

1) EM remains resilient, suggesting potential for several quarters ahead of outperformance. On top of Fed tapering, the Crimean crisis, multiple devaluations (Argentina, Kazakhstan), renewed China slowdown fears, EM is now facing the prospects of earlier than anticipated Fed rate hikes. Yet most EM currencies are nowhere close to the January lows and this resilience is noteworthy. Asia EM saw some catch-up weakness today from the FOMC yesterday, but Latin America and EMEA currencies are holding up fairly well today. As a result of Q1 price action, we think EM has a window of a few quarters now to do pretty well, ahead of eventual Fed rate hikes in 2015. Despite our more constructive view on EM, however, there will undoubtedly be pockets of underperformance within EM. TRY is a prime candidate here, and this group also should include ZAR, THB, and some others.

2) China announced a doubling of the permissible band from 1.0% to 2.0% around the daily fix, and has since encouraged significant weakness. China's announcement does not mean that the yuan is for all practical purposes floating. The PBOC still will play a critical role via its fix. Yet the yuan has proceeded to weaken by about 1.2% since the band-widening, with subsequently higher PBOC fixes suggesting further weakness is desired, not just greater two-way movements. While spot CNY has yet to test the new 2% band, it has now traded beyond the old 1% band. USD/CNY is up over 3% from the January 14 low. 1-month volatility (actual, not implied) for both CNY and CNH has shot up to near 4%, which is a multi-year high. Lastly, the 6.15-6.30 area is thought to be the range where holders of structured wealth management products (mostly onshore) will face intensifying losses.

3) The Crimea referendum was overwhelming, with 96.6% voting to rejoin Russia. Yet in some ways, the results did not really matter. The key was always what happens next. The US and Europe announce sanctions and a framework for their escalation. These sanctions so far are seen as timid, which is evidenced by this week’s rally in Russian markets as the ruble gained over 1% vs. the dollar while equities rallied some 5%. Some argue that because of clear reluctance of the US and Europe to show a more forceful response to the grabbing of Crimea, Putin is now going to press on into the eastern part of Ukraine. We shall see. If Russia stops with Crimea, then we think Ukraine becomes a non-issue for markets.

4) There were reports of re-weighting Colombia in the JPM bond index. Colombia’s share will reportedly rise to 5.6% from around 3.3% currently, starting May 30. Reports also suggest that weights for Russia, Turkey, Thailand, and Hungary may be reduced. Whilst this is good news for the nation, Colombian policymakers won't be happy with any related COP gains. Recent comments suggest levels near 2050 still seen as too strong, and they would probably like it closer to 2100. Instead, the JPM news is pushing USD/COP closer to 2000.