Author: Sujata Rao

Should South Africa’s central bank — the SARB – strike first with an interest rate hike before being forced into it?  Gill Marcus and her team started their two-day policy meeting today and no doubt have been keeping an eye on happenings in Turkey, a place where a pre-emptive rate hike (instead of blowing billions of dollars in reserves) might have saved the day.

The SARB is very different from Turkey’s central bank in that it is generally less concerned about currency weakness due to the competitiveness boost a weak rand gives the domestic mining sector. This time things might be a bit different. The bank is battling not only anaemic growth but also rising inflation that may soon bust the upper end of its 3-6 percent target band thanks to a rand that has weakened 15  percent to the dollar this year.

Interest rates of 5 percent, moreover, look too low in today’s world of higher borrowing costs  – real interest rates in South Africa are already negative while 10-year yields are around 2.5 percent (1.5 percent in the United States). So any rise in inflation from here will leave the currency dangerously exposed.

Therefore staying behind the curve could prove a mistake, say Tradition Analytics:

The fear is that, by continuing to run very low interest rates on the premise that it is protecting domestic economic growth…the central bank is setting up the economy for less price stability, more uncertainty and higher variability in the rand outcome.  South Africa can ill-afford another blow-off in the rand…Dismissing the possibility that the SARB may be forced into a hike is dangerous as another bout of rand weakness could push the inflation rate above the 7% mark at which point the question then morphs into how much above the 6% level the SARB will tolerate.

Analysts at Barclays write:

Other EM central banks such as Turkey, Brazil and Indonesia have tightened their respective policy stances of late and the rand  might come under selling pressure over the medium term from a relative real interest rate perspective if inflationary pressures gain traction.

Analysts polled by Reuters expect the SARB to make no move on Thursday, though some reckon a change in stance to neutral from dovish is possible.  Swaps markets, on the other hand, are pricing a 20 basis-point tightening this month and 100 bps over the next 12 months, moving away from the rate cuts they were expecting just a few weeks back.

Of all the emerging currency and bond markets that are feeling the heat from the dollar’s rise, none is suffering more than South Africa. A series of horrific economic data prints at home, the prospect of more labour unrest and the slump in metals prices are making this a perfect storm for the country’s financial markets.

Some worrying data from the Johannesburg Stock Exchange this morning shows that foreigners sold almost 5 billion rand (more than $500 million) worth of bonds during yesterday’s session alone. Over the past 10 days, non-resident selling amounted to 10.7 billion rand. They have also yanked out 1.2 billion rand from South African equities in this time. And at the root of this exodus lies the rand, which has fallen almost 15 percent against the dollar this year. Now apparently headed for the 10-per-dollar mark, the rand’s weakness has eaten into investors’ total return, tipping it into negative return for the year.

What a contrast with last year, when a record 93 billion rand flooded into the country on the back of its inclusion in Citi’s prestigious WGBI bond index.  That lifted foreign holdings of South African bonds to well over a third of the total. Investors at the time were more willing to turn a blind eye to the rand’s lacklustre performance, liking its relatively high yield and betting on interest rate cuts to help the duration component of the trade.

As we wrote earlier this ye ar, the majority of these bond purchases by foreigners were made when the rand was much firmer. Even allowing for substantial currency hedging, calculations by UBS show that the currency is now well under levels at which longer-term bond returns would be in the red. The same likely applies to equity investments too –  in dollar terms South African stocks have lost over 13 percent, among this year’s worst performing emerging markets.

Policymakers may have turned a blind eye to the rand’s falls over the past year,  reckoning on a net gain from a weak currency  to the export-reliant economy. But further weakness leading to a foreign investor exodus will quickly change the equation for South Africa, which has a current account deficit to finance, running at around 6.5 percent at present.

Analysts at Citi write:

From the pure macro point of view, it is still hard to believe in a sustainable rand rally amidst further deterioration of terms of trade (pressure on platinum, iron ore, gold prices), and some degree of contraction in volumes as well. Pressure on capital flows suggest medium term difficulty to finance the current account gap, and once again, negates any possibility of a major comeback in the rand.

Markets are waiting to see how U.S. data is shaping up in coming days. A series of strong U.S. data is likely to fuel a further sell-off in emerging market currencies, with the rand at the forefront.

The received wisdom is dollar strength = weaker emerging market currencies. See here for my colleague Mike Dolan’s take on this. But as Mike’s article does point out, all emerging markets are not equal. It follows therefore that any waves of dollar strength and higher U.S. yields will hit them to varying degrees.

ING Bank says in a note sent to clients on Tuesday that emerging currency gains in recent years have been closely tied to foreign investments into domestic bond markets. Recent years have seen a torrent of inflows into local debt, driving down yields on the main GBI-EM index and significantly boosting its market value. Hence, it makes sense to examine how the GBI-EM’s biggest constituents might fare under a scenario of a surging dollar and Treasury yields (In the two years before a Fed tightening cycle commences, 5-year Treasury yields can trade 120-150 basis points higher, ING analysts point out).

In almost every one of the emerging markets examined by ING, spreads over U.S. Treasuries have tightened dramatically since the start of 2012. Ergo, they are vulnerable to correction.

But the ING analysts also look at:

a) correlations between the yield spread and respective currencies’ exchange rates

b) the magnitude of the inflows.

They found the Russian rouble and Mexican peso most tightly correlated to their respective bond spreads over Treasuries. The peso notably is free floating while Russia, worried about weak growth, is less likely to intervene to boost the rouble at present. The ING analysts write:

While the Fed normalising interest rates should not necessarily derail EM investments per se, a disorderly correction in yields probably leaves the Mexican peso most exposed. We are also interested in the rouble’s high positive correlation. A deteriorating ex-energy current account position and the strong dollar story keep us firmly as dollar/rouble buyers on dips.

The Brazilian real, Turkish lira and Malaysian ringgit had the lowest links with bond yield spreads, ING found. With the Brazilian and Turkish central banks having kept their currencies more or less in strict check, that does not seem surprising.

The corporate bond juggernaut continues apace in emerging markets.

In a note at the end of last week, analysts at Bank of America/Merrill Lynch estimated that companies from the developing world have sold debt worth $179 billion already this year. Originally, the bank had forecast $268 billion in corporate debt issuance in 2013, a touch below last year’s $290 billion but it is finding itself, like many others, marking up its estimates.

Oleg Melentyev,  credit strategist at BofA/Merrill, writes that recent bumper bond sales imply quarterly issuance is running at 10-11 percent of market size, well above the past average. Melentyev points out that the first 4.5 months of the year tend to account for 35 percent of full-year total debt sales by EM companies.  If this formula were applied now,  it would imply total 2013 new debt issuance at $420 billion.

For now, however, the bank expects $316 billion in full year corporate issuance from EM, with Asia accounting for $126 billion of this.

Clearly, all this doesn’t come without risk. While the drying-up of syndicated loan markets is at least partly responsible for the corporate bond boom, there is no denying that companies are raising more and more money in a market that is only too willing to lend.  That has pushed the  sector past the $1 trillion mark, making it bigger than the U.S. high-yield debt market. Just since the beginning of 2012, the stock of EM corporate hard currency bonds has increased by over $400 billion, JPMorgan said in a note published last week.

What of investors’ returns? The picture is not as rosy as in past years. Higher yield assumptions on U.S. Treasuries could reduce potential returns this year by 1.0-1.5 percentage points, JPM analysts warn. Year-to-date,  investment grade emerging corporate debt has returned just 1 percent while high-yield has provided 3 percent, BofA/ML said.  That’s well below the 4.1 percent return Thomson Reuters data shows on global high-yield debt.

But things could yet pick up. JPM recommends staying overweight its CEMBI corporate debt index, reckoning the sector’s relatively high yields will provide some insulation against Treasury upheavals. Melentyev of BofA/Merrill expects 3.7 percent returns on EM corporate debt this year. But speculative-grade EM credits, he reckons, will be returning a healthy 7.8 percent.

We wrote here yesterday on how Turkish hard currency bonds have been given the nod to join some Barclays global indices as a result of the country’s elevation to investment grade. Turkish dollar bonds will also move to the Investment grade sub-index of JPMorgan’s flagship EMBI Global on June 28.

Local lira debt meanwhile will enter JPM’s GBI-EM Global Diversified IG 15 percent Cap Index —  the top-tier of the bank’s GBI-EM index. But the big prize, an invitation into Citi’s mega World Government Bond Index, is still some way off. Requiring a still higher credit rating, WGBI membership is an honour that has been accorded to only four emerging markets so far.

Still, the Turkish Treasury is not complaining.  Even before last week’s upgrade to investment grade by Moody’s, it was borrowing from the lira bond market at record cheap levels of around 5 percent for two-year cash. Ten-year yields are down half a percentage point this year. One reason of course is the gush of liquidity from Western central banks. But most funds (at least those who were allowed to do so) had not waited for the Moody’s signal before buying Turkish bonds. So the bond market was already trading Turkey as investment grade.

RBS analysts reckon that by end-April, Turkey had raised 40 percent of this year’s 152 billion-lira borrowing plan, while the average bid-cover ratio at bond auctions this year has been 3.2, compared to 2.5 in 2012. They write:

We anticipate demand to strengthen further following the recent rating upgrade by Moody’s to the investment grade level, providing Turkey with a whole new investor base.

Whether the influx of foreigners is such a good thing can be debated — non-residents now own almost a quarter of the Istanbul bond market, from less than 10 percent in 2009, RBS notes. That leaves Turkey more reliant on foreign money of the speculative, yield-seeking variety. The positive is that lower yields make the treasury bond market less attractive to local banks, which hopefully pushes them into the business of lending to the private sector– the place they really should be.  Turkish banks now own 49 percent of the government bond market,  a sharp fall from 57 percent just a year back, RBS says:

We anticipate (Turkish t-bill) holdings to decline further, as banks allocate funds away from relatively low yielding government bonds and instead lend to the real economy at higher rates.

So investment grade may bring in hot money but if it drives yields down further, that will be good news for the economy — if more foreigners move to higher-yielding longer-tenor bonds, and second, if it weans Turkish banks off their T-bill habit.

Surprising as it may seem, the Egyptian pound has got some fans.  The currency has languished for months at record lows against the dollar and the headlines are alarming — the lack of an IMF aid programme, meagre hard currency reserves, political upheaval. So what’s to like ?

Analysts at Societe Generale say that just looking at the spot exchange rate of the pound is missing the bigger picture. Instead, they advise buying 12-month non-deliverable forwards on the pound — essentially a way of locking into a fixed rate for pound against the dollar in a year’s time depending on where you think it may actually trade. They write:

The implicit yield at this point is 21 percent for the 12m NDF, which we think is quite attractive. The way to think about Egypt NDFs is to approach them as a distressed asset. The risk/reward is quite attractive, and a lot of the bad news has been priced in. Yes, there have been serious delays in the programme negotiations with the IMF and that has clearly been a negative for the overall country view, but I would like to point out that the actual 12m NDF level has hardly budged in the process. This to me suggests that the valuation looks particularly good.

One year  forwards are typically calculated by assuming the currency will depreciate over 12 months by an amount equivalent to the currency’s deposit rate over that period. However, the non-deliverable forward on dollar/pound, a cash-settled FX forward calculated from open market pricing, implied a pound exchange rate at 8.5 pounds per dollar in a year’s time – more than 20 percent weaker than today’s spot price of 6.9 per dollar. This means that there is more than 10 percent pure currency depreciation (i.e. outside of the deposit rate) priced on the NDF. Given that this is well in excess of what many assume will be the actual pound decline, the trade starts to look attractive despite all the economic and political pessimism. In other words, the NDF rate is assumed to have priced in excessive gloom.

Graham Stock, an investment strategist at frontier fund Insparo, also likes the pound. He says a maxi devaluation does not appear on the cards as wealthier neighbours such as Qatar, Libya and Turkey have stepped up with multi-billion dollar loans. The currency collapse that looked imminent at the end of 2012 hasn’t happened as the central bank has managed to stabilise the pound by rationing dollars. Moreover analysts now reckon that Egypt will muddle through without IMF aid this year – instead it may tap the IMF after elections (due later this year) when measures such as scrapping subsidies can be more easily implemented. Meanwhile (Stock says):

You get compensated for taking the risk and you earn good carry. They may not be able to do an IMF deal but they are getting a lot of support from neighbours, there is general willingness to support them. You want the yield which is 15-20 percent.

Not everyone is into the trade though. The implied yield of 18-21 percent — well above what one can earn in other high-yield markets such as India or Brazil — is alluring but risks too are big given Egypt’s balance of payments problem and ugly politics. Luis Costa, head of CEEMEA currency and debt strategy at Citi, first wants to see Egypt cutting energy subsidies which currently eat up a third of government spending. Once  that happens, Costa says, he will take another look at the pound.

There seems to be no end to the rip-roaring bond rally across emerging Europe.  Yields on Turkish lira bonds fell to fresh record lows today after an interest rate cut and stand now more than a whole percentage point below where they started the year.

True, bonds from all classes of emerging market have benefited from the flood of money flowing from central banks in the United States, Europe and Japan, with over$20 billion flowing into EM debt funds since the start of 2013, according to EPFR Global. Flows for the first three months of 2013 equated to 12 percent of the funds’ assets under management.

But the effect has been most marked in emerging European local currency bonds — unsurprising, given economic growth here is weakest of all emerging markets and central banks have been the most pro-active in slashing interest rates.  Emerging European yields have fallen around 50 basis points since the start of the year, compared to a 20 bps average yield fall on the broader JPMorgan index of emerging local bonds, Thomson Reuters data shows.

The IMF today advised Poland to continue cutting rates “without delay” to boost the economy. That should give another leg-up to zloty bonds, where short-dated yields are already at record lows.

The flows have also been a boon to troubled countries such as Hungary that might otherwise have scrabbled for money. Instead, Budapest had by end-April fulfilled more than 65 pct of its 2013 funding needs and has since indicated it might not need to tap international bond markets again this year.

But the catch is that the central bank money-printing won’t last forever, with Fed officials already hinting at tapering off the $85 billion a month asset purchase programme. Once that happens, a stronger dollar and higher U.S. yields are inevitable. Both have always spelt bad news for emerging assets and this time will be no different.

In the local currency debt space, central Europe is possibly most vulnerable to an investor exodus.  An RBS index of 10-year bonds from central Europe, Middle East  and Africa is currently yielding 4.75 percent. That’s almost a 300 basis-point premium over Treasuries.  But note: the average for the GBI-EM index is 5.2 percent. RBS analysts ask at what level of bond yield will flows begin to dry up? They say:

If it is yield differentials with developed markets, then a lot more. If we use real yields as reference and if past inflation is any use, then most countries already pay zero or negative real yields. That makes CEEMEA bonds already expensive. 

They note however:

Expensive is not a “relevant” word when faced with a wall of money. It is making money that is relevant.

As Citi’s chief executive famously said at the height of the pre-crisis markets boom, as long as the music plays, you’ve got to get up and dance.  The  music is of a different kind these days, but it is still playing. And for now, investors are still dancing.

More on the subject of Japanese overseas investment.

As we said here and here, Japanese cash outflows to world markets have so far been limited to a trickle, almost all from retail mom-and-pop investors who like higher yields and are estimated to have 1500 trillion yen ($15.40 trillion) in savings. As for Japan’s huge institutional investors — the $730 billion mutual fund industry and $3.4 trillion life insurance sectors — they are sitting tight.

If some are to be believed, the hype over outflows is misguided. Morgan Stanley for one reckons Japanese insurers’ foreign bond buying may rise by just 2-3 percent in the next two years, amounting to $60-100 billion. Pension funds are even less likely to re-balance their portfolios given large cash flow needs, the bank said.

But a Reuters survey last week revealed several insurance companies are indeed considering boosting unhedged foreign bond holdings.  Insurers currently hold almost half their assets in Japanese government bonds and risk being crowded out of the JGB market as the central bank ramps up purchases.  A recent survey by Barclays also showed Japanese investors keen on overseas debt.

Barclays analyst Bill Diviney offers the following explanation as to why institutional investors haven’t ventured out so far:

From the life insurer investment plans released last week the basic takeaway was that in terms of current levels in currency and given the rally in emerging and developed bonds of late they seem to be uncomfortable with the current price levels and the sense I get is that they are waiting fro a dip in the market. So the markets have risen in anticipation of Japanese flows but the investors themselves want to wait until there is more value and better buying levels.

He adds:

Judging from what they are saying they will be shifting allocations away from JGBs. That will have implications for fixed income market. But… their main interest is in developed markets, they are cautious and not really interested in chasing high yields. 

A survey by Barclays  (see graphic above) revealed that U.S. and German debt were Japanese investors’ preferred choices while only 20 percent of respondents thought emerging market bonds would see an increase in Japanese investment. Unsurprising, given how risk-averse these investors are. (Italy and Spain get even fewer votes) But Diviney reckons  emerging bonds will benefit from Japanese  outflows indirectly, via so-called displacement flows — if Japanese cash drives down yields on Treasuries and Bunds, some other investors might be pushed to seek returns in emerging markets, he says.

Emerging markets bear John-Paul Smith first made his call to underweight emerging equities at the end of 2010. In a note released late on Monday he points out that such a position would have paid off handsomely — since end-2010 emerging equities have underperformed MSCI’s World index by 27.5 percent and U.S. MSCI by 37.6 percent.

Smith, who is head of emerging equity strategy at Deutsche Bank, sees no reason to change his call. Reckoning that the cyclical heyday of emerging markets is past, he is advising clients to hold on to developed and U.S. equities at the expense of emerging markets. The reason? China, pivotal for the rest of the EM world for commodities, trade.

Smith writes:

We are maintaining our existing underweight recommendations for GEM versus DM/US and current country weightings within GEM because the ongoing structural deterioration in the sustainable growth rate of the Chinese economy will continue to be the dominant narrative for the GEM equity asset class, in our view. Since the start of the year it has been increasingly evident at the micro level that the massive increase in total corporate financing has not as yet fed through into anything resembling a commensurate pickup in final demand.

Recent data from China would appear to bear that out. Economic growth and industrial data have both disappointed while Fitch has downgraded the country’s local currency rating, warning of risks to the economy from so-called shadow banking. And corporate results have not been reassuring — over 70 percent of companies, whether Hong Kong- or mainland-listed, undershot earnings forecasts for 2012,  according to Thomson Reuters Starmine data.

Smith again:

From a more bottom-up perspective, the ongoing deterioration in the underlying return on invested capital has now reached a point which threatens the viability of the entire economy.

So how China plays out will determine performance of the rest of the asset class. If China slows down gradually, emerging equities would underperform, led by commodity producers Russia and Brazil, while commodity importers such as India and  Turkey would gain. A more dramatic outcome in China would swiftly hit the most expensive markets such as Thailand and Malaysia, and also affect countries with current account deficits.

Within emerging markets, Smith is shunning Brazil, Russia, China and Korea but he has tactical overweights in Poland, Taiwan, Mexico, Turkey and is neutral/overweight in India — trades that would broadly benefit from a Chinese slowdown.

Where is the Japanese money? Mostly it has been heading back to home shores as we wrote here yesterday.

The assumption was that the Bank of Japan’s huge money-printing campaign would push Japanese retail and institutional investors out in search of yield.  Emerging markets were expected to capture at least part of a potentially huge outflow from Japan and also benefit from rising allocations from other international funds as a result.  But almost a month after the BOJ announced its plans, the cash has not yet arrived.

EM investors, who seem to have been banking the most on the arrival of Japanese cash, may be forgiven for feeling a tad nervous. Data from EPFR Global shows no notable pick-up in flows to EM bond funds while cash continues to flee EM equities ($2 billion left last week).

But first, some good news. Retail investors are demonstrating some interest in emerging assets. Barclays says launches of toshin or investment trusts last week garnered $2 billion in subscriptions, with a Pacific Rim equities fund, partly geared to Asia, receiving $1.2 billion.  The previous week saw a $500 million ASEAN fund while an emerging equities toshin started in March took in $1.6 billion. There has also been net new uridashi bond issuance in the Mexican, Brazilian, Turkish and Russian currencies over the past few weeks, Barclays data shows.

The bad news is that Japanese  funds and insurers — and that’s where the big money is — have steered clear of emerging markets, and indeed foreign assets so far.   Barclays writes that could be bad news for markets such as Hungary and South Africa, which have poor fundamentals and have benefited from talk of Japanese cash:

Aggregate Japanese flows to EM have not yet been significant, suggesting a risk that position-taking in EM longs (in anticipation of Japanese flows) could be disappointed. This could leave EM local markets, where fundamentals are weak, at risk of a setback.

Barclays notes, however, that Japanese investors it has surveyed recently described the 3-month prospects for emerging bonds and equities as “promising”. That probably indicates:

Japanese investor interest for EM is there, but…these investors probably only buy EM aggressively during price dips.

There is also the question of what the BOJ will do next. Signs are that Abenomics is starting to work, yet core inflation continued to fall last month,  widening the gap with the central bank’s 2 percent inflation target.  If the BOJ is forced into further easing action, Japanese investment outflows may well materialise.

The jury may be out on whether Messrs. Abe and Kuroda will succeed in cajoling the Japanese economy from its decades-long funk but the cash is betting they will. Domestic and foreign investors have stampeded for Tokyo equities, and Morgan Stanley has been crunching the numbers.

Since 2005, Japanese investors built up a 14 trillion yen (over $140 billion) portfolio of foreign equities. But between January-March 2013, they offloaded a third of this — about $39 billion.  Going back to July 2012 when they first started bringing cash home, the Japanese have sold $53 billion in foreign equities, or 36 percent of equity holdings.

If one were to include all foreign portfolio investments, they sold a net $74 billion worth of assets in the first three months of 2013. Morgan Stanley says this is the the most since 2005. You can see their graphic below (click on it for a bigger version).

Not surprising then that the Nikkei has been on a roll with returns of  34 percent this year. Aside from the Japanese money, foreign cash has also flooded in — foreigners have bought $23 billion worth of Japanese equities in the first two months of 2013, according to Japanese government data.  Broadly, that is a 7 percent rise in cumulative holdings. Asian investors’ holdings alone have jumped 26 percent.

So what now? Morgan Stanley’s survey of Japanese funds revealed that most had higher allocations to local equities than usual. While only around 5 percent said they would increase their weighting, half  of those surveyed intended to keep the current position.

“This data supports our view that further upside for the Japan equity market is data and policy dependent,” Morgan Stanley analysts wrote.

Indians have reacted to the latest gold prices falls by — buying more gold. And why not? Aside from Indians’ well known passion for the yellow metal (yours truly not excluded) gold has by and large served well as an investment: annual returns over the past five years have been around 17 percent, Morgan Stanley notes.

Now, gold’s near 20 percent plunge this year has wiped some $300 billion off Indians’ gold holdings, Morgan Stanley estimates in a note (households are believed to own about 15,000 metric tonnes of gold). So is the gold rush in India over?

Possibly. Indian gold imports have doubled to around 3 percent of GDP in the past five years. That rise is partly down to greater wealth which translates into more wedding jewellery purchases. But the more unpleasant side of the equation is India’s inflation problem. Look at the following charts from MS that shows how negative real interest rates have encouraged savings in gold rather than financial instruments:

Signs now are that inflation is ebbing — wholesale price growth in March slowed to the slowest in more than three years. The fall in oil and industrial metals prices, if sustained, should see this process continue. The government has also been slashing spending to bring its huge budget deficit under control. Morgan Stanley writes:

Over the past five years, real rates have been largely negative. The source of negative real rates has been the high fiscal deficit. Fiscal support is unwinding and real rates are turning up. This will cause gold appetite to recede.

So while Indians’ emotional attachment to gold may not be tarnished,  it could be less in demand as an inflation hedge. In fact, demand could fall by as much as two-thirds, MS reckons.  Gold savings have averaged 2.5% of GDP over the past three years versus 1.5% in the preceding 20 years.  So even a return to trend levels  would be very significant.

If Indians do buy less gold in future, some of their cash could find its way into stocks and bonds — MS calculates a 100 basis-point  fall in demand relative to GDP will add $15 billion to liquidity and savings.  That’s at least one of the reasons Mumbai stocks are on track for their best week since early December.

India’s finance minister P Chidambaram can be forgiven for feeling cheerful. After all, prices for oil and gold, the two biggest constituents of his country’s import bill, have tumbled sharply this week. If sustained, these developments might significantly ease India’s current account deficit headache — possibly to the tune of $20 billion a year.

Chidambaram said yesterday he expects the deficit to halve in a year or two from last year’s 5 percent level. Markets are celebrating too — the Indian rupee, stocks and bonds have all rallied this week.

But are markets getting ahead of themselves?  Jahangiz Aziz and Sajjid Chinoy, India analysts at JP Morgan think so.

Chinoy and Aziz acknowledge that India could shave up to $25 billion off its annual import bill  if commodity prices do continue falling.  They warn however:

Relying on falling global commodity prices – over which policymakers have absolutely no control — to alleviate India’s external imbalances is tantamount to living on a wing and a prayer. Falling commodities will undoubtedly help this year’s current account deficit but cannot be a “plan” or “strategy” for sustained reduction.

Further:

Even if the price correction sustains, this is unlikely to translate into an equivalent reduction of the deficit.

Why not? A closer look at some of the factors that are troubling JPM.

First,  coal imports are on course to double from two years back as domestic output lags  electricity generation, they note, adding that imports could rise another $3-4 billion over the coming year. Second, iron ore production and exports have collapsed due to mining bans in some Indian states  — exports are estimated at $1.5 billion this year from $6 billion 3 years ago. Meanwhile, with no iron ore production at home, imports of scrap metal have almost doubled over 3 years.

Finally, JPM say there has been little attention paid to the rate at which foreign investors are repatriating profits from India. (see their graphic)

In itself this is not a sinister phenomenon — examples elsewhere show that as the FDI stock grows,  repatriation of returns tends to weigh on the current account.   What is worrying in India is the scale and pace of repatriation  — Chinoy and Aziz point out that net profit repatriation from India has tripled from $4 billion in 2010 to $12 billion in 2012 and the deterioration in net investment income outflows has been almost 1 percent of GDP over the last 5 years. They add:

The non-linear manner in which (repatriation) has accelerated during the very years in which the investment climate has weakened, macroeconomic uncertainty has risen, and concerns about currency depreciation have renewed, suggests that it is related to the policy and investment climate in India…what’s more things could get worse before they get better.

In sum, they expect all these phenomena to widen the current account deficit by $14 billion, more than offsetting the savings made on oil and gold.

Chidambaram will be aware of all this.  He told Reuters yesterday that his main aim now is to deal with the “last mile” bottlenecks — fuel supply, environment clearance, forest clearance, land acquisition — some of the factors plaguing the economy and FDI outlook.  India-watchers will be praying he succeeds.

Asian equity markets tend to be casualties of weak yen. That has generally been the case this time too, especially for South Korea.

Data from our cousins at Lipper offers some evidence to ponder, with net outflows from Korean equity funds at close to $700 million in the first three months of the year. That’s the equivalent of about 4 percent of the total assets held by those funds. The picture was more stark for Taiwan funds, for whom a similar net outflow equated to almost 10 percent of total AuM. Look more broadly though and the picture blurs; Asia ex-Japan equity funds have seen net inflows of more than $3 billion in the first three months of the year, according to Lipper data.

Analysts polled by Reuters see more drops ahead for the yen which they predict will trade around 102 per dollar by year-end (it was at 77.4 last September). Some banks such as Societe Generale expect a 110 exchange rate and therefore recommend being short on Chinese, Korean and Taiwanese equities.

But the weak yen may not be unilaterally bad news for Asian companies. Morgan Stanley analysts have compiled a list of Asian shares that could gain from falling yen costs. Take India’s Maruti-Suzuki. It has zero exposure to yen in terms of revenue but its cost exposure (due to import or components) is 34 percent. A similar picture at China Motor Corp. in Taiwan. Another Taiwanese firm, semiconductor maker Siliconware Precision has a 2 percent revenue exposure to Japan but the yen accounts for 15 percent of its cost base, according to MS data.

Other examples.  MS highlights Taiwan’s casings maker Catcher which holds 54 percent of its debt in yen. It calculates that every 1 percent fall in the yen translates to 1.3 percent upside to its annual income. Tour operators and airlines could also benefit if they are able to send more visitors to newly-cheap Japan.

So a basket of Taiwanese “winner” stocks picked by MS, has returned 10 percent in dollar terms since last November. And broader Taipei stocks are up 1.5 percent year-to-date, compared with a 4 percent drop in Seoul.

So what of South Korea? The Seoul index is down around 4 percent so far this year. But MS point out that companies such as Samsung Engineering and Hyundai Heavy Industries actually performed pretty decently during past periods of yen weakness. As we have written in the past, auto and electronics makers are indeed vulnerable to the weak yen, but not every sector will necessarily take a hit.

Will the yen continue to weaken?

Most people think so — analysts polled by Reuters this month predict that the Japanese currency will fall 18 percent against the dollar this year. That will bring the currency to around 102 per dollar from current levels of 98. And all sorts of trades, from emerging debt to euro zone periphery stocks, are banking on a world of weak yen.

Now here is a contrary view. David Bloom, HSBC’s head of global FX strategy, thinks one-way bets on the yen could prove dangerous. Here are some of the points he makes in his note today:

–  Bloom says the link between currencies and QE (quantitative easing) is not straightforward. Note that after three rounds of QE the dollar is flexing its muscles. The ECB’s LTRO too ultimately benefited the euro.

–  The BOJ surprised investors with the scale of its bond buying plan relative to the size of its economy. But Bloom says the Fed has actually tripled its monetary base since 2008 while the Bank of England has expanded it fivefold. The BOJ on the other hand plans to double it over the next two years.

– Bloom calculates that the BOJ plan relative to Japan’s monetary base justifies a yen/dollar depreciation of 15 percent. Instead the currency has fallen almost 30 percent since October.  The yen would have merely moved to 88 per dollar from a November level of around 80, had the market known the BoJ planned to double its monetary base, he says, adding:

So the Bank of Japan’s actions have not been as awe-inspiring as some claim, and may very well be priced in.

And even if the yen does weaken further, Bloom says the benefits to Japan will be somewhat negated as other countries, especially neighbours in Asia, also try to dampen their own currencies. He says:

The currency war has just been raised another notch, and the yen will not have a free ride.

And what of the implications for global markets? The reckoning is that the prospect of further yen weakness will be the catalyst to push trillions of dollars currently locked up with Japanese households,  mutual funds and insurers out into the world to seek yield. This too should not be taken as a given, Bloom warns. He reminds clients of 2000, when markets anticipated a wave of money flowing out of Japanese Postal Savings accounts into overseas assets as time deposits matured. That did not eventually happen. Nor did the yen weaken much.

Someone’s loss is someone’s gain and as Russian and South African markets reel from the recent oil and gold price rout, investors are getting ready to move more cash into commodity importer India.

Stubbornly high inflation and a big current account deficit are India’s twin headaches. Lower oil and gold prices will help with both. India’s headline inflation index is likely to head lower, potentially opening room for more interest rate cuts.  That in turn could reduce gold demand from Indians who have stepped up purchases of the yellow metal in recent years as a hedge against inflation.

If prices stay at current levels, India’s current account gap could narrow by almost one percent of GDP in this fiscal year, analysts at Barclays reckon.  They calculate that $100 oil and gold at $1,400 per ounce would cut India’s net import bill by around $20 billion, bringing the deficit to around 3.2 percent of GDP.

Markets are celebrating these developments, with Mumbai’s stock markets jumping 2 percent today, the biggest one-day rise in seven months. Indian oil companies, which must supply subsidised fuel to the population, gained 3-4 percent on the day. On bond markets, 10-year government bond yields fell to six-week lows. Analysts at JP Morgan are advising clients to stay long Indian debt, predicting two interest rate cuts and a 50 bps fall in the  5-year yield. They also suggest buying 5-year overnight index swaps or OIS  (A swap that exchanges a floating overnight rate for a fixed interest rate). Currently at 7.17 percent, this should fall below 7 percent in coming months, they say.

Steve Ellis, an emerging debt fund manager at Fidelity Worldwide Investment says:

We have been increasing exposure to India. We are more optimistic than the market on the reform process and India will benefit from the lower oil and gold prices.

Indian equities have suffered in recent weeks, however, on fears of a rollback in reform momentum and weakening growth. A monthly survey by Bank of America/Merrill Lynch on Tuesday showed investors swinging into a net 27 percent underweight position on India this month, from a 44 percent overweight last month.

Analysts at HSBC for instance are underweight India — they cite the  current account deficit and inflation as reasons. But the commodity price collapse, if sustained, could prove a game changer on both these fronts.

There’s cash in that trash.

Analysts at Bank of America/Merrill Lynch are expounding opportunities to profit from the burgeoning waste disposal industry, which it estimates at $1 trillion at present but says could double within the next decade. They have compiled a list of more than 80 companies which may benefit most from the push for recycling waste, generating energy from biomass and building facilities to process or reduce waste. It’s an industry that is likely to grow exponentially as incomes rise, especially in emerging economies, BofA/ML says in a note:

We believe that the global dynamics of waste volumes mean that waste management offers numerous opportunities for those with exposure to the value chain. We see opportunities across waste management, industrial treatment, waste-to-energy, wastewater & sewage,…recycling, and sustainable packaging among other areas.

There is no denying there is a problem. Around 11.2 billion tonnes of solid waste are produced by the world’s six billion people every day and 70 percent of this goes to landfill. In some emerging economies, over 90 percent is landfilled.  And the waste mountain is growing. By 2050, the earth’s population will reach 9 billion, while global per capita GDP is projected to quadruple. So waste production will double by 2025 and again from 2025 to 2050, United Nations agencies estimate.

And in emerging markets, challenges and opportunities are both enormous, BofA/ML says. Just Brazil for instance needs investments of $180 billion in this sector. For one, recycling is less widespread. Second, as countries grow richer they produce more rubbish. Third, all big emerging countries have multi-billion dollar plans to improve waste disposal.

Lets look at some of the opportunities BofA/ML has identified:

– Disposal and recycling of municipal solid waste (rubbish, in common parlance) is currently worth $400 billion but over the next decade,  $87 billion in investments are expected in this sector.

– Waste-to-energy (energy recovery from waste): One ton of rubbish can create 500-750 kilowatts of power. This market is worth $7.4 billion in 2013 and  could grow to $81 billion by 2022.

– Sustainable packaging: Accounts for a third of solid waste in developed countries. Worth almost $109 billion in 2011, the market is expected to grow to $178-212 billion by 2015-18.

– e-waste (discarded electrical or electronic devices):  Recycling/reuse of e-waste components was worth $13.9 billion in 2012 but could grow to between $25 and 44.3 billion by 2017-20. One example of how lucrative this can be – -recycling one million mobile phones can recover 24 kg of gold, 250 kg of silver and more than 9,000 kg of copper.

Wastewater and sewage treatment:  The biggest investments are needed in the developing world but in the United States alone, infrastructure of $1 trillion could be needed over the next 25 years, BofA says, citing research from the American Waterworks Association.

To profit from all this clearly needs a long-term commitment. Companies highlighted by BofA/ML range from sewage treatment firms Copasa in Brazil and Severn Trent in Britain;  waste-to-energy firms China Everbright and UK’s Pennon and sustainable packaging producers U.S. Rock-Tenn and Hong Kong’s Lee & Manpaper. The analysts add:

Although it is difficult to accurately gauge the link between such exposure and share price performance, we still consider waste-related  exposure an important and positive point to track, given that waste is a sustainability megatrend with a 20-25 year lifespan.

Taiwan’s forecast-beating export data today came as a pleasant surprise amid the general emerging markets economic gloom.  In a raft of developing countries, from South Korea to Brazil, from Malaysia to the Czech Republic, export data has disappointed. HSBC’s monthly PMI index showed this month that recovery remains subdued.

With Europe still in the doldrums, this is not totally unsurprising. But economists are growing increasingly concerned because the lack of export growth coindides with a nascent U.S. recovery. Clearly EM is failing to ride the US coattails.

Does all this confirm the gloomy prediction made last month by Morgan Stanley’s chief emerging markets economist, Manoj Pradhan. Pradhan reckons that a U.S. economy in recovery would be a competitor rather than a client for emerging markets, as  the world’s biggest economy tries to reinvent itself as a manufacturing power and shifts away from consumption-led growth. It is the latter that helped underwrite the export-led emerging market boom of the past decade.

It’s early days yet. Yet the impact of the U.S. rebound this time does appear different from the past.

Typically, a recovery in the United States leads to a rise in demand for all sorts of products – chemicals,  home furnishing, clothing, footwear, light manufacturing,  electrical appliances, machinery and equipment, transport – and this leads to a broad-based rebound in imports, analysts at UBS say. That has not happened in this cycle, and imports from  EM in particular have lagged. The answer, according to UBS, lies in the kind of things the United States has been importing. Look at their chart below  – most in demand are heavy machinery and transport equipment because the rebound is centred on construction, autos and infrastructure. UBS says:

The US does not need EM to supply into these sectors – these are the sectors that it can supply to itself, or potentially import from other ‘industrialised’ economies such as Germany…. Our initial analysis suggests that EM may not be able to fully participate in the cyclical upturn in the United States.

The competitive advantages of emerging markets kick in with consumer sectors such as household appliances, phone handsets and clothing. But U.S. demand for these is stagnant, possibly because of deleveraging by households and also due to the relatively weak pace of job creation.

The U.S. recovery could yet broaden out to other sectors as it gathers pace.  But until this happens, the economic recovery in  emerging markets will be subdued.

There is another hope though — China. Taiwan is a case in point. Its 3.3 percent export improvement last month was down to China.  Taiwanese exports to China rose 5.2 percent on the month after a 21 percent jump in February.  Taiwanese exports to the U.S., on the other hand, fell 1.9 percent, adding to a 12 percent slump in the previous month.

The Bank of Japan unleashed its full firepower this week, pushing the yen to 3-1/2 year lows of 97 per dollar.  Year-to-date, the currency is down 11 percent to the dollar. But those hoping for a return to the carry trade boom of yesteryear may wait in vain.

The weaker yen of pre-crisis years was a strong plus for emerging assets, especially for high-yield currencies. Japanese savers chased rising overseas currencies by buying high-yield foreign bonds and as foreigners sold used cheap yen funding for interest rate carry trades. But there’s been little sign of a repeat of that behaviour as the yen has fallen sharply again recently .

Most emerging currencies are flatlining this year and some such as the Korean won and Taiwan dollar are deep in the red. The first reason is dollar strength of course, but there are other issues. Take equities — clearly some cash at the margins is rotating out to Japan, where equity mutual funds have received $14 billion over the past 16 weeks.  While the Nikkei is up 21 percent, Asian indices are broadly flat. In South Korea whose auto firms such as Hyundai and Kia compete with Japan’s Toyota and Honda, shares are bleeding foreign cash. The exodus has helped push the won down 5 percent to the dollar in 2013.

Second, the much-vaunted outflows from Japan have not yet lived up to expectations.  JPMorgan tracks Japanese investment trusts with $67 billion in assets but says only $2.3 billion have flowed to emerging bonds this year, all of it in January and February.

But most crucially,  emerging markets and their currencies are just not as attractive as they were back in 2004-2007 — the heyday of the carry trade.

Back then, economic growth in emerging markets was booming,  currencies were strengthening and interest rates were high. Now the gap between developed and emerging markets GDP growth has shrunk to a decade-low of just three percentage points. Emerging corporates’ profit growth has is running at flat. And policymakers are far less inclined to tolerate hot money flows that will push up their currencies. That’s especially so in Asia where countries often compete with Japan on exports.

Bhanu Baweja, a UBS strategist, says investors seeking “a playback of the mid-2000s” are being over-optimistic. He notes for instance that emerging currencies offered carry of 8-10 percent back in 2008, compared to around 4 percent now. Therefore the correlation between yen and emerging currencies will  turn out less negative than many expect and could even turn positive if exports fail to pick up, he warned clients in a recent note. (see graphic)

Aside from 2004-2007, Baweja notes two other recent periods of yen weakness  — the first, around the Asian crisis of 1997-98 when emerging currencies weakened along with yen; second around 2000-2001, a time of weak global growth and crises in Argentina and Turkey.  That time, emerging currencies stayed broadly flat on a trade-weighted basis.  So the 2004-2007 period may just have been an exceptional time when the stars were aligned for EM carry trades, he says.

Sebastian Barbe at Credit Agricole in Paris broadly agrees with this analysis. But he does expect the carry trade will pick up in time — selectively. It is difficult for the Korean won and Taiwan dollar to appreciate when the Nikkei is booming and the yen falling, Barbe says, but currencies in Latin America may gain, especially as some countries such as Brazil will start raising interest rates this year. Even in Asia, some currencies such as Thai baht can be seen as appreciation bets.

Emerging markets should take heart however. If Japan’s economy picks up after 16 years of deflation, all will benefit.  And a weak yen is not bad news for everyone — many Asian countries such as Thailand, Malaysia and Indonesia import Japanese car and electronics components to  assemble and sell locally.

Societe Generale analyst Wee-Khoon Chong says:

The yen move is creating uncertainty on exports in the region so I would say the impact so far is negative… but longer term no one will complain if Japan is out of recession and sees stronger growth.