Author: Sujata Rao

It’s not shaping up to be a good year for emerging equities. They are almost 3 percent in the red while their developed world counterparts have gained more than 7 percent and Wall Street is at record highs. When we explored this topic last month, what stood out was the deepening profit squeeze and  steep falls in return-on-equity (ROE).  The latest earnings season provides fresh proof of this trend and is handily summarized in a Morgan Stanley note which crunches the earnings numbers for the last 2012 quarter.

The analysts found that:

–With 84 percent of emerging market companies having already reported last quarter earnings, consensus estimates have been missed by around 6 percent. A third of companies that have already reported results have beaten estimates while almost half have missed.

– Singapore, Turkey and Hong Kong top the list of countries where earnings beat expectations while earnings in Hungary, Korea and Egypt have mostly underwhelmed. Consumer durables companies recorded the biggest number and magnitude of misses at 82 percent.

– Asian firms missed earnings forecasts by 4 percent, Latin America by 6 percent and EMEA-based firms by 3 percent, Morgan Stanley estimate. (Note: MS include Australia in the Asian list but not Japan)

– Outside of EM, the picture is mixed: while U.S. S&P 500 companies have reported an aggregate earnings beat of 5 percent, companies from MSCI Europe have missed consensus by 4.2 percent.

All in all, the picture is not reassuring. But investors are still banking on the abundant global liquidity to come to the rescue.  Late last month, Reuters surveyed more than 450 analysts and the consensus among them was for double-digit gains on emerging equities by end-2013 — see below for the graphic. Now markets just have to buck up or they risk missing that consensus as well.

What’s Argentina’s Plan B?

President Cristina Fernandez de Kirchner has said she will sell the presidential palace in Buenos Aires, if need be, to keep paying creditors who agreed to restructure the country’s debts.  But it may not come to that. Warning: this is a complicated saga with very interesting twists.

A pair of hedge fund litigants demanding $1.3 billion in payments and a New York court are making it hard for Kirchner to keep paying international bondholders. But she might contemplate asking those existing creditors to swap into Argentine law bonds, to which the writ of the New York court will not extend.

First some background. Argentina is due to pay bond coupons this week and in June. Looks like the hedge funds will decline the payment proposal Argentina made last week; this could lead to a default.

Most investors reckon this week’s payment is safe and that the crash will fall in June.  Argentina pleaded in the NY court that its own laws prohibit it from paying more to the hedge funds than it pays other creditors. Out of court it is less polite, calling the two hedge funds vultures. See here for more.

So, back to a putative Plan B. Deputy President Amado Boudou said this weekend Argentina would find a way to pay the exchange creditors irrespective of the outcome of the court hearing. That has supported bond prices. But it also suggests he may resort to local law bonds. That option, in principle, may look attractive to creditors who might otherwise find themselves holding defaulted debt again. In reality, the switch may be tough to do. Why? Here’s what Stuart Culverhouse, head of research at Exotix in London says:

1. Changing a bond’s payment terms and jurisdiction would by itself constitute default.
2. U.S. domiciled funds may balk at helping Argentina circumvent the ruling of a U.S. court. That would apply also to clearing houses and paying agents because the U.S. court order warns that any intermediaries assisting Argentina to re-route payments will be in contempt of Court.
3. Local law bonds are not an attractive proposition. In effect you will be giving away some of your bondholder rights. This is because bonds will be subject to Argentine rather than New York laws, which have (so far at least) been considered the gold standard in so far as creditor protection goes.

The other problem is that local law bonds could automatically fall out of JPMorgan’s EMBI Global index of sovereign emerging debt, which 80 percent of investors in the sector benchmark to. Argentina makes up 0.9 percent of the index but going off-benchmark is not an attractive proposition, says Jeremy Brewin, a fund manager at Aviva Investors in London. He also says:

I don’t think Argentina have been sitting quietly for months and not working on Plan B… But under local law you hold all the risk… it all falls to Argentina’s ability to keep up payments in future.

Furthermore Plan B carries the risk that there will be a Plan C somewhere down the line. For instance if Argentina runs into economic difficulties it will be hard to resist pesifying the new local law bonds, ie swapping them from dollars into pesos, Brewin reckons.  And Kirchner’s problems will not end there. It is likely that many existing creditors will turn down Plan B if that involves switching to local law bonds and that means Buenos Aires risks a repeat of  the whole legal nightmare. As Brewin puts it:

Whoever refuses to take part in Plan B now will have elected to be the holdouts of the future.

The Cypriot crisis, stemming essentially from a banking malaise, reminds us that Europe’s banking woes are far from over. In fact, Stephen Jen and Alexandra Dreisin at SLJ Macro Partners posit in a note on Monday that five years into the crisis, European banks have barely carried out any deleveraging. A look at their loan-to-deposit ratios  (a measure of a bank’s liquidity, calculated by dividing total outstanding loans by total deposits) remain at an elevated 1.15. That’s 60 percent higher than U.S. banks which went into the crisis with a similar LTD ratio but which have since slashed it to 0.7.

It follows therefore that if bank deleveraging really gets underway in Europe, lending will be curtailed further, notwithstanding central bankers’ easing efforts. So the economic recession is likely to be prolonged further. Jen and Dreisin write:

We hope that European banks can do this sooner rather than later, but fear that bank deleveraging in Europe is unavoidable and will pose a powerful headwind for the economy… Assuming that European banks, over the coming years, reduce their LTD ratio from the current level of 1.15 to the level in the U.S. of 0.72, there would be a 60% reduction in cross-border lending, assuming deposits don’t rise… This would translate into total cuts in loans of some $7.3 trillion.

The coming storm is also likely to hit some innocent bystanders — emerging economies.

For years European banks have led the lending juggernaut in the developing world, accounting for 57 percent of total foreign claims in these countries. A pullback is already underway: Jen and Dreisen cite BIS data showing a 4 percent fall in European lending to EM since 2011. But with over 90 percent of cross-border lending to eastern Europe coming from European banks, more pain can certainly be expected.

Whatever is happening to all those Asian savers? Apparently they are turning into big time borrowers.

RBS contends in a note today that in a swathe of Asian countries (they exclude China and South Korea) bank deposits are not keeping pace with credit which has expanded in the past three years by up to 40 percent.

Some of this clearly is down to slowing exports and a greater focus on the domestic consumer.  Credit levels are also rising overall in these economies because of borrowing for big infrastructure projects.  But there are signs too that credit conditions are too loose.

Hong Kong, Singapore and Thailand are the three countries where credit is expanding most rapidly, according to RBS.  And in terms of household indebtedness, ratios in  Hong Kong, Malaysia and Singapore now exceed 65 percent of GDP (that’s not terribly far off US households’ debt-GDP ratios of around 80 percent)

RBS analysts acknowledge that these levels by themselves do not seem daunting. But they warn: 

What is however worrying is the pace of credit growth. …The combination of rapid credit disbursals and more importantly, the on-going divergence between credit disbursals and GDP growth implies that the system is becoming more vulnerable to income and interest rate shocks.

The analysts cite the example of Singapore  where household liabilities rose to 74 percent of GDP from 61 percent in the 2008-2012 period.  The corresponding increase in  household wealth was almost entirely concentrated in property, leaving households exposed to a decline in property prices or higher interest rates.

There are other potential consequences too. The rise in borrowing comes at a time when labour productivity across much of Asia is declining (see graphic). This divergence eventually will hit the region’s balance of payments — India, Indonesia and Thailand are already deficit countries while Malaysia’s surplus has fallen sharply.  Second, the rise in credit is impacting banks’ loan-deposit ratios (see graphic).

Signs are that savings rates are declining while there has also been a shift away from buying financial assets into gold or real estate — low interest rates are an effective deterrent to savers. RBS says:

This diversion…implies that unless deposit growth picks up, the current pace of credit growth can not be sustained. For deposits to rise, deposit rates need to rise and in real terms. The mismatch between lending and deposits also implies monetary tightening has been insufficient.

Any hopes of policy support for the rand from the South African Reserve Bank (SARB) have vanished.  The currency fell 1 percent after yesterday’s SARB meeting where  Governor Gill Marcus made it clear she would not be standing in the way of the rand’s move south. It is now trading at 9.32 per dollar.

More losses look likely, especially if foreign bond investors throw in the towel, a move which analysts at Societe Generale liken to “the market equivalent of a volcanic eruption”. Foreigners, after all, own more than 36 percent of the 1 trillion-rand market in local currency sovereign bonds.

Bearishness appears to have escalated since a Reuters poll of 32 analysts conducted in early-March.  Back then the mean forecast for the rand’s exchange rate in a month’s time was 8.94 per dollar, the poll found.  The 12-month mean forecast was for 8.787.

In a note this morning, Societe Generale said there was  “considerably more pain coming now that the central bank is not ready to provide some sort of backstop”.

Clearly, markets had expected a stronger statement from Marcus, who did recently say she thought the rand move looked “overdone”.  But the SARB has typically taken a more laissez-faire approach towards currency weakness. And right now there is another reason for this attitude — there is very little ammunition to mount any sort of defence of the rand.

Slowing capital and trade inflows have blown out the current account deficit, but the SARB’s reserve growth has also stalled.  This graphic from UBS shows how unfavourably South Africa’s reserve cover ratio  compares with most other emerging markets — only five other countries fare worse on this indicator:

Also,  liabilities against this war chest have been mounting,  driven up partly by corporate and bank borrowing.  Central bank data shows gross external debt as a percentage of GDP now stands at almost 35 percent, up more than 10 percentage points since early-2010.

SocGen (which had predicted a 1-month exchange rate of 9.2 per dollar in the Reuters poll) now sees the next stop for the rand at 9.60.  It also recommends selling 10-year rates to position for a bond market downtrend.

Victims of the dollar’s strength are piling up.

Total returns on emerging market local currency bonds dipped into the red for the first time this year, according to data from JPMorgan which compiles the flagship GBI-EM global diversified index of domestic emerging debt. While the EMBI Global index of sovereign dollar debt has already taken a hit the rise in U.S. yields, local bonds’ problems are down to how EM currencies are performing against the dollar.

JPMorgan points out that while bond returns in local currency terms, from carry and duration, are a decent 1 percent, that has been negated by the 1.3 percent loss on the currency side. With the dollar on the rampage of late  (it’s up almost 4 percent in 2013 against a grouping of major world currencies) that’s unsurprising. But a closer look at the data reveals that much of the loss is down to three underperforming markets — South Africa, Hungary and Poland. These have dragged down overall returns even though Asian and Latin American currencies have done quite well.

The graphic below shows South African local debt bringing up the bottom of the table, with the FX component of returns at around minus 9 percent  In rand terms however the return is still in positive territory, but only just. Hungary and Poland fare only slightly better.

Many bond positions are of course hedged. But as we wrote here yesterday  in an article on South Africa, escalating currency weakness can trigger exits from local bond markets.  And worryingly, JPMorgan notes that returns in local currency terms have plateaued at 1 percent over the past 10 days.

Sterling looks likely to be one of this year’s big G10 currency casualties (the other being  yen).  Having lost 7 percent against the dollar and 5.5 percent to the euro so far this year on fear of a British triple-dip recession, sterling probably has further to fall.  (see here for my colleague Anirban Nag’s take on sterling’s outlook).

Many see an opportunity here — as a convenient funding currency to invest in emerging markets. A funding currency requires low interest rates that can bankroll purchases of higher-yielding assets including stocks, other currencies, bonds and commodities. Sterling ticks those boxes.  A funding  currency must also not be subject to any appreciation risk for the duration of the trade. And here too, sterling appears to win, as the Bank of England’s remit widens to give it more leeway on monetary easing.

All in all, it’s a better option than the U.S. dollar, which was most used in recent years, or the pre-crisis favourite of the Swiss franc, says Bernd Berg, head of emerging FX strategy at Credit Suisse Private Bank.

Berg points out that while emerging currencies have been lacklustre this year against the dollar and euro, they have turned in a decent performance against sterling and yen. (check out his graphics below)

On the Brazilian real, Berg advises opening a 12-month short sterling, long real trade, targeting a 3 percent gain in this period. The real’s  effective exchange rate has risen more than 7 percent since the start of the year, with gains of more than 16 percent against the yen and 14 percent against the pound.  He is also recommending buying Mexican peso, Polish zloty, Turkish lira and Russian rouble against sterling and yen.

But those who have not moved in on the sterling-emerging FX trade yet are a bit wary. Huge short-sterling positions have been put on in recent weeks as expectation has grown of more QE in the UK, says UBS FX strategist Manik Narain (who incidentally likes the idea of sterling as an EM funding currency).  Instead, he advises waiting for positioning to be shifted back from short sterling to neutral.

Inflation is finally biting Brazilian policymakers. The real strengthened around 1.5 percent last week without triggering the usual shrill outcries from government ministers. Nor did the central bank intervene in the currency market even though the real is the best performing emerging currency this year. The bank in fact shifted towards a more hawkish policy stance during its March meeting, a move that seems to have had the blessing of the government.

Friday’s data showed the benchmark consumer price index, IPCA,   up 0.6 percent for a year-on-year inflation rate of 6.31 percent. President Dilma Rousseff, who faces elections next year, took to the airwaves soon after to reassure voters about her commitment to taming inflation, announcing a series of tax cuts. That effectively is a signal that there is now no political constraint on raising interest rates. According to the political risk consultancy, Eurasia:

If the government doesn’t enact measures during the first half of this year to anchor inflationary expectations, Rousseff would run one of two risks. She would either run the risk of inflation starting to eat into the disposable income of families in a manner that could hurt her politically, or relatedly, put the central bank in a position of having to raise interest rates more aggressively later in the year to control inflation with more negative repercussions to growth.

Accordingly swaps markets and analysts polls alike are penciling in more rate rises — the Selic rate is seen rising 75 bps by end-2013 to 8 percent. Second,  foreigners are betting on more real strength. The currency has broken 1.95 per dollar, a level that has previously triggered intervention (after spending a year hobbled in the 2.0-2.10 range) and the next level to watch for may be 1.9357, last hit in May 2009.

Bernd Berg, head of emerging currency strategy at Credit Suisse, reckons markets will keep testing the central bank’s tolerance for currency appreciation and the bank could respond with some intervention should the currency appreciate too fast. But it is not too-far fetched to expect the real to trade at 1.90 per dollar later this year, he says.

An action-packed week for emerging monetary policy.

First we had Poland stunning markets with a half-point rate cut when only 25 bps was priced. Governor Marek Belka said the double-cut marked a “full stop”  after several cuts.  Then came Brazil which kept rates on hold at 7.25 but turned hawkish after spending over 18 months in dovish mode. (Rates stayed on hold in Indonesia and Malaysia).

In Brazil, it was high time. Inflation and inflation expectations have been rising for a while, the yield curve has been steepening and anxiety has grown, not only about the central bank”s commitment to controlling inflation but also about its independence.  Whether the central bank will actually start a hiking cycle anytime soon is another matter. Barclays reckon it will, predicting three consecutive 50 bps rate hikes starting from April. But analysts at Societe Generale are among those who are betting on flat rates for now. They point out that since the meeting, the Brazilian yield curve has moved to its flattest in a year and the 2017 inflation breakevens (the difference between the yields on fixed-rate and inflation-linked bonds of similar maturity) have fallen more than 50bps:

This implies that simply by showing a small amount of vigilance, a great deal of structural inflation concerns seem to have dissipated.

Second, the real has appreciated almost 5 percent this year on rate hike expectations and inflation. A rate rise at a time when most other central banks are lowering rates, will draw more inflows to the real, something the government is unlikely to be happy about.

Mexico’s policy meeting later on Friday could be very interesting. The Banxico has kept interest rates on hold at 4.50 percent for four years but could finally opt for a cut. Five of the 21 analysts polled by Reuters predict a 50 bps cut to a record low 4 percent.

Governor Agustin Carstens warned however that lower interest rates are not a “done deal”, warning of an inflation uptick through April.

But many reckon this is the time to cut.  ING Bank analysts say that while inflation is indeed above the Banxico’s 3 percent target, it will rise further and easing will therefore be a harder prospect in coming months. Second, ING estimates that Mexico has received around $73 billion of net portfolio inflows over the last 12 months,  mainly into local debt and that makes a cut desirable at this stage. Analysts at the bank write:

A 50-75 bps rate cut would help reduce carry and the aggressive build-up of positions in Mexican assets – positions which could quickly become a source of financial instability were U.S. rates start to rise.

Argentina squares off today in a U.S. Appeals court with the so-called holdout creditors who are demanding $1.3 billion in payments on defaulted bonds. A decision will probably take a few days but supporters of both sides have been mustering.

Emails have been pouring into journalists’ inboxes thick and fast from the Argentine Task Force, a lobby group that wants Argentina to settle with bondholders and identifies its goal as “pursuing a fair reconciliation of of the Argentine debt default”.  And yesterday, a noisy pots-and-pans protest was held outside the London offices of Elliot Associates (the parent company of one of the two hedge fund litigants)  by groups supporting Argentina in its battle against those it terms “vulture funds”.  Nick Dearden, director of the Jubilee Debt Campaign, a group that calls for cancelling poor countries’ debts, says:

If the vulture funds are allowed to extract their pound of flesh from Argentina today, we will see a proliferation of vulture funds in Europe tomorrow.

Meanwhile, market jitters are also mounting. Argentine dollar bond yields have risen steadily since the start of the year, with the country’s 2017  dollar bond now yielding 15.5 percent, 400 basis points up from early January (it’s still off the 20 percent record high hit in November when a technical default looked imminent).

Debt insurance costs too have surged. The annual cost of insuring one year of exposure to $10 million of Argentine debt via CDS has risen to around $5 million, according to Markit. That is double the level of one-year CDS at the start of 2013.

Could Hungary’s run of good luck be about to end?

Despite controversial policies, things have gone the country’s way in recent months — the easing euro crisis and abundant global liquidity saw investors flock to high-yield emerging markets such as Hungary and also allowed it to tap international capital for a $3.25 billion bond. It has slashed interest rates seven times straight, cutting them this week to a record low 5.25 percent. The result is an increased reliance on international bond investors. Foreigners’ share of the Budapest bond market  is almost 50 percent, among the highest percentages in emerging markets.

But analysts at Unicredit write that both markets and economic data had validated rate cuts in 2012, which may not be the case any more. Annual headline inflation fell from 6.6% in September 2012 to 3.7% in January 2013 while the economy contracted 1.7% last year. As a result, net foreign buying of Hungarian bonds rose  in the second half of 2012 to 837 billion forints (an average daily rate of almost 6 billion forints), they note.  Markets are pricing at least 3 more cuts, that will take the rate to 4.5 percent.

But support from foreigners is ebbing. Since the beginning of the year, Unicredit points out, foreign investors have cut holdings of government bonds by 236.8 billion forints (average daily outflow of 6.1 billion forints). Moreover, the most recent rate cuts have failed to fully translate into bond yield corrections, they say.  While the short-dated 2-5 year segment of the curve dropped 23-40 basis points, the belly (the middle) of the curve dipped by only 9-24 bps and longer-dated yields over 10 years have risen by around 18 bps. And the fall in inflation too could be a thing of the past if the government resorts to tax hikes in order to meet the deficit target of 2.7% of GDP  — that would persuade the European Union to lift the excessive deficit procedure it has triggered against Hungary for repeated budget deficit overshoots.

The biggest complication could be the upcoming leadership change at the central bank, which is expected to tightly align monetary and government policies. That has contributed to the forint’s 1.5 percent weakening this year (after 11 percent gains in 2012) and many reckon portfolio flows could be seriously undermined.  Peter Attard Montalto, an economist at Nomura, calls outgoing governor Andras Simor “a level-headed defender of  financial stability, the currency, inflation and central bank independence even against unimaginable pressure from the government”. Montalto adds:

Foreign investors will find the institution much more closed and no longer the ‘safe haven’ for information and analysis. That may well be even more damaging in both the short and long run than any policy unorthodoxies.

The new governor is to be named on Friday and the front-runner is Gyorgy Matolcsy, widely seen as the architect of Hungary’s unconventional policies.

Happy birthday EMBI! The index group, the main benchmark for emerging market bond investors, turns 20 this year.  When officially launched on Dec 31 1993, the world was a different place. The Mexican, Asian and Russian financial crises were still ahead, as was Argentina’s $100 billion debt default. The euro zone didn’t exist, let alone its debt crisis. Emerging debt was something only the most reckless investors dabbled in.

To mark the upcoming anniversary, JPMorgan – the owner of the indices – has published some interesting data that shows how the asset class has been transformed in the past two decades.  In 1993:
– The emerging debt universe was worth just $422 billion, the EMBI Global had 14 sovereign bonds in it with a market capitalisation of $112 billion.
– The average credit rating on the index was BB.
– Public debt-to-GDP was almost 100 percent back then for emerging markets, compared to 69 percent for developed markets.
– Forex reserves for EMBI countries stood at $116 billion
– Per capita annual GDP for index countries was less than $3000.
Now fast forward 20 years:
– The emerging debt universe is close to $10 trillion, there are 55 countries in the EMBIG index and the market capitalisation of the three main JPM indices has swollen to $2.7 trillion.
– The EMBIG has an average Baa3 credit rating (investment grade) with 62 percent of its market cap investment-grade rated.
– Public debt is now 34 percent of GDP on average in emerging markets, while developed world debt ratios have ballooned to 119 percent of GDP.
– Forex reserves for EMBIG members stand at $6.1 trillion
– Per capita annual income has risen 2.5 times to $7,373.

What next? The thinking at JPM seems to be that the day is not far off when a country “graduates” from the EMBI and joins the developed world.  To be excluded from the EMBI group of indices, a country’s gross national income must exceed the bank’s “index income ceiling” (calculated using World Bank methodology) for three years in a row or have a sovereign credit rating of A3/A- for three consecutive years.

All eyes on the Hungarian central bank this week.  Not so much on tomorrow’s policy meeting (a 25 bps rate cut is almost a foregone conclusion) but on Friday’s nomination of a new governor by Prime Minister Viktor Orban.  Expectations are for Economy Minister Gyorgy Matolcsy to get the job, paving the way for an extended easing cycle. Swaps markets are currently pricing some 100 basis points of rate cuts over the coming six months in Hungary — the question is, could this go further? With tomorrow’s meeting to be the last by incumbent Andras Simor, clues over future policy are unlikely, but analysts canvassed by Reuters reckon interest rates could fall to 4.5 percent by the third quarter, compared to their prediction for a 5 percent trough in last month’s poll.

A rate cut is also possible in Israel later today, taking the interest rate to 1.5 percent. Recent data showed growth at a weaker-than-expected 2.5 percent in the last quarter of 2012 while inflation was 1.5 percent in January, at the bottom of the central bank’s target range.  But most importantly, according to Goldman Sachs, the shekel has been strengthening, having risen 7 percent against the dollar since November and 6.8 percent on a trade-weighted basis in this period. That could prompt a rate cut, though analysts polled by Reuters still think on balance that the BOI will keep rates unchanged while retaining a dovish bias. A possible reason could be that house prices — a sensitive issue in Israel — are still on the rise despite tougher regulations on mortgage lending.

Ten-year Indian bond yields have fallen 30 basis points this year alone and many forecast the gains will extend further. It all depends on two things though — the Feb 28 budget of which great things are expected, and second, the March 19 central bank meeting. The latter potentially could see the RBI, arguably the world’s most hawkish central bank, finally turn dovish.

Barclays is advising clients to bid for quotas to buy Indian government and corporate bonds at this Wednesday’s foreigners’ quota auction (India’s securities exchange, SEBI, will auction around $12.3 billion in quotas for foreign investors to buy bonds). Analysts at the bank noted that this would be the last auction before the central bank meeting at which a quarter point rate cut is expected. Moreover the Reserve Bank of India will signal more to come, Barclays says, predicting 75 bps in total starting March.

That is likely to be driven first by recent data — inflation in January was at a three-year low while growth has slowed to a decade low.  Barclays notes:

Based on our economists’ view of a 25bp repo rate cut in Q1, and a further 50bp in Q2, we expect the bond curve to fall around 55bp in a parallel move. As such, we recommend extending duration to long end bonds….Given high carry, attractive price returns and our forecast for modest nominal appreciation of the  rupee, we expect an approximately10% dollar return (FX unhedged), and a 7% return (FX hedged) on 30-year bonds in the next six months.

But what could eventually determine the extent of policy easing is the upcoming 2013-2014 budget.

Finance Minister Palaniappan Chidambaram has pledged an austere budget to keep an already massive fiscal deficit from ballooning further, and indications are he will keep his promise. Sources have told Reuters of  plans to slice 10 percent from the public spending target (after already cutting expenditure by 9 percent in the current fiscal year). while defense spending is also expected to be slashed. Net borrowing in the coming fiscal year will be limited to 5 trillion rupees ($93 billion), investors hope. Such austerity may exacerbate the slowdown but if they allow the RBI to cut rates, borrowing costs for companies will fall.

On the other hand,  should the budget fall short of expectations,  a huge bond selloff could ensue, leaving the RBI to support the market via bond purchases. Still, investors appear prepared to give the government the benefit of doubt — India’s 10 year yield is just off  a near three-year low and the mood is optimistic — always a rare sentiment ahead of an Indian budget.

The excitement continues over Russian assets becoming Euroclearable.   Euroclear’s head confirmed last week to journalists in Moscow that corporate debt would be the next step, potentially becoming eligible for settlement within a month. Russian equities are set to follow from July 1, 2014.

What that means is foreign investors buying Russian domestic rouble bonds will be able to process them through the Belgium-based clearing house, which transfers securities from the seller’s securities account to the securities account of the buyer, while transferring cash from the account of the buyer to the account of the seller.

The Euroclear effect in terms of foreign inflows to Russian bonds could be as much $40 billion in the 2013-2014 period, analysts at Barclays estimated earlier this month.  Yields on Russian government OFZ bonds should compress a further 50-80 basis points this year, says Vladimir Pantyushin, the bank’s chief economist in Moscow, adding to the 130 bps rally in 2012. Foreigners’ share of the market should double to 25-30 percent Pantyushin says, putting Russia in line with the emerging markets average.

The next round will be the story of corporate bonds,  he reckons.

A roughly 100 billion-rouble ($3,3 billion) market where foreigners own less than 10 percent, Russian corporate bonds stayed flat last year even amid the roaring rally on government bonds. That blew out their yield spreads over the OFZ curve to 150-200 bps compared to 60-100 bps before the Euroclear-linked rally took off. Pantyushin expects that spread to compress back to the norm, first driven by Russian banks searching for yield, and second, when foreigners surge in.

The significance could be broader, however. With so much demand for local rouble paper, Russia could decide to issue less dollar debt this year (it has already said a planned $7 billion bond is unlikely to come in the next three months). Second, Russian companies will benefit if their borrowing costs fall.  Pantyushin says:

Our estimate is that foreign demand can substitute $10-$12 billion a year and potentially up to $20 billion, which local banks can direct into lending and corporate bonds. Last year for the first time consumer lending was on par with corporate lending.

Ed Conroy, a fund manager at HSBC Global Asset Management, reckons that Russian stocks, in general unpopular with foreign investors, may start benefiting as well.  Currently a lot of foreigners balk at buying Moscow-listed stocks because in the absence of a central depositary, they must bear the credit risk.  Once stocks become Euroclearable in 2014, the 20 most liquid Moscow-listed companies will be tradable on what is known as “T + 2″ basis, meaning the deal must be settled within two days of the transaction taking place.  If more foreign investors buy locally, it should in turn allow the privatisation agency to float state-run companies in Moscow rather than London. But even before that happens, there could be a spill over from bonds’ euroclearability, Conroy said:

Allowing more people to buy government debt will cut the cost of capital and will push down the cost of equity as well. The cost of equity is between 11-16 percent, that’s a very big risk premium.

A bond trader in London is still marvelling at the market’s willingness to snap up a Eurobond from Hungary, calling it a country with “a policy mix so unorthodox even Aunty Christine won’t lend to them”.  But Hungary’s probable glee at bypassing the IMF and “Aunty Christine”  with $3.25 billion in two bonds that were almost four times oversubscribed, is probably short-sighted.

Hungary needs to raise the equivalent of $23.4 billion this year to repay maturing debt. The bond placement will enable Hungary to easily meet the hard currency component of this, and it has been enormously successful in luring buyers to domestic debt markets.  Such has been the demand for Hungarian bonds in recent months that foreigners’ holdings of forint-denominated government debt are at a record high of over 45 percent.

The success does not necessarily represent a thumbs-up for Prime Minister Viktor Orban’s policies but is more likely due to the yield Hungary paid — well over 5 percent for five and 10-year cash. In dollar terms that is not to be sneezed at, especially at a time when liquidity is abundant and the yield on mainstream dollar assets is low. The same reason is behind the demand for forint bonds, where Hungary pays over 5 percent on one-year paper. An IMF loan would have been far cheaper. (The rate for a standby loan of the kind Hungary had is tied to the IMF’s Special Drawing Rights (SDR) interest rate. Very large loans carry a surcharge of 200 basis points)

The dollar bond sale is forcing Budapest to pay lenders roughly double what it would have paid for an IMF standby loan, says William Jackson at Capital Economics:

Of the Hungarian government’s 5.1 billion euro of maturing hard currency debt this year, 3.6 billion euro consists of IMF loan repayments, which carry a much lower interest rate than the Eurobonds. By rolling over these repayments with Eurobonds, debt servicing costs will rise. Note too that the new dollar bonds add to Hungary’s underlying FX debt problem.  Around half of government debt is hard currency-denominated (c. 36% of GDP). And Hungary’s economy has contracted in  dollar (and euro) terms over the past five years – increasing the burden of dollar (and euro) debt in local currency terms.

According to Benoit Anne, chief EM strategist at Societe Generale:

The absence of (an IMF) safety net may haunt them in future…The IMF was a cheap insurance policy but the government has decided to ride the global liquidity-fuelled emerging markets appetite wave.

Cost was never likely an issue for Orban, who might view an IMF deal (entailing toeing stringent IMF terms) far costlier in political terms ahead of a 2014 election. The other, more widely voiced, concern is that with a successful Eurobond sale under its belt and an election looming, the government may feel more confident in pursuing its unorthodox growth agenda, Jackson says.

Meanwhile, the IMF’s representative in Hungary Iryna Ivaschenko warned the golden days may not last for Budapest:

Countries like Hungary which.. still have sizeable financing needs year after year are susceptible to sudden changes in investor sentiment which is inevitable.

The Year of the Snake is considered one of the less auspicious in the 12-year Chinese zodiac cycle. And 2013 is the year of the Black Water Snake, which comes around once every 60 years and is seen as the least fortuitous. How China’s stock markets turn out after years of poor performance remains to be seen but the snake is providing banks and asset managers with plenty of food for thought. Many of them have been gazing into the crystal ball to see what 2013 may hold for Chinese markets.

Fidelity Worldwide investments highlights the ‘Snakes and Ladders’ that could influence Chinese equities this year. (They have a great accompanying illustration)

Fidelity’s Raymond Ma reckons  there are six ‘R’s’ that could act as ‘ladders’ to buoy Chinese equity markets this year: recovery, reverse, reform, reflation, re-rating and rally. Under snakes he names inflation, a continued depreciation of the Japanese yen, excessive corporate debt/equity issuance,  a prolonged euro zone crisis and an earlier-than-expected end to quantitative easing in the United States.

But past snake years  have been the worst of the cycle for world markets, analysts at CMC Markets point out. Their analysis shows that  the S&P 500 and Hong Kong’s Hang Seng have generally posted losses, while UK returns have been below average. The Hang Seng has fared particularly poorly (down four snake years in a row with average losses of 16.7 percent) So, will the curse hold this year, CMC ask:

Will the year of the snake bite equities in 2013?

Agnes Deng, Head of HK China Equity at Baring Asset Management, is more optimistic. Water snakes have a reputation for transformation, in the same way that China’s economy is undergoing change. Moreover, Chinese zodiac snakes are female or yin, Deng says, contrasting the Snake with the “moody, broody, male yang energy” of the Dragon last year.  (Incidentally the supposedly auspicious Year of the Dragon, 2012, provided little cheer for Chinese equities). Deng says:

If the Black Water Snake holds true to form, it is our belief that the behaviour of the Chinese equity market in 2013 should be more suited to many investors than the unpredictability generally experienced last year under the gaze of the Dragon – a creature characterised by its dramatic and often volatile nature…..Like the Black Water Snake, the Chinese economy can be flexible, dynamic and is hard-working as it looks to achieve superior growth supported by what we see as strong fundamentals in the consumer sector, underpinned by rising domestic demand and a growing middle class.

She adds:

Like the Black Water Snake’s preference for having carefully thought-out tactics, we expect our bottom-up stock selection process to be of benefit, especially in the consumer and industrial sectors.

A lot may depend on the birth year of the investor however. Stephen Jen at SLJ Macro Partners:

In the Year of the Snake, there should be great fortune for those who are intuitive and cunning – the two traits of a snake.

The recent, steady upward creep in U.S. Treasury yields is starting to have an effect on appetite for high-yield credit, investors’ favourite for over a year.

Emerging dollar bond funds have suffered capital outflows for the first time since June 2012, waving goodbye to around $300 million in the week to Feb 6, according to EPFR Global, the Boston-based fund tracker.  Global  high-yield bond funds saw net outflows of $1.33 billion, and according to another set of data from JPMorgan, emerging market hard currency ETFs (exchange traded funds)  saw net outflows of $550 million.  JPMorgan notes:

Amid U.S. Treasury volatility, EM credit has suffered both on total returns as well as fund flows.

Assets like emerging market debt tend to suffer when Treasury yields, the so-called risk-free rate, rise. Ten-year U.S. yields recently broke over 2 percent for the first time since last April, having risen more than 30 basis points since early December. They have since eased to 1.94 percent but many reckon that signs of economic recovery as well as some inflation fears will lead to a further selloff in Treasuries. JPMorgan for instance expects the 10-year yield to reach 2.25 percent this year.

Emerging dollar bonds which returned 18.5 percent last year are in the red this year with losses of 1.6 percent while last week alone they lost 0.6 percent, JPM data shows.

Moves in U.S. Treasuries haven’t entirely soured the emerging markets story, however.  Funds investing in domestic EM bonds, denominated in emerging market currencies, took in $1.3 billion in the past week and year-to-date EM fixed income has received almost $10 billion. And emerging equity funds absorbed a net $3.43 billion in the week to Feb 6, the 22nd consecutive week of net inflows, EPFR notes.

Russian debt finally became Euroclearable today.

What that means is foreign investors buying Russian domestic rouble bonds will be able to process them through Belgian clearing house Euroclear, which transfers securities from the seller’s securities account to the securities account of the buyer, while transferring cash from the account of the buyer to the account of the seller. Euroclear’s links with correspondent banks in more than 40 countries means buying Russian bonds suddenly becomes easier.And safer too in theory because the title to the security receives asset protection under Belgian law. That should bring a massive torrent of cash into the OFZs, as Russian rouble government bonds are known.

In a wide-ranging note entitled “License to Clear” sent yesterday, Barclays reckons previous predictions of some $20 billion in inflows from overseas to OFZ could be understated — it now estimates that $25 to $40 billion could flow into Russian OFZs during 2013-2o14. Around $9 billion already came last year ahead of the actual move, Barclays analysts say, but more conservative asset managers will have waited for the Euroclear signal before actually committing cash.

Foreigners’  increased interest will have several consequences.  Their share of Russian local bond markets, currently only 14 percent, should go up. The inflows are also likely to significantly drive down yields, cutting borrowing costs for the sovereign, and ultimately corporates. Already, falling OFZ yields have been driving local bank investment out of that market and into corporate bonds (Barclays estimates their share of the OFZ market has dropped more than 15 percentage points since early-2011).  And the increased foreign inflows should act as a catalyst for rouble appreciation.

Each of these points in a bit more detail:

a) Foreigners’ share of the Russian bond market is among the lowest of major emerging markets.  Compare that to Hungary, where non-residents own over 40 percent, or South Africa and Mexico, where foreigners’ share of local paper is over 30 percent.

b) Foreign buying last year compressed Russian yields sharply, eventually pushing down 10-year yields by 130 basis points over the year as foreigners moved further along an increasingly flattening curve.  But Russian 10-year yields around 6.5 percent will remain attractive to foreigners, comparing favourably with most other emerging markets.  And at home, falling government bond yields will benefit the economy as a whole as local banks change their focus. Barclays write:

(Falling yield) provides cushion to the (finance ministry) which plans to borrow 1.2 trillion roubles internally, versus 0.9 trillion last year. This also accommodates the reallocation of Russian banks’ portfolios  from OFZ into retail lending and corporate and municipal bonds  driven by higher returns.

c) Barclays advises clients to buy 10-year OFZs in anticipation of further gains, and suggests doing this on an unhedged basis to take advantage of potential rouble appreciation.  While the rouble has outperformed other emerging currencies in the past year, Barclays expects the outperformance to continue.