Author: Sujata Rao

The Czech central bank surprised many this week after its policy meeting. Widely expected to announce the timing and extent of FX market interventions, Governor Miroslav Singer not only failed to do so, he effectively signalled that intervention was no longer on the cards — at least in the short term  In his words, looser monetary conditions were now “less urgent”.

What changed Singer’s mind? After all, data just hours earlier showed Czech industrial production plunging  12 percent year-on-year in December. The economy has not grown since mid-2011 and is likely to have contracted by more than 1 percent last year. Singer in fact predicts a second full year of recession. But some slightly upbeat-looking forward indicators could be cause for cheer. According to William Jackson at Capital Economics:

We think that the need for further policy loosening was tempered by the tentative pick-up in the most recent survey data as well as the fall in the crown (versus the euro) since the start of the year.

Until yesterday’s meeting, the crown had fallen 3 percent since the start of the year to seven-month lows against the euro.  January purchasing managers indexes (PMI) this week also showed the Czech indicator rising more than expected to 48.3, up from December’s three-year low of 46.0. That gelled with a pick-up in PMIs also in neighbouring Poland and Hungary.  A separate survey also shows that the business climate in emerging Europe ticked higher in January for the first time since April. The OeKB Central and Eastern Europe Business Climate index of around 400 Austria-based direct investors edged up to 17 points, from 14 in October and the Czech component rose two points to 24, the highest since the second quarter of 2012.

Even more crucial perhaps have been the recent indicators from Germany, United States and China, on which hinge the fortunes of the export-dependent Czech economy. The German PMI chalked up its biggest one-month rise in January since August 2009, soaring to its highest since June 2011.  The Czech National Bank has increased its medium-term inflation and growth forecasts slightly. According to Singer:

The possibility of the greatest shocks seems to be a little dampened.

Jackson of Capital Economics notes however that Singer has not closed the door on further easing and still expects inflation to fall below target by early 2014.

Perhaps more importantly, the crown reacted to Singer’s remarks yesterday by rallying 1.5 percent. It is up a further 0.4 percent today and that wipes out most of the currency’s 3 percent depreciation since the start of 2013.  Analysts reckon that markets will take Singer’s comments as a signal he is not inclined to intervene and are likely to push the crown higher as a result, undoing some of the monetary loosening on which he had based his decision.

The boom in emerging corporate debt is an ongoing theme that we have discussed often in the past, here on Global Investing as well as on the Reuters news wire. Many of us will therefore recall that outstanding debt volumes from emerging market companies crossed the $1 trillion milestone last October. This year could be shaping up to be another good one.

January was a month of record issuance for corporates, yielding $51 billion or more than double last January’s levels and after sales of $329 billion in the whole of 2012. (Some of this buoyancy is down to Asian firms rushing to get their fundraising done before the Chinese New Year starts this weekend). What’s more, despite all the new issuance, spreads on JPMorgan’s CEMBI corporate bond index tightened 21 basis points over Treasuries.

JPM say in a note today that assets benchmarked to the CEMBI have crossed $50.6 billion, having risen 60 percent year-over-year.  Interest in corporates is strong also among investors who don’t usually focus on this sector, the bank says, citing the results of its monthly client survey. One such example is asset manager Schroders. Skeptical a couple of years ago about the risk-reward trade-off in emerging debt, Schroders said last month it was seeing more opportunities in emerging corporates, noting:

Stronger economic growth in developed markets and because of surging new issue volumes which permit investment in a greater variety of companies and countries.

There could be headwinds however. One could be a rise in Treasury yields that would make higher-risk assets less attractive. Corporate bonds are less well cushioned than in the past and many see valuations as looking a tad rich after last year’s 150 bps  spread compression on the CEMBI. Certainly, hardly anyone expects the kind of double-digit yields that came through in 2012.

But many reckon the risks from U.S. Treasuries will be far greater for U.S. high yield and emerging sovereign debt. According to Mike Conelius,  who runs an EM bond fund at T.Rowe Price:

(EM corporate) yields generally exceed those of corporate bonds in the United States, and companies in many cases are conservatively leveraged and managed with large cash reserves and little debt on their balance sheets. Yet they have a greater tailwind for growth, and the asset class is benefiting from investors’ search for yield.

Fans of the sector will point out that the CEMBI  yield on average is still 320 basis points over Treasuries, while the EMBI Global sovereign bond index trades around 275 bps  — in these yield-scarce days that 45 bps represents no mean pick-up.

Emerging bond issuance and inflows have had a strong start to the year but can it last?

Data from JPMorgan shows that emerging market sovereigns sold hard currency bonds worth $9.6 billion last month while companies raised $51.2 billion (that compares with Jan 2012 issuance levels of $17.5 billion for sovereigns and $23.9 billion for corporates). Similarly, inflows into EM debt were well over $10 billion last month, very probably topping the previous monthly record,  according to JPM.

But U.S. Treasury yields are rising, typically an evil omen for equities and emerging markets. Ten- year U.S. yields, the underlying risk-free rate off which many other assets are priced,  rose this week to nine-month highs above 2 percent. That has brought losses on emerging hard currency debt on the EMBI Global index to  2 percent so far this year. (there is a similar picture across equities, where year-to-date returns are barely 1 percent despite inflows of around $24 billion). Historically, negative monthly returns caused by rising U.S. yields have tended to lead to outflows.

The S&P500 U.S. equity index is trading at five-year highs, however, despite Treasuries’ creep higher. That would appear to indicate greater confidence in the growth outlook.  Support for emerging markets may also come from Japanese retail cash that is fleeing a falling yen. Morgan Stanley analysts, for instance, do not expect significant outflows just yet, noting that “the nature of inflows overall (into emerging debt) has been more structural than in past years and therefore tends to be much stickier”. They add:

We believe that EM investors should not be overly concerned. The main reason for this is the expectation of a range-bound UST going forward, with only 25 bps further widening projected. Neither the pace nor the extent of this change seems disruptive to us, even with a potential temporary overshoot on the upside.

But some steps to protect returns look warranted. MS analysts, for instance, noted that 60 percent of the sovereign debt index is made up of investment grade credits that trade at very tight spreads over Treasuries (see their graphic below). They recommend positioning in longer-duration 10-year bonds especially in high-beta, higher-yield names that offer more of a spread cushion to Treasuries.

JPMorgan analysts also advise holding onto overweight positions in emerging dollar debt.  They suggest focusing on corporate debt rather than sovereigns because of the yield pick-up. Within the sovereign asset class, higher-yield names such as Venezuela could prove a better bet in the current Treasury environment instead of stronger, low-beta credits such as Brazil, whose yield attraction diminishes as Treasury yields rise, JPM says. They also reckon the current Treasury sell-off is a temporary one, as likely budget spending cuts looming after March 1 will constrain debt supply from the United States.

What a difference a few months have made for Indian markets.

The rupee is 8 percent up from last summer’s record lows. Foreigners have ploughed $17 billion into Indian stocks and bonds since Sept 2012 and foreign ownership of Indian shares is at a record high 22.7 percent, Morgan Stanley reckons.  And all it has taken to change the mood has been the announcement of a few reforms (allowing foreign direct investment into retail, some fuel and rail price hikes and raising FDI limits in some sectors). A controversial double taxation law has been pushed back.  The government has sold some stakes in state-run companies (it offloaded 10 percent of Oil India last week, netting $585 million).  If the measures continue, the central bank may cut interest rates further.

Above all, there have been promises-a-plenty on fiscal consolidation.

The promises are not new. Only this time, investors appear to believe Finance Minister P. Chidambaram.

Chidambaram who was on a four-city roadshow to promote India to investors, pledged in a Reuters interview last week not to cross the “red line” of a 5.3 percent deficit for this year in the Feb 28 budget. Standard Chartered, one of the banks that organised Chidambaram’s roadshow, sent out a note entitled: “The finance minister means business”.

FM Chidambaram has gained market credibility on back of measures announced since Sept. 2012. ..if he follows through on these pledges….markets will have more reason to cheer.

So what can be expected if the budget does deliver the goods? Assuming global central banks continue to gush liquidity, the Indian stock rally might continue.  Indian stocks trade at 16 times forward earnings, slightly below their historical averages.  The rupee too should rise further. It has an implied yield of around 6 percent,  one of the highest in the world. And unlike many other emerging markets, India won’t be averse to some appreciation from current levels of around 53. 15 per dollar. According to Arvind Mayaram, head of economic affairs at India’s finance ministry:

Once you see fiscal consolidation start to happen, you will see the rupee strengthen further… the rupee at 52-53 (per dollar) is good. It will be still competitive but imports will become cheaper and inflation will moderate.

And what of India’s woeful infrastructure?  India’s pot-holed roads, power cuts and clogged-up ports will take years, if not decades, to fix. But the government does seem keen to deal with the problem. Mayaram, in London for a recent infrastructure roadshow, said in an interview that the government had fulfilled targets for  $500 billion infrastructure investments in the five years to 2012 and  half of this had come from the private sector. Another $1 trillion is planned by 2017, giving an annual  investment rate of around 38-40 percent of GDP, he said.

All that is good. But elections loom in 2014 and the ruling Congress is likely to pressure Chidambaram to be generous to voters.  UBS analyst Manik Narain says a lot of foreign cash has headed  to India recently on the promise of yield and the premise that the inflows will be welcome (unlike in many Asian and Latin American countries, where governments are increasingly fearful of hot money). But he says the peak could be close if reforms are not quickly deepened:

Given how much pressure the Congress is under, I find it surprising the market is trading with so much optimism.  The truth of the matter is that the reform steps India has taken are welcome but they are really only baby steps. A sliver of reform is making India look attractive.

 The ball, as Chidambaram has acknowledged, is firmly in the Indian government’s court.

Rate cuts are still coming thick and fast in emerging markets — in some cases because of falling inflation and in others to deter the gush of speculative international capital.

Arguably the biggest event in emerging markets is tomorrow’s Reserve Bank of India (RBI) meeting which is expected to yield an interest rate cut for the first time in nine months.

India’s inflation, while still sticky, eased last month to a three-year low of around 7 percent. And a quarter point rate cut to 7.75 percent will in effect be a nod from the RBI to the government’s recent reform efforts.  In anticipation of a rate cut, Indian 10-year bond yields have dropped 50 basis points since the start of the year.  But the RBI, probably the world’s most hawkish central bank at present, has warned that markets need not expect a 50 bps cut or even a sustained rate-cutting campaign. Governor Duvvuri Subbarao said last week inflation still remains too high for comfort, while on Monday the RBI said in a quarterly report that more reform was needed to make the central bank turn its focus on growth.

In Colombia, the  BanRep is likely to cut rates later today for the fifth time in seven months. Growth slowed to 2.1 percent in the third quarter, considerably below forecasts, while inflation in December was 2.4 percent, well below the midpoint of the target range.  Then there is the matter of the peso which has risen to the 1750 per dollar level that has triggered intervention in the past. Many analysts therefore reckon currency strength will be the main driver for the central bank’s decision later today. From that angle too, a cut looks logical.
According to Bank of America/Merrill Lynch:

We expect Banrep to compromise by cutting, and maintaining FX intervention unaltered, presenting the cut as a policy that tackles both deceleration and appreciation….another cut at Monday’s meeting would seem to be a safe bet.

A quarter point rate cut is also a given in Hungary tomorrow. That will bring the total easing since August to 100 bps.  A central bank board dominated by government appointees, dismal economic growth indicators and last month’s fall in inflation all add up to further monetary easing.  The board is clearly divided — Governor Andras Simor has said the current inflation levels do not justify a rate cut but he is likely to be outvoted by the government nominees who dominate the central bank board. Analysts at Goldman Sachs note that a weaker forint (it is down more than 2 percent to the euro since the start of January) is complicating the picture but they do not expect it to stop the central bank from cutting:

We think that the MPC will look through the recent weakening of the forint and some widening of bond yields. But the sell-off may give it some food for thought about the impact that a more accommodative stance under the new management may have on the forint, financial stability, and growth.

Israel today and Malaysia on Thursday are expected to keep interest rates unchanged. Given the weak numbers from Israel recently, the risks to interest rates are to the downside but analysts note that the bank cut rates in December and does not typically change rates in two consecutive months.

The issue of the falling yen is focusing many minds these days, nowhere more than in South Korea where exporters of goods such as cars and electronics often compete closely with their Japanese counterparts. These companies got a powerful reminder today of the danger in which they stand — quarterly profits from Hyundai fell sharply in the last quarter of 2012.  (See here to read what we wrote about this topic last week)

Korea’s won currency has been strong against the dollar too, gaining 8 percent to the greenback last year. In the meantime the yen fell 16 percent against the dollar in 2012 and is expected to weaken further. Analysts at Morgan Stanley pointed out in a recent note that since June 2012, Korean stocks have underperformed Japan, corresponding to the yen’s 22 percent depreciation in this period. Their graphic below shows that the biggest underperformers were consumer discretionary stocks (a category which includes auto and electronics manufacturers). Incidentally, Hyundai along with Samsung, makes up a fifth of the Seoul market’s capitalisation.

Shares in Hyundai and its Korean peer Kia have fared worst among major global automakers for the past three months – down 5 percent and 18 percent, respectively.  Both companies expect sales this year to be the slowest in a decade. Toyota on the other hand has risen 30 percent and expects to reach the top spot in terms of world sales for the first time since 2010.

Lim Hyung-geun, a fund manager at GS Asset Management, is one of the many investors who have offloaded Hyundai stock, helping to push its shares down 5 percent on Thursday.  The strong won is one reason, he tells Reuters:

Hyundai’s ability to overcome worsening external factors will be put to the test this year.   

There is a bright spot for Hyundai however. It stands to benefit from Japan’s territorial dispute with China which has seen consumers  in the world’s biggest car market boycott Japanese goods. Hyundai expects China sales to rise 13.3 percent compared with 12 percent last year.  Sales of Japanese brands such as Nissan and Toyota on the other hand are down 16-30 percent down from year-ago levels.

What a varied bunch emerging markets have become. At last week’s monetary policy meetings, we saw one rate rise (Serbia) and differing messages from the rest. Mexico turned dovish while hitherto dovish Brazilian central bank finally mentioned the inflation problem. Russia meanwhile kept markets guessing, signalling it could either raise rates next month or cut them.

This week, a cut looks likely in Turkey while South Africa and the Philippines will almost certainly keep interest rates steady.

Turkey’s main policy rate – the one-week repo rate – and overnight lending rate are widely expected to stay on hold at 5.50 percent and 9 percent respectively on Tuesday. But some predict a cut in the overnight borrowing rate – the lower end of the interest rate corridor, motivated partly by the need to keep the currency in check.   The lira is trading near 10-month highs, thanks to buoyant inflows to Turkish capital markets.  That has helped lower inflation from last year’s double-digit levels.

Goldman Sachs in fact, reckon the central bank will cut both the borrowing and lending rates by 25bps and also raise the Reserve Option Coefficient (the amount of foreign currency that lenders have to provide for the gold portion of their central bank reserves). They write:

We believe that the Bank has shifted focus towards the financial stability risks posed by accelerating capital inflows, and away from domestic inflation. We believe a combination of ROC hikes and (more visibly) cuts to the borrowing and lending rates, bringing the interest rate corridor down, will be used to lean against these inflows and their subsequent FX appreciation pressures.

Analysts at BNP Paribas agree:

While the current level of the lira is unlikely to be strong enough to elicit an aggressive reaction from the central bank, we still think that a measured 25 basis points cut to the lower end of the interest rate corridor is likely at next week’s central bank’s policy meeting, as a precaution against ongoing capital inflows.

In South Africa on the other hand, it is the currency’s weakness that is likely to force the central bank (SARB) to hold its hand.

This is a market that could really do with an interest rate cut — persistent labour unrest means GDP growth is likely to undershoot forecasts for 2.9-3.0 percent this year. But all 23 economists polled by Reuters see the SARB keeping rates  at 5 percent this  Thursday. Data this week expected to show annual price growth close to the central bank’s 6 percent upper limit and that’s partly down to the currency which lost almost a fifth of its value against the dollar last year. In 2013 the rand  is already down 5 percent and the central bank cannot risk weakening it further. Goldman Sachs again:

If anything, announcements of mine closures, a third sovereign rating downgrade, ongoing rand volatility, and the potential for further widening of the CA deficit are likely to have pushed the hurdle for a rate cut higher than in 2012 second half.

Philippines in comparison looks lucky. Inflation is close to the lower end of the central bank’s target band while GDP growth is running around 6 percent. The peso appreciated 6 percent last year against the dollar.  No wonder Governor Armando Tetangco is relaxed. He said last week that balanced inflation risks and robust GDP growth suggested the “current policy settings are appropriate.”  Expect rates to be left at a record low 3.5 percent on Thursday.

(corrects name of hedge fund in para 3 to Symphony Financial Partners)

Any doubt about the importance of a weaker yen in thawing the frozen Japanese economy will have been dispelled by the Nikkei’s surge to 32-month highs this week. Since early December, when it became clear an incoming Shinzo Abe administration would do its best to weaken the yen, the equity index has surged as the yen has fallen.

Those moves are giving sleepless nights to Japan’s neighbours who are watching their own currencies appreciate versus the yen. South Korean companies, in particular, from auto to electronics manufacturers, must be especially worried. They had a fine time in recent years  as the yen’s strength since 2008 allowed them to gain market share overseas. But since mid-2012, the won has appreciated 22 percent versus the yen.  In this period, MSCI Korea has lagged the performance of MSCI Japan by 20 percent. Check out the following graphic from my colleague Vincent Flasseur (@ReutersFlasseur)

David Baran, co-founder of Tokyo-based Symphony Financial Partners, notes the relative performance of Hyundai and Toyota (Hyundai shares have fallen 2.5 percent this year adding to 13.5 percent loss in the last quarter of 2012. Toyota on the other hand is up 5 percent so far in 2013 after gaining 31 percent in Oct-Dec last year). Baran says he has gone long the Nikkei and short the Seoul index (the Kospi) and (Hong Kong’s) Hang Seng, while taking a short position on the yen. He says:

Dollar/yen went from 125 to 77 at the exporters’ expense and the Koreans benefited massively from this. Now, if we get a situation where the yen goes into the mid-90s or lower, Japanese corporates will be fantastically profitable and that’s what people are starting to build into equity  allocations. The feeling is that greater damage will be towards Korean exporters in favour of the Japanese.

Analysts at Morgan Stanley predict the won may appreciate another 10 percent  against the yen by year-end. But they are less worried about the outlook for Korean exporters, telling clients this week that unless the yen/won cross depreciated another 30 percent, Korean exports would not be structurally undercut.

The reasons? Many Korean companies have moved production overseas to countries like Thailand and India and are therefore less reliant on the won’s exchange rate. Second, Korean exports compete less with Japan’s than in the past. (“Think more Samsung v. Apple, not v. Sony,” Morgan Stanley tell clients) . Lastly, the global growth cycle appears to be finally turning, they say:

BoJ-induced currency strength…is likely to undercut Korean exporters’ earnings in the short term. However, as the pace of currency decline eases, we expect global growth to outweigh any concerns related to reduced export competitiveness vs. the Japanese.

For now, foreign cash is headed for Japanese shares. Fund tracker EPFR Global say inflows  hit a 20-week high last week while Bank of America/Merrill Lynch’s monthly investor survey shows global equity funds went overweight Japan in January for the first time since mid-2011.

Eventually, what this means is that the Bank of Korea — and others in Asia — will have to act to support their own export sectors. Expect more currency wars in the months ahead.

As Moscow takes up the helm of the G20 grouping this year, Russian central banker Alexei Ulyukayev said on Wednesday: “We’re on a threshold of a very serious, confrontational actions in the sphere that is known … as currency wars.”

When will Brazil’s central bank admit it has an inflation problem? Markets will be watching today’s rate-setting meeting for clues.

There is no doubt about the outcome of today’s meeting at the Banco Central do Brasil (BCB) — no one expects it to do anything but leave interest rates steady at the current 7.25 percent. But the BCB has been focused on growth for 18 months and has cut interest rates by 525 basis points in this time, its actions helping to drive the real 10 percent lower last year versus the dollar. The government meanwhile has unleashed huge doses of fiscal stimulus. The result, rather than a growth recovery, is a steady rise in inflation.

Goldman Sachs’ Latin America economist Alberto Ramos points out that Brazilian inflation came in above the 4.5 percent target for the third straight year in 2012 and the balance of inflation risks has deteriorated. Gasoline prices are to rise from next week and drought is making hydro-power generation more costly. Analysts polled by Reuters expect 2013 price growth at 5.53 percent. Ramos writes:

We are of the view that at a certain point the central bank needs to own the inflation problem and acknowledge that just remaining on automatic pilot may not be enough to drive inflation to the 4.5% target by year-end 2013.  

The bank will not raise interest rates any time soon and is sticking to a 4.8 percent inflation forecast for 2013 . Ramos says the bank must at least change its post-meeting message in which it has referred to “a stable/unchanged monetary stance for a prolonged period of time”.

That would serve the monetary authority well to bolster credibility as an inflation targetter and would still not necessarily commit the central bank into having to deliver Selic rate hikes in 2013.

What of markets? Brazilian interest rate futures are  implying a quarter point rate hike within the next 6 months and 60 bps of rate hikes over the coming year.  Given the central bank’s dogged focus on growth, that sounds too hawkish. Analysts at TD Securities reckon that instead of an orthodox rate hike, Brazil may  deploy some macroprudential measures to tighten policy via absorbing excess liquidity in the banking system. The BCB may also try the exchange rate mechanism. TD analysts note that the real has already gained some ground in recent weeks and is now ranging between 2.02 and 2.05.

Brazil is not alone of course. The growth versus inflation conundrum has been dogging central banks around the world, with even some Fed officials recently voicing concern about the consequences of unlimited money printing. The argument continues.