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Emerging Markets ExplorerEM Turning a Corner

April 2016

Strategy — Look for High Beta Macro — China Humming on Stimulus Watch — Oil

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Emerging Markets Explorer

CONTENTS

Executive Summary................................................................................................................................................................................... 3

SEB EM Forecasts ...................................................................................................................................................................................... 4

Macro Overview: Markets Have Priced in Weak Macro Backdrop ..................................................................................................... 5

Theme: China’s Property Puzzle ............................................................................................................................................................. 8

Theme: USD Pegs — To Break Or Not To Break .................................................................................................................................. 10

Strategy: Join the EM, Oil, and Commodity Rally While it Lasts ........................................................................................................ 13

Trading Ideas........................................................................................................................................................................................ 13 Fixed Income: EM Back with a Vengeance — But for How Long? ................................................................................................ 14

Country Section ........................................................................................................................................................................................ 17

Asia ............................................................................................................................................................................................................. 17

China ..................................................................................................................................................................................................... 17 Hong Kong ............................................................................................................................................................................................ 17 India ....................................................................................................................................................................................................... 17 Indonesia ............................................................................................................................................................................................. 18 South Korea ......................................................................................................................................................................................... 18 Malaysia ............................................................................................................................................................................................... 18 Philippines ........................................................................................................................................................................................... 19 Singapore ............................................................................................................................................................................................. 19 Taiwan .................................................................................................................................................................................................. 19 Thailand ............................................................................................................................................................................................... 20

Emerging Europe ..................................................................................................................................................................................... 20

Czech Republic ................................................................................................................................................................................... 20 Hungary ............................................................................................................................................................................................... 20 Poland .................................................................................................................................................................................................. 21 Russia ................................................................................................................................................................................................... 21 Turkey .................................................................................................................................................................................................. 22 Ukraine ................................................................................................................................................................................................. 22

Latin America ........................................................................................................................................................................................... 23

Brazil ..................................................................................................................................................................................................... 23 Mexico .................................................................................................................................................................................................. 23

Sub-Saharan Africa ................................................................................................................................................................................. 24

South Africa ......................................................................................................................................................................................... 24 Disclaimer ................................................................................................................................................................................................. 25

Contacts ................................................................................................................................................................................................... 26

EDITOR

Per Hammarlund

CONTRIBUTORS

Olle Holmgren

Andreas Johnson

Magnus Lilja

Dennis Masich

Louise Valentin

Sean Yokota

Disclaimer: See page 25

Contacts: See page 26

Cut-off date: 13 Apr, 2016

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Executive Summary

TRADE IDEAS (MORE ON P. 13)

LONG INDIA

Our top pick in Asia: good carry, rate

cutting cycle finished for 2016 and stable

current account.

LONG KOREA ABOVE 1,200

Export cycle will have bottomed out by

2H 2016, real rates will remain elevated

and a high CA surplus will be maintained.

LONG RUB

Among top candidates to buy as

correlation with oil is strong and oil

projected to go as high as $60 per barrel

by 3Q. Target USD/RUB at 60 with oil at

$50.

LONG CZK

We keep the short EUR/CZK (target

25.00, stop 28.32) that was initiated

October 9, 2015. Inflationary pressure

keeps building putting pressure on the

CNB to remove the floor under EUR/CZK.

LONG MXN

We expect USD/MXN to reach 16.90 by

3Q 2016 from the current 17.50 on the

back of higher oil prices.

MACRO OVERVIEW

Emerging Market (EM) economies face a weak backdrop characterized by a sluggish global macroeconomic environment.

There are still concerns about slowing Chinese growth, rising debt and deleveraging, capital outflows and the outlook for

commodities but this has been priced into EM assets with low valuations creating more upside than downside risks. In the

near term, 1-2 months, we see a risk for a technical correction but for the remainder of the year EM assets are expected to outperform Developed Markets.

THEMES

The first theme focuses on what Oxford Economics (OEF) calls the “world’s ‘most important’ sector”. China’s housing market

development is splashing across media headlines and gaining clients’ attention globally. Our view is that the mass market will

stabilize around early Q4 and experience a cyclical rebound. China’s housing market is diverse. Recent property price surge

and reintroduction of tightening measures are to specific top tier cities and developments in mass market are very different.

Unless you have exposure to assets in these top cities, we recommend focusing on the mass market for global impact such as commodity prices and get optimistic closer to 4Q. Right now, we are still in the waiting game.

The second theme article picks up on the sustainability of the USD pegs maintained by Saudi Arabia, Hong Kong, and Nigeria.

So far, several countries have been forced to abandon or adjust their USD pegs, including Azerbaijan, Egypt and Kazakhstan.

Markets have also questioned the ability of Saudi Arabia, Hong Kong and Nigeria to sustain their own pegs. We argue that the pegs in Saudi Arabia and Hong Kong will hold but that Nigeria will be forced to devalue the naira.

STRATEGY

We have over the past couple of years been optimistic about EM assets in general. However, the current rally is the strongest

since the first “Taper Tantrum” in May 2013, with our general EM FX index rising by more than 7% against a basket of USD;

EUR, JPY, GBP, and CHF. The long-term outlook for commodities is for renewed price pressures due to overinvestment during

the boom years in the decade after the turn of the millennium. However, the strength of the current rally is a sign that EM

assets had lost too much in too short of a time, and that the long-term downward trend has been broken, at least for 2016. IN

Asia we favour India because of the positive growth outlook, and the KRW above 1,200 against the USD. Nevertheless, in the

near term, we are cautious on Asian currencies, as central banks are in a monetary easing cycle led by China. In Latin America

and in parts of EMEA, policy rates have been rising or remain high, which is in combination with low valuations are presenting

good buying opportunities. We favour the MXN in Latin America, as it has lagged the EM rally. We also find the RUB severely

undervalued should oil head back to $50 or even $60 per barrel, as our oil analyst foresees. Lastly, we prefer to stay long the CZK, as the Czech Republic’s Swissie moment is sure to come before too long.

In the Fixed Income space, we see opportunities for differentiation and selective longs in EM debt markets, but think a rally at

the same strong pace in EM assets from here onwards is relatively unlikely, as long as the fundamental issues of growth

momentum remain unresolved. If this is the last leg of this rally, we could see some profit taking in the near future. Coupled

together with a wide range of economic uncertainties across the globe, it leads us to adopt a more balanced stance in our portfolio. However, we are increasing the duration from 3.3 years to 4.5 years in order to come closer to the index.

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SEB EM Forecasts

FX Rates (end of period) Policy Rates (end of period)

14-Apr-2016 Spot 2Q-16 3Q-16 4Q-16 1Q-17 2Q-17 Apr 14, 2016 Current RateNext

MPC2Q-16 3Q-16 4Q-16 1Q-17 2Q-17

vs. EUR Asia

PLN 4.30 4.29 4.35 4.20 4.10 4.10 China Lending 4.35 -- 4.10 3.85 3.85 3.85 3.85

HUF 311 316 320 315 310 302 Deposit 1.50 1.25 1.00 1.00 1.00 1.00

CZK 27.0 27.1 27.1 27.1 25.0 25.0 RRR 17.00 16.00 15.00 14.00 13.00 12.00

RON 4.47 4.50 4.45 4.40 4.35 4.32 South Korea 1.50 Apr 19 1.25 1.00 0.75 0.75 0.75

TRY 3.22 3.14 3.19 3.18 3.20 3.29 India 6.50 Jun 7 6.50 6.50 6.50 6.25 6.25

RUB 74.8 69.3 64.8 66.8 65.1 65.7 Indonesia 6.75 Apr 21 6.75 6.75 6.75 6.75 6.75

vs. USD Malaysia 3.25 May 19 3.00 3.00 2.75 2.75 2.75

RUB 66.5 63.0 60.0 63.0 62.0 62.0 Philippines 4.00 May 12 3.75 3.50 3.25 3.25 3.25

TRY 2.86 2.85 2.95 3.00 3.05 3.10 Thailand 1.50 May 11 1.25 1.00 0.75 0.75 0.75

PLN 3.83 3.90 4.03 3.96 3.90 3.87 Taiwan 1.500 Jun 21 1.380 1.130 1.000 1.000 1.000

HUF 277 287 296 297 295 285 Emerging Europe

CZK 24.0 24.6 25.1 25.6 23.8 23.6 Poland 1.50 May 6 1.25 1.25 1.25 1.50 1.75

UAH 25.65 26.50 27.00 28.00 28.00 28.00 Czech 0.05 May 5 0.05 0.05 0.05 0.05 0.25

ZAR 14.68 15.20 15.70 16.20 16.30 16.50 Hungary 1.20 Apr 26 1.05 0.90 0.90 1.10 1.50

KES 101.2 105.0 106.0 108.0 110.0 115.0 Turkey 1W repo 7.50 Apr 20 7.50 7.50 8.00 9.50 10.00

NGN 199 205 230 230 230 230 O/N Borrowing 7.25 7.25 7.00 7.50 8.50 8.50

BRL 3.50 3.50 3.45 3.75 3.90 3.95 O/N Lending 10.50 10.50 10.50 11.00 11.50 12.00

MXN 17.54 17.30 16.90 17.00 17.00 17.00 Romania 1.75 May 5 1.75 1.75 1.75 2.00 2.50

CLP 671 680 690 700 710 710 Russia 11.00 Apr 29 11.00 10.00 9.00 8.50 8.00

CNY 6.49 6.60 6.80 6.90 6.80 6.75 Ukraine 22.00 -- 20.00 15.00 15.00 15.00 12.00

CNH 6.50 6.65 6.90 7.00 6.90 6.80 Latin America

HKD 7.76 7.80 7.80 7.80 7.80 7.80 Brazil 14.25 Apr 27 14.25 14.25 14.25 14.25 14.00

IDR 13,204 14,000 14,200 14,200 14,000 14,000 Mexico 3.75 May 5 3.75 3.75 4.00 4.25 4.50

INR 66.6 68.0 69.0 70.0 69.0 67.0 Chile 3.50 May 17 4.00 4.25 4.50 4.75 5.00

KRW 1,157 1,220 1,240 1,250 1,200 1,200 Sub-Saharan Africa

MYR 3.89 4.10 4.18 4.20 4.15 4.10 S. Africa 7.00 May 19 7.50 7.50 7.50 7.50 7.50

PHP 46.2 47.0 48.5 49.0 48.5 48.5 Source: Bloomberg, SEB

SGD 1.36 1.39 1.44 1.45 1.44 1.43

THB 35.2 36.0 37.5 38.0 37.5 37.0

TWD 32.4 34.0 34.5 35.0 34.5 34.0

EUR/USD 1.12 1.10 1.08 1.06 1.05 1.06

USD/JPY 109.1 116 123 127 125 123

EUR/SEK 9.18 9.10 9.00 8.90 8.85 8.80

USD/SEK 8.16 8.27 8.33 8.40 8.43 8.30

Real GDP Consumer Price Inflation2012 2013 2014 2015 2016 2017 Target Latest SEB Forecasts

SEB EM Aggregate 7.4 6.4 4.7 4.0 4.3 4.7 2016 % y/y 2014 2015 2016 2017 2018

Asia Asia 2014

China 7.7 7.7 7.3 6.9 6.5 6.0 China 3.0 2.3 Mar 2.0 1.4 2.0 2.5 --

India 6.0 6.4 7.0 7.3 7.5 7.7 India 5.0 4.8 Mar 7.2 4.9 5.5 5.7 --

Indonesia 6.0 5.6 5.0 4.8 5.0 4.9 Indonesia 4.5 (±1) 4.5 Mar 6.4 6.4 5.0 5.3 --

South Korea 2.3 2.9 3.3 2.6 3.2 3.3 South Korea 2.0 1.0 Mar 1.3 1.3 1.5 1.2 --

Singapore 3.7 4.7 3.3 2.0 2.2 1.9 Singapore -- -0.8 Feb 1.0 -0.5 0.4 1.0 --

Philippines 6.7 7.1 6.1 5.8 5.9 5.3 Philippines 3.0 (±1) 1.1 Mar 4.1 1.5 2.5 2.8 --

Malaysia 5.5 4.7 6.0 4.9 4.1 3.9 Malaysia 3.0–4.0* 4.2 Feb 3.2 2.1 2.8 2.5 --

Taiwan 2.0 2.2 3.9 0.8 2.3 2.6 Taiwan -- 2.0 Mar 1.2 -0.3 0.8 1.0 --

Thailand 6.5 2.9 0.9 2.8 3.3 3.5 Thailand 2.5 (±1.5) -0.5 Mar 1.9 -0.9 1.5 2.0 --

Emerging Europe Emerging Europe

Poland 1.6 1.3 3.3 3.6 3.6 3.8 Poland 2.5 (±1) -0.9 Mar 0.0 -0.9 0.8 2.0 2.5

Czech Republic -0.8 -0.5 2.0 4.3 3.0 3.0 Czech Republic 2.0 (±1) 0.3 Mar 0.4 0.3 1.7 2.5 3.0

Hungary -1.6 0.2 3.5 3.0 2.4 2.4 Hungary 3.0 (±1) -0.2 Mar -0.2 -0.1 2.0 3.0 4.0

Turkey 2.2 4.2 3.0 4.0 3.3 3.4 Turkey 5.0 7.5 Mar 8.9 7.7 8.5 7.6 9.0

Romania 0.6 3.5 3.0 3.8 3.3 3.3 Romania 2.5 (±1) -3.0 Mar 1.1 -0.6 0.1 2.6 2.8

Russia 3.5 1.3 0.7 -3.7 -1.5 1.2 Russia 4.0** 7.3 Mar 7.8 15.6 8.0 6.4 --

Ukraine 0.2 0.0 -6.6 -11.0 1.0 2.0 Ukraine -- 30.8 Mar 2.1 48.5 18.0 10.0 --

Latin America Latin America

Brazil 1.9 3.0 0.1 -3.8 -3.5 1.5 Brazil 4.5 (±2) 9.4 Mar 6.3 9.0 8.0 6.0 --

Chile 5.6 4.0 1.8 2.1 2.6 3.5 Mexico 3.0 (±1) 2.6 Mar 4.0 2.7 3.0 3.5 3.2

Mexico 4.0 1.3 2.2 2.5 2.7 3.8 Chile 3.0 (±1) 4.5 Mar 4.4 4.3 4.0 3.3 3.5

Sub-Saharan Africa Sub-Saharan Africa

South Africa 2.2 2.2 1.6 1.3 0.9 1.7 South Africa 3.0–6.0 7.0 Feb 6.1 4.6 6.4 6.3 6.0Source: IMF, OECD, Bloomberg, SEB *BNM forecast; **2017. Source: SEB, Bloomberg, Consensus Economics.

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Macro Overview: Markets Have Priced in Weak Macro Backdrop

Emerging Markets are facing another year characterized by a sluggish global macroeconomic environment.

Yet, the weak backdrop has been priced into EM assets and commodities, with low valuations creating more upside than downside risks.

Selloffs in EM assets will likely be short-lived and present attractive entry levels.

We believe India, Korea, Poland, Brazil, and Mexico will present the best buying opportunities in 2016.

Past performance is not a good guide for future market

performance. SEB’s EM FX index — 20 EM currencies

against a basket of USD 40%, EUR 20%, JPY 15%, GBP

12.5%, and CHF 12.5% — weakened by 14.8% between

January 9, 2015 and January 20, 2016, bringing the

cumulative depreciation since before the first “Taper

Tantrum” in May 2013 to 27%. Since January, EM currencies

have recovered part of their losses. Nevertheless, they

remain 22% below the level when the US Fed first

announced its intention to normalise interest rate after the

2008–2009 crisis. The sharp fall in EM asset prices means

that markets have largely priced in a gloomy outlook for

global growth and commodity prices. The adjustment in EM

FX has been made, with many individual EM currencies now

looking undervalued. What then should we expect for the next 3–6 months?

In the near term, 1–2 months, the momentum of the EM

rally since January will likely stall, and we see a risk for a

technical correction. EM assets and global risk appetite

have simply strengthened too much in too short of a time.

However, for the remainder of the year, EM assets look likely to outperform Developed Markets (DM).

The key factors determining the trend in EM over the

coming months will be 1) global growth; 2) inflation and

monetary policy; 3) concern about rising debt and

deleveraging; 4) capital flows to EM; and 5) the outlook for commodities and oil.

SLOWING ECONOMIC GROWTH

In the World Economic Outlook (WEO) from April, the IMF

expects world GDP growth to accelerate to slightly to 3.2%

in 2016 from 3.1% in 2015. Although it represents a

downward revision from the IMF’s January forecast, markets

had been bracing themselves for worse. The IMF forecasts

EM and developing economies to grow by 4.1% in 2016, up

slightly from 2015 on the back of stable growth in Asia, and

a bottoming out of the recession in Russia. The high EM

growth rates during the commodity-boom years between

2001 and 2011 will not return. However, even the IMF’s

revised outlook is subject to stronger downside than upside

risks. Without a new commodity boom (a highly unlikely

proposition), the differential between EM and DM growth

will narrow as a result of slowing growth in EM over time and accelerating growth in DM.

US manufacturing activity has yet again started the year

softer than expected, but looks set to recover in the second

half spurring total GDP growth of 2.4%, the same as in

2015. Although US 10-year yields have been trending down,

touching below 1.70% and suggesting market concern

about the health of the US economy, the labor market is too

strong for us to expect a sharp slowdown in growth, let alone a recession.

Chinese growth is changing composition from being driven

by exports and investments to domestic consumption and

services. The transition will be delayed by the government’s

stimulus, especially in the form of infrastructure

investments. We also see a loosening of monetary policy

boosting credit growth, which should support consumption

and eventually help stabilize the Chinese property market.

Although exporters of commodities to China will suffer,

headline GDP growth of 6.5% and signs that companies in

the consumer goods and services sector pick up some of

the slack from manufacturing, will help dispel fears of a hard landing in China.

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The laggard of the large economies will again be the

Eurozone, which looks set to grow by no more than 1.9% in

2016. The German and Spanish economies will provide

most of the impetus for growth, but it will not be enough to take the EU out of the doldrums.

SUBDUED INFLATION OUTLOOK

The outlook for inflation is for continued price pressures.

Except for the usual suspects, Brazil, Colombia, Turkey,

South Africa, which have seen inflation surge on FX

weakness, price pressures are subdued. The reason for the

recent uptick in headline inflation is a sharp rise in food

prices, in particular in China and Taiwan. However, these

prices increases are not reflected in broader food stuff

indexes, but are country specific. As such the uptick in food

inflation and headline inflation should be temporary. In

addition, as exchange rates stabilise in Russia, Brazil and

other high inflation markets, the country-specific drivers

behind the uptick in our EM CPI should help moderate the

headline number. Indeed inflation in Russia has dropped to

7.3% y/y in March from 12.9% in December and in Brazil to 9.4% from 10.7%.

Expansionary monetary policies will dominate our forecast

horizon (6 months) and most likely for the major part of the

next 12 months. While the ECB has not delivered what

markets had expected in terms of additional easing, a

hawkish turn in policy is almost inconceivable. In addition,

the US Fed, probably fearing excessive USD strength

destabilising capital flight from China, will not be in any

hurry to hike rates. We are expecting one hike in September

and one in December, although the risk is that the Fed will opt for only one hike (in December).

With China looking set to ease monetary policy further,

other Asia central banks will follow. This easing bias is a key

reason for our expectation of an upward movement in the

USD/Asian currency pairs in the near term, before a

stabilisation and recovery in late 2016 and early 2017. When

it comes to Latin America, and EMEA, the recent EM rally

will allow central banks either to put the hiking cycle on

hold (Mexico and Chile), or even start to ease, as in the case

of Brazil and Turkey. Even South Africa, which is facing

rising inflationary pressure both from a weak exchange rate

and a severe drought, may find time to pause its hiking cycle.

DEBT DELEVERAGING: HANGED FIRE

The key known risk to our predominantly positive outlook

for EM resides in fast rising debt levels, most importantly in

China, Hong Kong, Russia, Malaysia, and Turkey. According

to estimates by the Institute of International Finance (IIF),

roughly $240 billion in USD denominated loans and bonds

is coming due in 2016 and $265 billion in 2017. While some

countries have seen sharply higher public debt ratios, the

bigger concern is a rise in non-financial corporate sector

debt. Despite alarm being raised by the IMF and in

particular the BIS, debt levels continue to rise, albeit at a

slowing pace. One mitigating factor is that the majority has

been issued in local currencies and that issuance has

shifted even more from USD to local currency debt in 2015

and 2016. Nevertheless, EM non-financial corporate debt

has risen to above 100% of GDP, higher than among advanced economies at below 90%.

A sudden drying up of liquidity, whether in local or foreign

currencies, would have a devastating impact. A shift in

expectations of how fast the US Fed will hike its policy rate,

may cause global interest rates to jump and tighten credit

conditions in EM. A key risk to monitor is if a rise in US core

CPI (and personal consumption expenditures) will force the Fed to hike even without a strong US economy.

CAPITAL FLOWING AGAIN TO EM

After an unprecedented seven consecutive months of net

portfolio investment outflows, capital to EM started to

return in February this year. Importantly, the main driver of

the outflows leading up to February was China, which has

seen its foreign currency reserves fall by $780 billion or

almost 20% (not accounting for valuations changes) between June 2014 and March 2016.

While total capital outflows appear to be continuing in

China, one of the key stabilizing factors for EM generally has

7


been the PBOC’s stabilization of the Chinese yuan. Since

letting the CNY depreciate by almost 6% between August

2015 and January 2016, it has strengthened the CNY by 2%

against the USD. The Chinese authorities emphasize that

they no longer look at only the bilateral USD/CNY rate, but

instead on the CNY against a trade-weighted basket of

currencies. Yet, the appreciation against the USD has had stabilizing effect on EM.

The US Fed and the ECB are seemingly acting more in sync

since January — that is, the US is not going to hike as fast as

previously signaled and the ECB will not ease as much as it

had let markets believe. This tacit, or even perhaps explicit

understanding, will prevent the USD from appreciating

sharply against other major currencies, which in turn will

allow the PBOC to guide the CNY weaker against the basket

of currencies that it now uses as a benchmark. As long as

the CNY is stable or only decline very gradually against the USD, capital will keep flowing to EM this year.

COMMODITY PRICES

Commodity prices will remain under pressure, but will not

experience the sharp falls seen in 2015. Falling commodity

prices has been a key factor behind slowing growth in EM

and international trade. As such it has been a key factor

behind generally negative sentiment towards emerging

markets. Beyond our forecast horizon of 6–12 months,

commodity prices should come under renewed pressure

due to overinvestment during the boom years, as well as

slowing demand growth in China (once the stimulus

programs are withdrawn). Nevertheless, in the next six

months, the technical commodity rally is showing no real

signs of reversing. Some commodity-importing EM

economies such as Turkey and the CEE3 do not benefit

directly from higher prices. Nevertheless, rising, or even

stable commodity prices will be a key support factor for EM assets, FX, as well as bonds and equities.

Speculation about the Doha summit scheduled for April 17

is being dominated by a potential deal between Russia and

Saudi Arabia to freeze oil production. Some form of deal

now appears likely, and has been driving oil higher over the

last few weeks. However, it will be largely symbolic without Iran, Iraq, Libya, and Venezuela.

The spot price for Brent crude oil at $44.50 per barrel on

April 13 represents a near 60% rise since January 20. We

see Brent averaging $45–$50 per barrel, even periodically

trading in the low $60s in the second half of 2016. Yet, after

such a staggering comeback, the potential for downside

surprises is increasing, especially if Iran boosts output faster

than expected and US shale producers ramp up production with oil at $60 per barrel.

INVESTMENT STRATEGY

When it comes to investment strategy, over the long term

(1–5 years), we recommend staying long reformers with

moderate (external) debt levels such as the Czech Republic,

India, Korea, Mexico, the Philippines, and Poland. In the

short term, we stay opportunistic. As concerns about the

challenges confronting EM waxes and wanes, so will

financial market volatility. However, these swings also bring

investment opportunities. (Please, see our trading ideas on p. 13.)

Per Hammarlund

8


Theme: China’s Property Puzzle

China’s housing market development is splashing across

media headlines and gaining clients’ attention globally. Our

view is that the mass market will stabilize around early Q4

and experience a cyclical rebound. China’s housing market

is diverse. Recent property price surge and reintroduction of

tightening measures are to specific top tier cities and

developments in mass market are very different. Unless you

have exposure to assets in these top cities, we recommend

focusing on the mass market for global impact such as

commodity prices and get optimistic closer to 4Q. Right now, we are still in the waiting game.

CHINA HOUSING BACKGROUND

China’s housing market is differentiated into tiers. This

makes sense since incomes vary drastically depending on

where you live (e.g. Shanghai GDP per capita is US$15,900

vs inland Guizhou is $4,100). No set definition exists but we

consider first tier to include the 4 mega cities of Beijing,

Shanghai, Guangzhou and Shenzhen. Second tier cities

include capitals of provinces mostly on the east coast

(Changsha, Chengdu, Chongqing, Dalian, Hangzhou,

Nanchang, Nanjing, Ningbo, Qingdao, Sanya, Shenyang,

Tianjin, Wuhan, Wuxi, Xian). We have lumped third tier and everything else into one category.

The excess inventory that we often hear about is very

different compared to the tiers. As you can see from the

chart below, third tier cities and below make up the bulk of

the national excess inventory (77% of total) whereas second tier (18%) and first tier (5%) are very small.

China: 3rd

Tier Cities Account for Bulk of Excess Inventory

RECENT PROPERTY MEASURES

The excess inventory classification helps explain the recent

price movements and the reintroduction of policy

tightening measures. As the chart below shows, the price

surge has been concentrated in first tier that is up 26% yoy.

This is much bigger than second tier (3% yoy) and third tier

and below (-0.3% yoy), which is still contracting. First tier

has had no supply-side, excess inventory issues. However,

first tier has benefited from government measures to boost

demand with low interest rate environment and removal of macro-prudential measures.

China: Property Prices 1st

Tier Rec

With first tier prices surging and spreading to select second

tier cities, the loosening measures are morphing into

tightening measures. The recent tightening measures are a

combination of the following. First, down payment

requirements have increased in Shenzhen (40% from 30%

for first time buyers), Shanghai (50% from 40% for second

home purchases) and Nanjing (30% from 20-25% for

second mortgages). Second, for non-local buyers, the

government is increasing years of income and social

security taxes paid before being able to purchase a home in

these cities. Third, capital gains tax of 5% was introduced

on property held for less than 2 years to prevent flipping

and speculation. Fourth, announcements have been made

to increase supply, which makes sense looking at the

inventory chart, especially in first tier. The key point is that

tightening measures are targeted to specific cities and they

are too concentrated to make a shift in the national market and macroeconomic indicators.

FOCUS ON MASS MARKET

If you are focused on global commodity prices and overall

China’s economic growth rate, the outlook on third tier and

below market is the most important. For timing we use the

chart below, which is the change in the inventory level. We

want to see “Other” inventory growth rate in green fall

towards the first and second tier growth rates (blue and red

lines) to turn optimistic on the national housing market. We

think inventory volume growth (real terms) matching

China’s real GDP growth rate of 6.0-6.5%yoy are

sustainable levels. A 6.0-6.5%yoy growth in inventory will

prevent “excess inventory” issues and price declines, both

of which we have been experiencing since late 2014 to now in third tier and below markets.

0

50

100

150

200

250

300

350

400

Jan

-12

Jul-1

2

Jan

-13

Jul-1

3

Jan

-14

Jul-1

4

Jan

-15

Jul-1

5

1st tier

2nd tier

3rd & lower tier

inventory, vacant houses waiting for sale (mln sq meters)

-10

-5

0

5

10

15

20

25

30

35

Jan

-12

Jul-1

2

Jan

-13

Jul-1

3

Jan

-14

Jul-1

4

Jan

-15

Jul-1

5

Jan

-16

1st Tier

2nd Tier

Other

New Residential Property Price 2011=100, yoy%

9


China: Change in Inventory Levels

SEVERAL MONTHS OF TURBULENCE, TURN MORE POSITIVE IN Q4

We’ve had inventory destocking and price increases

because sales have been strong due to relaxing of macro

prudential measures and lower interest rates (chart below,

green line). Most likely, sales were high in February and in

the coming March data as people tried to front-run

purchases ahead of the new tightening measures. We’ll

likely get pull back in April and May, but we think it will be

temporary or limited to the smaller first and second tier

cities. Since the mass market is not experiencing tightening

measures, the overall sales momentum will remain positive

in Q2 and into Q3. With positive sales, we think mass

market inventories will decline to reasonable levels by Q4,

which will finally lead to sustainable price increases and

beginning of new construction. To get positive on China

and commodities, wait until the new construction cycle picks up again in Q4.

China: Construction cycle expected to pick up in Q4

Sources of all charts: CEIC, Macrobond, SEB

Sean Yokota

0

10

20

30

40

50

60

0

10

20

30

40

50

60

Jan

-13

Mar

-13

May

-13

Jul-1

3

Se

p-13

Nov

-13

Jan

-14

Mar

-14

May

-14

Jul-1

4

Se

p-14

Nov

-14

Jan

-15

Mar

-15

May

-15

Jul-1

5

Se

p-15

Nov

-15

Jan

-16

1st Tier

2nd Tier

Other

vacancy houses waiting for sale yoy%, SEB

-30

-20

-10

0

10

20

30

40

50

60

70

08 09 10 11 12 13 14 15 16

SEB China construction indicator

Sales by floor space

% yoy 3mma

10


Theme: USD Pegs — To Break Or Not To Break

So far, several countries have been forced to abandon or

adjust their USD pegs, including Azerbaijan, Egypt and

Kazakhstan. Markets have also questioned the ability of

Saudi Arabia, Hong Kong and Nigeria to sustain their own

pegs. Our main scenario is that pegs in Saudi Arabia and

Hong Kong will hold but that Nigeria will be forced to devalue the naira.

Generally, three main factors may cause a currency peg to

be adjusted or abandoned. Firstly, domestic fundamentals

may deteriorate. For example, if a country’s domestic

inflation is not contained, its peg may by itself cause the

currency to become overvalued resulting in persistent

current account deficits. Secondly, global financial markets

may exert excessive adverse pressure. When risk aversion

increases, carry trades invested in emerging countries

unwind making pegs impossible to defend. Such a situation

may arise due to a fall in the price of an important export

product, for example oil. Thirdly, policymakers may change direction and alter the currency regime.

SAUDI PEG EXPECTED TO HOLD

The riyal has been pegged to the USD since 1986 at an

exchange rate of 3.75. During this period, the country’s

interest rates have followed closely their US counterparts.

Currently, the Saudi economy is under pressure from low

prices for oil, which ordinarily generates around 90% of

government revenue. This together with a marked

deterioration in relations between Saudi Arabia and Iran has

fuelled speculation that the peg may be abandoned. In

January, USD/SAR forward rates spiked indicating that

markets were speculating against the peg. Subsequently

however, market pressures have receded and forward prices fallen.

Our main scenario is that the peg will hold. In a worst-case

scenario based on a sharp slowdown in China affecting

global growth and driving oil prices down to new record

lows, the probability of Saudi Arabia abandoning the peg

might be 5-10%. If the peg is ended, a major devaluation of

the riyal should follow, possibly of between 30% and 50%, before the currency is re-pegged.

To counter the effects of present low oil prices, Saudi Arabia

is spending international reserves and has also announced

key fiscal measures and reforms. The 2016 budget projects

a deficit of around 13% of GDP, which suggests debt could

rise quickly, although from low levels. However, the deficit

will mainly be financed by drawing down reserves and by

issuing debt. The government has also embarked on a programme of subsidy reform to reduce expenditure.

A key measure is the government’s plan to privatise part of

Saudi Aramco, the state-owned oil company.

Communications suggest that the IPO (involving no more

than 5% of the company’s total equity) will take place in

2017 or 2018. The offering forms part of the state’s plan to

expand the Public Investment Fund (PIF) and to turn it into

the world’s largest sovereign wealth fund, with eventual

assets controlled worth over USD 2trn. Initially, the PIF will

focus more on domestic assets due to the Aramco IPO,

although the government plans to increase the share of

foreign investments to 50%. That partial privatisation of

Aramco has been suggested shows that Saudi Arabia is

serious about reform; in previous periods when government

finances were under pressure due to low oil prices, privatisation was not even discussed.

Consequently, we expect the peg to hold. Proposed reforms

and fiscal tightening have improved the country’s medium-

term fiscal outlook but will harm its GDP growth.

Historically, the peg has successfully withstood low oil

prices. Intervention has been discretionary and infrequent;

speculation occurred in the 1990s when oil prices were

under downward pressure but was countered through

intervention and implementation of macro prudential

measures. Abandoning the peg and devaluing the riyal

would increase the value of oil exports expressed in local

currency but provide few other benefits. Negative effects

include sharply rising inflation, a loss of credibility and more volatile oil revenues.

HONG KONG PEG UNLIKELY TO BREAK BUT PROPERTY MARKET IS UNDER PRESSURE

The Hong Kong peg was introduced in 1983 setting the

value of the currency at HKD7.8 vs USD. Since 2005, it has

remained within a HKD7.75 – 7.85 band. The primary

monetary policy objective is to maintain exchange rate

stability. Due to the peg, policy rates are de facto set by the

Fed. Consequently, the December rate hike immediately caused rates in Hong Kong to rise.

During the Asian crisis of 1997-1998 the peg was defended

forcefully and has not come under serious pressure since

then. Like Saudi Arabia, forward rates spiked in January but

11


have fallen more recently. The peg is unlikely to be

abandoned as it is backed by a currency board that ensures

local currency can only be issued to the extent that it is fully

covered by the central bank’s holdings of foreign exchange.

The board allows for unlimited exchange of the pegged

currency and changes in the monetary base are matched by

variations in US dollar holdings. The monetary authority

may therefore intervene indefinitely though at the cost of an equivalent shift in the monetary base.

The import of US monetary policy through the peg causes

fluctuations in property prices, inflation and wages. Fed

hikes exert significant stress on the property market. On the

one hand, the property boom has now ended with both

house prices and the number of real estate transactions

reportedly falling. However, several factors mitigate the

effects of a housing market slump. Loan-to-value ratios are

relatively low, the link between house prices and private

consumption is limited, and construction activity accounts

for a fairly small share of GDP. While we expect Hong Kong

to maintain the peg, economic growth will slow due to a Fed-induced housing market downturn.

Although the Hong Kong peg is unlikely to be broken, it may

be abandoned voluntarily. However, a floating currency

would result in unacceptable volatility as Hong Kong is a

small, export driven economy. A crawling USD peg is also an

unlikely currency regime since interest rates would still track

the Fed funds rate closely. In the longer run, a link with the

renminbi makes more sense. Currently, such an

arrangement would only bring limited gains as economic

cycles in Hong Kong and mainland China are not closely

aligned. Furthermore, the USD is still the main currency

used for trade and financial transactions, although this is

changing. Integration with China is growing and as the

renminbi continues to replace the US dollar in local

transactions it will make sense to peg the currency to the

renminbi instead. Still, a change is several years off.

Integration must strengthen further and China should continue to deregulate its financial system and currency.

NIGERIA: PEG ADJUSTMENT EXPECTED IN 2016

After depreciating sharply at the end of 2014 and the

beginning of 2015 the naira has been pegged to the USD at

197 since March last year, and been supported by capital

controls introduced in mid-2015. Like Saudi Arabia, Nigeria

is under pressure from low oil prices; around 60% of

government revenue is derived from the oil and gas sector

and represents an important constituent of domestic

demand. Unlike Saudi Arabia and Hong Kong, the Nigerian

USD peg looks untenable. The naira has slumped in trading

on the unofficial parallel market indicating that the currency is very substantially overvalued.

The peg and capital controls are hurting the economy

contributing to a sharp slowdown in economic growth,

which decelerated to 2.8% in 2015, after increasing by

more than 6% in 2014. Compared to Saudi Arabia and

Hong Kong, fundamentals are much weaker and most

economic indicators have worsened recently. Inflation is

running above 11%, external balances are deteriorating,

and the budget deficit is widening. Investment is suffering

due to a shortage of foreign exchange and uncertainty

caused by expectations of devaluation. Foreign exchange

reserves have been under pressure and have declined

markedly; at the end of 2015 reserves covered six to seven months of imports, which is below IMF recommendations.

Further, Nigeria lacks a coherent economic policy to

counter low oil prices. Although the IMF has urged its

government to abandon the peg and remove curbs on

access to foreign exchange, authorities have so far resisted

devaluing the currency. President Buhari has declared his

concerns over the resulting inflationary impact and its

effect on households. There is anxiety that imported

inflation would impact consumer prices, particularly for food and fuel.

We expect the exchange rate to be devalued and re-pegged

during 2016. The absence of a clear economic policy to deal

with low oil prices combined with a deteriorating economic

situation will eventually cause the central bank to devalue

the naira and adopt a new currency band. Central bank

12


independence is limited and the decision to devalue the

naira is therefore a political one. Devaluation will occur

when President Buhari is convinced it will help investment.

However, concerns over rising inflation suggest that any

devaluation should be limited to around 20%, bringing the

official USD/NGN rate to 230-240, significantly below what

is needed to restore confidence in the currency regime.

There is little likelihood of more radical change, such as adopting a managed float.

Andreas Johnson

13


Strategy: Join the EM, Oil, and Commodity Rally While it Lasts

Trading Ideas

LONG INDIA

India remains our top pick in Asia and we like India for the

following three reasons. First, it has very good carry of

around 6.5% annualized versus the USD. In a period

negative interest rates in developed markets, over 6% yield

is very attractive. Second, we think the rate cutting cycle

has finished for 2016. With inflation hovering around 5.4%

for 2016 and policy rate of 6.5%, India provides positive

real yields that will support the currency. Third, the current

account will remain stable with relatively flat oil prices.

India’s trade deficit is mostly oil imports and India remains a major beneficiary of low oil.

The main risk to this trade is in September when RBI

Governor Rajan’s term ends. We believe his term will be

extended but he’s tough stance on inflation has been disliked by the Modi government.

LONG KOREA (KRW) ABOVE 1,200.

While we see KRW initially weakening to 1,240 from interest

rate cuts, above 1,200, we find value in KRW and like to go

long for 3 reasons. First, we think by 2H 2016, the export

cycle will have bottomed out and US demand will return.

Korea still is a manufacturing powerhouse and will benefit

from pickup in global demand. Second, even though BoK

will deliver rate cuts, we think real rates will remain elevated

and support KRW. BoK wants the households to deleverage

and needs positive real rates so that households don’t over-

borrow again. Third, Korea will maintain high current

account surplus. The combination of recovery in exports

and dampened imports from household deleveraging will

keep the trade surplus high and support the KRW. At

current price of 1,150, it is too soon but we would like to accumulate KRW after another sell-off.

LONG RUB

Target USD/RUB at 60, with Brent oil at $50. Do not expect

any support for the RUB from Russia’s macroeconomic

environment. However, with correlation to oil at very high

levels and with oil projected to go as high as $60 per barrel

by 3Q, the RUB is among the top candidates to buy. The

central bank has been given a mandate to establish its

inflation-fighting credentials and will not prevent a RUB

appreciation on the back of rising oil prices, as it will help

bring down inflation. The key risk is if the RUB runs ahead of

oil, potentially going below 60 against the USD. Such

excessive will likely prompt the CBR to sell RUB (to

replenish reserves), or lower the policy rate more aggressively.

LONG CZK

We initiated a short EUR/CZK at a spot rate of 27.12 (target

25.00, stop 28.32) on October 9, 2015 in anticipation of an

earlier than expected removal of the floor under EUR/CZK.

Contrary to our expectations, the Czech inflation outlook

has not firmed since the inception of the trade.

Nevertheless, inflationary pressure in the form of strong

wage growth keeps building. Given the potential upside to

the trade, we are keeping the position even though it is

costing points. The CNB may decide to act before market

pressure builds. The President, who is generally critical of

the floor, will appoint a new governor by July 2016. The CNB

is unlikely to remove the floor before the nomination,

nevertheless a change may come any time. It’s the central bank’s role to defend the credibility of any exchange rate.

LONG MXN

We have expected the MXN to outperform many other EM

currencies, due to the government’s ambitious reform

agenda. However, business-friendly policies and, most

importantly, energy sector reform have not been enough to

improve sentiment towards the MXN. The positive impact of

reforms have been more than fully offset by falling oil prices

and, lately, of threats to Mexico’s sovereign ratings. Oil

prices are now recovering and we believe that fiscal

consolidation efforts together with higher oil-related

revenues will spare the government from downgrades,

which in turn will allow the MXN to catch up with the other

oil-dependent EM currencies. We expect USD/MXN to reach

16.90 by 3Q 2016 from the current 17.50.

14


Fixed Income: EM Back with a Vengeance — But for How Long?

What a difference a couple of months can make. One could

be forgiven for thinking that risk assets in general, and

Emerging Markets (EM) in particular, were poised for a

much worse performance at the start of the year. But the

reality is that those expectations failed to materialise.

Compared to our last update in November last year,

sentiment towards EM and risky assets in general has made

a 180 degree turnaround. This shift has been driven by

reduced worries over the state of the Chinese economy. In

addition, the dovish Fed certainly opened the door for a risk

rally, at least, over the short term. This is a mirror image of

things that caused havoc towards the end of last year.

Suddenly it feels like the sky is the limit and no news can be bad news.

There is a potentially very important conclusion for re-

balancing of our model portfolio to be drawn from all this —

as much as there was an over-reaction to the downside

back then, the current positive rally has, probably, overshot to the upside this time around.

Although, the technical picture remain supportive for EM

sovereign credits, with issuance expected to remain

relatively moderate, economic conditions for this asset

class remain less inspiring, with growth still on the weaker

side. Nevertheless, for now, a credit-positive external

environment is overshadowing fundamental issues for EM, as low rates environment is certainly good news for credit.

STABILIZING EM BOND FUND FLOWS

Large inflows into EM funds, not least into debt-dedicated

funds, contributed to a very strong performance by EM

assets across the board. However, we believe, a certain

degree of caution is warranted going forward, following

such a strong reversal. According to the Institute of

International Finance (IIF), a majority of recent net inflows

are retail-related, which means that they can quickly turn

around. Institutional investors have largely remained on the

sidelines, but look ready to start allocating more of their

assets into EM assets, offsetting a potential withdrawal of

retail funds. Another factor behind the flow reversal was a

knee-jerk reaction to the Fed pledging to keep rates low for

longer. Some residual flows are left to go through, but they

should taper off in the near future together with the retail flows.

Statistics from the Emerging Markets Trade Association

(EMTA) are showing lower debt trading volumes, which, in

turn, is raising the risk of high volatility and spurring

outflows, should the going get rough. And with liquidity

provided by dealers being squeezed further, investors need

to stay ahead of the curve in credit space, not to get caught overinvested and desperate to get out.

SEB EM BASKET UPDATE

Since our last publication in November 2015, SEB’s model

portfolio has delivered a return of 5.3% in local currency

and 7.8% in USD terms. This compares to 3.3% and 8.3% respectively for JPM’s GBI-EM Global Diversified index.

EM local debt was finally able to perform on the back of

Fed’s dovish outlook. In general, EM assets’ valuations

became too attractive for “bottom fishers” to miss their

chance. Brazil and Russia were the two countries that really

stood out, as being very cheap across the board. ECB’s

latest round of stimulus also helped the cause. Corporate

bond purchases by ECB are positive for EM bonds, even if

EM bonds are not directly eligible. As yields vanish in

developed markets (DM), the hunt for yield will imbue EM with new strength.

SEB EM Bond Portfolio Nov 10 2015 to Apr 12 2016

GBI-EM SEB Yield Duration

Weight Weight 10 nov '15 Years Currency Local ret. USD ret.

Poland 10% 10.0% BBB+ 2.09% 3.7 5.1% 1.3% 6.5%

Hungary 5% 5.0% BB+ 2.38% 3.3 6.7% 3.1% 9.9%

S. Africa 10% 8.0% BBB- 7.67% 2.7 -3.3% 1.7% -1.7%

Turkey 10% 8.0% BB+ 9.97% 2.6 2.7% 5.5% 8.4%

Columbia 7% 7.0% BBB 2.28% 3.2 -2.6% -0.2% -2.8%

Russia 5% 15.0% BB+ 10.04% 3.8 -1.2% 7.0% 5.7%

Indonesia 9% 8.0% BB+ 8.67% 3.0 3.8% 7.1% 11.2%

Malaysia 10% 9.0% A- 3.66% 3.2 13.0% 2.7% 16.0%

Brazil 10% 15.0% BB 15.44% 3.8 7.4% 14.1% 22.6%

Mexico 10% 15.0% BBB+ 5.19% 3.7 -4.3% 2.9% -1.6%

Average 100% BBB- 7.5% 3.4 2.4% 5.3% 7.8%

GBI-EM: 3.27% 8.3%

Performance since Nov 10

Rating

S&P

(LT-FC)

15


CHANGES TO SEB EM PORTFOLIO

2016 started with various “black swan” events, such as

S&P’s downgrade of Polish government debt, Moody’s

outlook change to “Negative” on Russian debt, and

Croatia’s downgrade. The number of countries and

companies that have either been put on negative watch, or

been downgraded by the rating agencies is increasing at an

alarming pace. Perhaps, not all ratings changes are

completely unexpected, but most of the time, timing of the

actual downgrade catches everyone off-guard. It is yet to

translate into actual defaults, as those stay relatively low, even in the High Yield space.

That said, we see opportunities for differentiation and

selective longs in EM debt space, but think a rally at the

same strong pace in EM assets from here onwards is

relatively unlikely, as long as the fundamental issues of

growth momentum remain unresolved. In fact, we might be

seeing the last leg of this rally and we could see some profit

taking in the near future. Coupled together with a wide

range of economic uncertainties across the Globe, it leads

us to adopt a more balanced stance in our portfolio.

However, we are increasing the duration from 3.3 years to 4.5 years in order to come closer to the index.

EM valuations are certainly less appealing after the recent

monster rally. With benchmark spreads retracing most of

the widening, EM seems to be rather fairly priced against

DM from a longer term perspective. Most of the returns

should be coming from the EM FX leg in the next few months.

Looking at individual positions, in Brazil, we think that the

Real (BRL) has moved a lot in a short amount of time. The

current political situation is likely to remain turbulent and

complicated, with the final outcome far from clear. With

conditions for a growth recovery worsening, real GDP

growth in the coming months will remain weak. Weak

growth and a relatively stable BRL will help to moderate

inflation, which in turn will likely lead to lower interest rates.

We are decreasing our exposure in the portfolio for the next six months, but maintain a slight overweight position.

We also scale back on RUB/OFZ exposure, keeping an

overweight position, following a strong rally and, what seem

to be, overoptimistic hopes on future CBR policy, overly

aggressive easing cycle is being priced in. The escalating

conflict in the Nagorno-Karabakh region is also a cause for

concern. It is yet to be seen how Russia is going to react and

what, if any, actions it is going to take. However, assuming

“status quo”, some softening of sanctions, mainly from the

EU, is likely towards the second half of the year, or early

next year, which would be very positive for all Russian assets.

Maintain underweight in South Africa on the back of a risk

of a downgrade given the continued political instability,

which would cause capital outflows and weakening of the

rand. There was also a surprise spike in CPI, caused by food

inflation, which could, eventually, lead to more aggressive rate hikes.

The CEE countries have strong trade and financial ties with

the Euro area. This implies that the region is highly exposed

to Euro area policies, in particular ECB QE program and the rate pick-up regional bonds offer to core markets.

With that in mind, we move Poland to a slight overweight,

despite low nominal rates, as we believe that there is a

chance the new MPC won’t be able to maintain same policy

of maintaining interest rates at current levels, given a

significantly lower inflation path both domestically and

externally within the EU. Moody’s recent comments on the

political risk, as a result of a “constitutional crisis”, might be

interpreted as a hint of an upcoming lowering of the

outlook or even a downgrade. However, at this stage, it

would no longer be unexpected, as it was in the case of the

S&P downgrade, and should have a limited impact on both bonds and zloty.

We move Hungary to a slight overweight for a couple of

reasons. Firstly, domestic factors should warrant more

monetary easing in the upcoming months. And, secondly, a

rating upgrade to investment grade might still be on the cards.

16


Colombia continues to be an interesting case in our view.

Recent inflation and inflation expectations figures were

relatively high, but that was mainly driven by perishable

food items. That should change later in the year, given good

weather conditions and stronger peso. Banrep is likely to

continue with its hiking path for a while, but it should be

nearing the end of its tightening cycle. Should the rate go to

7%+, it would be highest in Latin America. Recent euro-

denominated deals largely secured funding needs for 2016, implying lower supply during the remainder of the year.

Our Mexico call, unfortunately, did not play out, as we were

expecting it to, in the previous period. However, we remain

constructive on both credit and currency. Mexican Peso’s

(MXN) performance is closely correlated to BRL. With stable

commodity prices and strong BRL performance, we believe

there is room for MXN to display strong performance in the coming months.

Dennis Masich and Magnus Lilja

New SEB EM Bond Basket Apr 12 2016

GBI-EM SEB Yield Duration

Weight Weight 12-apr Years

Poland 10% 12.0% BBB+ 2.28% 4.7

Hungary 5% 7.0% BB+ 2.21% 5.2

S. Africa 9% 8.0% BBB- 8.64% 4.3

Turkey 10% 10.0% BB+ 9.34% 3.9

Columbia 7% 6.0% BBB 3.30% 4.6

Russia 5% 10.0% BB+ 9.32% 5.0

Indonesia 10% 12.0% BB+ 7.31% 4.3

Malaysia 10% 10.0% A- 3.42% 4.1

Brazil 10% 11.0% BB 13.44% 4.7

Mexico 10% 14.0% BBB+ 5.28% 4.4

Average 100% BBB- 6.6% 4.5

Rating

S&P

(LT-FC)

17


Country Section

Asia

China

Macro: The economy will slow to 6.5% in 2016, which is in-

line with government’s target and lower than 6.9% in 2015.

Manufacturing and heavy industry will be the main drag on

growth as the government rebalances towards less capital

and debt intensive services and consumption. The Achilles’

heel of China’s economy is the total debt at over 240% of

GDP and how to grow without debt. President Xi will move

forward with lower growth as a cost to avoid a debt crisis in

the future. The tolerance of how low growth can go will

depend on the development in the labor market. The

government believes that generating 10 million jobs a year

will keep the labor market stable. The policy response will

be determined on the balance between the labor market

and growth level. If the 10 million job target is achieved

earlier than expected, the government will be comfortable pushing down growth below the 6.5% target.

The upside risk to growth will be in construction where sales

have been increasing and depleting inventories. Continued

de-inventory measures taken by the government will boost

sales and revive construction activity this year. Watch housing inventory closely towards Q3/Q4.

Monetary policy will be loosened so that a) the large debt

can be rolled over smoothly b) low growth and limited credit

growth will lead to low inflation. We expect 50bps cut in

deposit and lending rates and another 300bps cut in

reserve requirement ratio in 2016. Furthermore, the central

bank will start targeting short term interest rates instead of

1 year deposit and lending rates. We think 7 day repo rate will fall towards 1.5% compared to 2.3% currently.

FX/Rates/Equity: CNY will depreciate in 2016 to 6.90.

Relative fundamentals point to weaker China vs US and the

looser monetary policy will weaken CNY. CNY will become a

cyclical currency like all other currencies and we don’t see a

recovery in CNY until economic fundamentals accelerate.

On rates, we want to receive or hold government bonds

since we expect more rate cuts with lower inflation and

liquidity is needed to soak up government bond issuances

and smooth rolling over of short term wealth management

products. The government will start running larger fiscal

deficits, reaching 3-4% of GDP. There will be plenty of

demand for safer government debt compared to

deteriorating corporate bonds and longer end rates will not

rise. Lower rates will put a floor in equities but for the

Shanghai Composite to break 5,000 again, it will need

better fundamentals, which is again an economic acceleration.

Hong Kong

Macro: The tension between Hong Kong and mainland

China persists even though the protests in Hong Kong have

lost momentum. Discontent in Hong Kong has been a

multi-year trend and rooted in social and economic

inequality. The Mainland Chinese government appears to

make this conflict a war of attrition. The protests hurt the

Hong Kong economy and Beijing has a bigger pocket to

withstand the pain. On the other hand, we don’t expect a

mass violence since the situation in Hong Kong has not

deteriorated enough. Unemployment rate is still low and

GDP per capita is high. Residents have much to lose if the

situation becomes violent. We see a muddle through

scenario and will weigh on Hong Kong’s economic

performance especially through lower mainland tourist spending.

FX/Rates/Equity: We don’t like HKD and look to use it as a

hedge for USD strength. USDHKD is moving up, and we

expect it to move further to the upper part of the band.

Hong Kong inherits US interest rate policy from the USD

peg and low rates have pushed up asset prices in Hong

Kong. However, there are several risks for a weaker HKD.

One, as the US economy recovers, US yields rise from a

hawkish Fed. The rise in rates through the peg will pressure

Hong Kong rates to rise and lower Hong Kong asset prices.

Both of these will make HKD weaker. Furthermore, long

USDHKD can act as hedge if China or general global risk re-

emerges. Long USDHKD is also a small positive carry hedge.

This is also negative for the equity market (HSI) since

interest rates will rise with the US. Also, when HKD comes

under pressure from diverging economic trends between

US and China, HKD is limited in the sell off at 7.85 but the

equity market has much bigger room to fall. Shorting the

equity market is a better risk reward than shorting the currency.

India

Macro: India is taking over China as the high growth

economy and will grow 7.5% in 2016 compared to 7.3% in

2015. The economy will improve from lower inflation that

has halved from over 10% to 5%. Stable prices are leading

to rise in consumption and that is spilling over to higher

production and investment. RBI has cut the policy rate by

150bps in the last 1.5 years and that should also lead to

higher growth. Prime Minister Modi has disappointed

market expectations in the reform process and we expect

very little reforms to support the economy. His recent loss

in state election in Bihar showed that gaining majority in the

upper house will be difficult and will hinder the pace of reforms.

18


Main risk to India is fiscal slippage. The Goods and Services

Tax has yet to be approved and with Modi facing political

headwinds, his government may resort to short term fiscal

handouts to win votes and popularity. This can undermine the low inflation and low rate outlook.

Another event risk is related to RBI Governor Rajan’s term,

which expires in September 2016. Rajan has been

instrumental in driving inflation lower. His term should be

extended but his removal would be a big blow to India’s positive economic and market outlook.

FX/Rates/Equity: For 2016, we don’t see much movement

in INR but we would like to go long vs rest of Asia to pick up

carry of around 6.5% (annualized). India is a major

beneficiary of lower oil prices, which can potentially close

the trade deficit. Also, we think RBI is finished with rate

cuts and stable positive real rates should support the currency.

For rates, we prefer steepeners since we expect growth to gain some momentum.

Equity market should continue to do well with the economic

recovery. The foreign flows have turned outward recently

due to risks from Fed rate hikes. However, we see this as

positive development and lightening in positioning and an

ideal moment to re-enter India. We also believe that

domestic buying will increase as they see better growth environment coupled with low inflation.

Indonesia

Macro: Indonesia’s growth should finally stabilize at 5.0%

in 2016 compared to 4.8% in 2015. Growth has been

declining since 2011 from fall in commodity prices where

Indonesia is heavily exposed. We think commodity prices

are reaching a trough and should not drive growth lower

from here. Another growth driver was credit growth but

that has more than halved since 2013, slowing down

investment and consumption. Indonesia still has low debt

and can leverage up, unlike China. However, the weakening

currency has forced the central bank to keep tighter policy

and that has stalled credit growth. The central bank has

delivered 75bp cuts in interest rates in 2016 and that should push growth higher in 2H 2016.

The risk to growth is to the upside where government

spending and investment are gaining momentum and can

push growth towards 5.5%. Also, Indonesia joining TPP

would be positive structurally in reducing tariffs and improving manufacturing sector.

FX/Rates/Equity: IDR will depreciate in 2016 towards

14,200, compared to 13,200 currently. The government has

chosen growth over currency to grow the manufacturing

sector. With the fall in commodity prices and exports,

manufacturing needs to be new growth engine and a weaker currency will help in developing this sector.

For rates, we prefer steepeners or paying the back end since

we expect some recovery in economic growth and inflation

expectations to rise. We think receiving front end will be limited as rate cuts are finished.

Equity market should continue to underperform.

Indonesia’s equity market is still one of the most expensive

in Asia. Interest rate cuts should help but the loss in the currency should neutralize any gains.

South Korea

Macro: Korea has shifted from 5% to 3% growth economy.

As a manufacturing power house, the slowdown in global

trade and global demand weighs on growth. Furthermore,

Korea’s private sector debt is one of the highest in the world

and that prevents corporates and households to borrow

and grow. Bank of Korea has set a policy that will require

households to deleverage and that will keep growth limited.

Lastly, Korea is heavily reliant on Chinese demand and will

be impacted by the structural slowdown in China. Growth

will rebound slightly to 3.2% in 2016 from 2.7% in 2015 because the effect of MERS epidemic wears off.

One possible catalyst that can make Korea positive is policy

change but we are not seeing that yet. President Park is

starting to relax some populist measures against Chaebols

where she has learned that they are needed to get the

domestic economy going. The dead property market has

gained relief where major property projects are getting approved faster than expected.

FX/Rates: Korean Won (KRW) has been weakening

following the rest of Asia and will continue to do so towards

1250 compared to 1150 currently. Weakening RMB will drag

KRW lower along with interest rate cuts. Lower growth,

limited credit growth will keep inflation low and Bank of

Korea will cut by 75bps in 2016 to bring the policy rate to 0.75%. We like buying bonds in this environment.

The equity market should underperform. Interest rate cuts

will provide some support but Korea is shifting to a mature

economy with limited upside in growth and asset prices and

will become less attractive. Furthermore, competition is

increasing from Japanese companies focusing on market

share (under-cutting prices) and Chinese companies moving up the value chain.

Malaysia

Macro: Malaysia’s economy should slow to 4.1% in 2016

from 4.6% in 2015. PM Najib gave cash hand-outs 2 years

ago to influence the last election and he will be reversing

them in 2016, which will weigh on growth. In addition,

exports will face headwinds since Malaysia is reliant on

palm oil and natural gas exports. The lower commodity

prices will also reduce revenue projections and slow public and private investment.

19


Political risk has increased over scandals on government

owned 1MDB strategic investment company that may have

misallocated funds and struggles to meet debt obligations.

Default risk has subsided from sales of assets to China but

the Malaysia’s governance structure are still under question

and putting pressure on Prime Minister Najib’s political

position. It seems that Mr Najib has eliminated his critics and will hold onto his position but the situation is still fluid.

Positive risk can arise from early signing of Trans Pacific

Partnership (TPP) in that can accelerate deregulation and improve reform sentiment.

FX/Rates: MYR was the worst performing currency in 2015

from a perfect storm of rising US yields, lower commodity

prices reducing current account surplus and political risk. In

2016, MYR will weaken. Foreigners still own 48% of the

government bond market and inflows will not increase as

US yields become more attractive and China stops

accumulating FX reserves and buying Asian bonds. Interest

rates will be reduced by 50bps to help growth in a low

inflation environment. It will not underperform since the political risk and 1MDB default risk has subsided.

Rates will fall and receiving in the front end makes sense.

Backend should be avoided since we don’t expect growth

but fiscal situation may deteriorate from lower revenue related to lower oil prices.

Philippines

Macro: The economy should accelerate to 5.9% in 2016

compared to 5.8% in 2015. Philippines faced economic

headwinds in 2013 from typhoon Haiyan and policy

tightening but we expect a small rebound as the economy

normalizes and public investment rises heading into the

2016 Presidential election. President Aquino’s term ends in

mid-2016 and he will want the economy to be strong going

into the election as well as for his legacy. Public spending

has faced bottlenecks and those will likely be spent to prop-up the economy.

The recovery can also get support from monetary easing

where we expect rates cuts of 75bp to end 2016 at 3.25%.

The central bank hiked policy rates in 2015 to protect itself

from capital outflow as US interest rates start to rise.

However, with subdued and falling inflation, the central

bank will have to focus back on the economy and deliver some easing.

FX/Rates: PHP has outperformed other Asian currencies

since it has a solid current account surplus and the central

bank is rewarding PHP holders with higher interest.

However, Philippines cannot fight the Fed and PHP will play

catch-up to rest of Asia and peak around 49. Remittances,

the back bone of the currency is slowing. On rates, we

prefer steepeners since we expect more fiscal spending to

come through and the economy to rebound in 2016 and lift

the back end. Short end will fall with rate cuts to support the economy.

Singapore

Macro: Singapore as a small, open economy will improve

slightly to 2.2% growth in 2016 compared to 1.9% in 2015

on better export outlook. We don’t expect a huge rebound

since Singapore is following China in improving the

composition and quality of its growth. Singapore is limiting

immigration to boost low income residents’ job potentials and to reduce income inequality.

We think domestic economy will be tough because

Singapore inherits much of the rise in US interest rates and

crimps the property market. We are already seeing 6

months of interest rates rising from close to 0% to as high

as 1.8% and since most mortgages are flexible, the impact is felt very quickly by households and reduces consumption.

FX/Rates/Equity: SGD should depreciate versus USD to

1.45 by end 2016. Inflation has fallen below 0% from lower

oil and property tightening measures. Core inflation

remains elevated but it will follow headline and ease

towards 0% and gives room for more easing. MAS eased

policy twice in 2015 from 2% annualized appreciation pace

to now 0.5% in the SGD vs trading partners. We expect another easing in 2016 to move to 0% appreciation.

As mentioned above interest rates will rise from higher US

rates and weaker SGD policy. Higher rates will also be negative for the equity market.

Taiwan

Macro: Taiwan should benefit from the US economic

recovery since exports are over 70% of GDP and sensitive

to global demand. Taiwanese manufacturers’ sentiment,

which has historically been an excellent indicator of future

exports, predicts a bottoming in exports by 1H 2016. The

economy should recover to 2.3% in 2016 compared to 1.5%

in 2015. The recovery will be limited since Taiwan is the

second most leveraged economy to China’s demand after

Hong Kong and will suffer from a slowing China. On the

domestic front, credit growth and property prices are still

contracting. The central bank will likely ease interest rates

by 50bps to take the policy rate to 1.00% to cushion domestic demand

Taiwan China relationship development will be a key focus

in 2016. President Tsai’s attitude towards China will likely be negative at the beginning and hurt sentiment.

FX/Rates/Equity: We are short TWD vs USD 3M NDF for

three reasons. First, we think monetary policy will be eased

further with lower inflation. Policy rate is 1.5% and we

forecast a reduction to 1.00% and bring the overnight

interbank rate to 0.25% from current 0.4%. Furthermore,

with interest rate so low, the central bank will resort to

20


currency weakness to fight deflation. Second, the trade

surplus got a boost from lower oil prices in 2015 but with

prices stable, the surplus should diminish going forward.

Third, TWD was supported by prospects of Shanghai

Taiwan stock connect but with how Shanghai Hong Kong

connect has disappointed, we expect capital outflow. All in

all, the central bank is likely content with a weaker TWD to support growth and exports with deflationary pressure.

Thailand

Macro: Thailand’s economy is normalizing after the military

has taken over the economy and protests have stopped.

We see the economy recovering to 3.3% in 2016 from 2.7%

in 2015. Consumption will rebound from people returning

to work and to the stores. Public investment will also rise as

the military has full authority to reallocate funds. Tourism

should return and help the small and medium sized enterprises.

However, this is a temporary relief and the economy will not

normalize long term until elections are held that reduces

political risk. The next general election has been delayed

and current estimate is mid 2017 but authorities have

already stated that it could be delayed by minimum 2-3

months. Before the election, the constitution must be must

be approved by a referendum in August 2016. External demand is also still low and hinders economic recovery.

FX/Rates/Equity: Over-valuation in THB has been

corrected but THB should still weaken this year towards 38.

Further monetary policy easing will be delivered with CPI in

negative territory. The influx of tourism that increased the

current account should slow. Much of the tourism inflow was due to one-off policy changes in China visas.

Due to the weak economy we think Bank of Thailand will

deliver 75bps of rate cuts in 2016 to 0.75%. Thailand can

afford to cut since it has a current account surplus. This in

turn will help the equity market outperform in Asia but

strong upward move in the equity market is unlikely with a

weak economy and political noise expected to pick up in 2017.

Emerging Europe

Czech Republic

Real GDP growth looks set to ease to 3.0% this year (above

consensus) from an impressive 4.3% in 2015. The key

reason for the slowdown is a reduction of funds coming

from the EU as the new programme period gets started.

Nevertheless, unemployment is at its lowest and job

vacancies at its highest since 2008 pointing to tight labour

market. Real wages are growing strongly at around 3.8%,

which will underpin healthy domestic demand growth. The

Czech economy is, like Poland and Hungary, strongly linked

to the German export sector. Although growth has slowed

somewhat, the Czech economy is soon hitting capacity constraints.

The central bank has pledged to keep the 27.00 floor under

the EUR/CZK rate until at least H1 2017. However, rising oil

prices and very strong domestic demand growth look likely

to drive up inflationary pressures. The central bank is now in

a pickle. If it waits to remove the floor, money will be

pouring in as inflationary pressure builds, making an

adjustment much more volatile than it would be now. One

strategy could be to lower the floor gradually, but that would only feed speculation of further CZK appreciation.

While inflationary pressures have been taken longer to

materialise than we anticipated when we entered a short

EUR/CZK position on October 9, 2015, accelerating money

supply growth will eventually kick in. The central bank has

been mulling negative interest rates to stem speculative

inflows and boost inflation, but the MPC members have so

far resisted, believing that the cost is greater than the

benefits. We expect the central bank to give up the floor

sooner than the consensus, perhaps already in 2016,

bringing EUR/CZK to 25.0 or even lower. It is the central

bank’s duty to assure markets of the viability of an exchange rate until they change it.

Hungary

After having been in the doldrums for a majority of the past

six years, the Hungarian economy is showing signs of

picking up, with growth hitting 3.2% y/y in 4Q 2015.

Consumer and business confidence, and industrial

production have dipped somewhat in the beginning of

2016, but remain at historically high levels. Monetary easing

in the Eurozone and global price pressures have allowed the

Hungarian central bank also to enter into a new rate-cutting

cycle, even introducing negative rates on excess reserves

deposited by banks. With a reduction of external debt

vulnerability, speculation of rating agency upgrades to

“investment grade” status, and a more settled economic

political outlook, the central bank has the room to ease

monetary policy further, potentially as low as to 0.75% from

21


the current, although our main scenario is for the main rate to bottom out at 0.90%, implying two more cuts.

Although the central bank appears comfortable with

EUR/HUF moving higher from the current 310, we think that

it will struggle to bring it much higher than 320 more than

temporarily. A pickup in growth, falling unemployment, and

higher energy price, will lead to capital inflows leaving the HUF largely tracking the PLN and the RON in 2H this year.

Poland

The Polish economy is going from strength to strength.

Although it slowed slightly in the beginning of 2016, it

remains one of the fastest growing economies in the EU,

and will likely expand by around 3.7% or more this year.

Nevertheless, as with the other EU countries, inflation is

low, suggesting that Poland will keep monetary policy loose

in order not to allow the PLN to appreciate too much

against its CEE peers and the EUR. For the moment, that

has not been driving force for markets. The main risk to

Polish assets including the PLN is politics. However, we

believe that downside risks dominate in the first half of the

year as the new PiS government asserts its influence over

domestic institutions (from media, to the civil service, the

judiciary, and the central bank) and distance itself from

Brussels. Not to draw the analogy too far, but the PiS is marking its territory.

In the second half of the year, the political noise should

quieten, especially once the constitutional crisis has

dissipated and focus more on the still-good economic

outlook, which will support the PLN. In addition, inflation

will bottom out on a stabilisation of oil prices and a gradual

economic recovery in the EU. Any potential interest rate

cuts by the new NBP MPC will also have been executed by

then, turning the attention to the initiation of the next rate hiking cycle.

Having said this, the risks are decidedly on the downside.

The PiS seems bent on implementing all its popular

electoral promises, despite a negative impact on Polish

assets. In addition, its belligerent attitude towards the

European Commission and admiration of Hungary’s Fidesz

party suggest that there will be little improvement in

relations with the EU. A key risk is that no government

representative takes charge of and drives through

amendments to the President’s CHF mortgage conversion

proposal. If a bill based on President Andrzej Duda’s

suggestions is passed by parliament, it could force banks to absorb a cost of almost 4 times banks’ annual profits.

With valuation of the PLN at a very low level, we are sticking

to the positive view on Poland and the PLN in large part

because the last time that the PiS was in power (Oct/Nov

2005 to Oct/Nov 2007), the PLN strengthened by roughly

10% against the EUR. In other words, over a 12-m period,

the PLN will be driven more by Poland’s economic outlook

than its political travails; and the economic outlook is still strong.

Russia

The fall in oil prices in late 2015 and early 2016 increased

uncertainty about the Russian economy. Oil prices have

since recovered strongly and are expected to average $45–

$50 per barrel in the second half of 2016 although after the

60% rally in crude oil (Brent) between January 20 and April

13, risk is on the downside. Low oil prices are putting

pressure on budget revenue. Belt-tightening to contain the

budget deficit will primarily impact public sector

investments since government is wary of cutting social

spending ahead of parliamentary elections in September.

Western sanctions continue to hamper investments,

primarily in the energy sector. Our view is that the EU will

start easing sanctions towards the end of 2016 while US sanctions will remain.

Most economic data such as investment, industrial

production and retail sales are still falling in year-on-year

terms but the decline has slowed and the worst of the

recession should be over. There are signs of stabilisation in

manufacturing and the sharp deceleration in inflation is

starting to feed through to real wages. The policy rate has

been on hold at 11.0% since August 2015 but we expect the

central bank to start softening the interest rate policy as

22


inflation continues to decelerate. At the end of 2016 we

expect a policy rate of 9.0%. The recession will continue for

some time yet and we expect GDP to fall by 1.5% in 2016.

Positive growth should return towards the end of the year.

However, a strong rebound is unlikely due to structural problems.

The RUB was one of the EM currencies that weakened the

most early in 2016. The correlation between RUB and oil

prices has weakened somewhat recently but is still high.

Authorities do not seem to have been overly concerned by

the currency weakening; an advantage is that it helps to

mitigate the effect of the fall in oil prices on budget

revenues by pushing up government oil revenue in local

currency terms. The recent rebound in oil prices along with

a general improvement in EM sentiment has pushed the

RUB higher and the appreciation has been somewhat faster

than we expected. SEB forecasts that the price of oil will

average $45/barrel in 2Q, $50 in Q3, and $45 in Q4. In Q3,

oil even looks likely to break above$60 per barrel

periodically. Under these assumptions, we expect the RUB

to strengthen in Q3, with the USD/RUB pair potentially

testing 50 (if oil heads to 60). However, as oil prices

moderates somewhat in 4Q, USD/RUB should end the year

close to 63. We expect volatility to be significant, driven by

changes in the price of oil. In addition, if oil goes to $60, we

believe that the central bank will have enough scope

(because of imported disinflation) to ease policy and buy reserves to weaken the RUB to support the budget.

Turkey

The outlook for Turkey and the TRY is mixed and we do not

see a convincing picture on where markets will move over

the coming months. The most likely scenario is for the

economy to simply muddle through. Real GDP growth looks

set to moderate to 3.3% this year from 4.0% in 2015, while

inflation accelerates to more than 8% from 7.7% in 2015

and target of 5.0%. The new central bank governor

(formerly deputy governor), Murat Cetinkaya, should ensure

policy continuity. However, like Basci, he will not be able to fully fend off political pressure to lower interest.

We foresee the TRY weakening against the USD by some

5% by the end of the year, essentially compensating for

relatively higher inflation in Turkey. Nevertheless, the risks

are on the downside. The TRY’s Achilles heel is the country’s

large external financing need. Gross reserves barely cover

short-term debt. Any loss of investor confidence will be

transmitted immediately to TRY weakness, especially if the

central banks looks likely to acquiesce to political pressure.

In addition, a battle for how the constitution should be

changed is brewing. President Erdogan wants an executive

presidency, but a majority of the public is currently against

it, while Erdogan’s party appears to be split.

Ukraine

Ukraine is now past the most acute economic crisis. GDP

contracted by around 11% in 2015 but the fall in GDP is

decelerating and was 1.4 per cent in year-on-year terms in

the fourth quarter. A recovery in investment has started,

driven by rebuilding in conflict-hit areas, and will contribute

to fixed investment for several years. There are other

positive developments. Industrial production is recovering.

The severe weakening of the hryvnia 2014-2015 has helped

to narrow the current account deficit through a sharp

contraction of domestic demand. Fiscal tightening has

resulted in a sustained improvement in the budget deficit

but also acts as a drag on economic activity. Inflation is still

high but is decelerating sharply; in March CPI inflation was

close to 21% compared to the full year average for 2015 of

48%. We expect growth to resume in 2016 and GDP is

projected to increase by a meagre 1%. Structural problems

and continued high political risk hinder a sharp rebound.

Medium-term recovery is dependent on continued reforms and support from the IMF and the EU.

Although the economy has improved risks are rising due to

deterioration in the domestic political situation. Stalled

reforms and a failure to tackle corruption have prompted

key officials to leave the administration and the IMF has

postponed disbursement of the third tranche of the four-

year Extended Fund Facility (EFF) program. Public support

for the government has weakened greatly and makes it

23


harder to implement reforms. At present there are efforts to

establish a new government and appoint a new Prime

Minister. If this succeeds new elections can be avoided but

huge uncertainty will remain and a growing risk of a shift

towards populist policymaking. Hopefully, a stabilisation of

the political situation could restart the reform process and the frozen IMF program.

The UAH is supported by extensive capital controls but

pressure remains and the currency has weakened since the

start of the year. Although the economy is improving, the

balance of payments situation is still fragile. Foreign

exchange reserves have recovered from critically low levels

but are still too small to stop a strong devaluation pressure

since they do not allow for currency interventions. Risks to

the UAH are primarily linked to the domestic and foreign

political development and to the IMF programme. We see the USD/UAH rate ending 2016 at 28.00.

Latin America

Brazil

Brazil is experiencing a severe economic downturn; in the

fourth quarter of 2015 GDP fell by 6% in year-on-year

terms. The downturn is broad based. At first driven by

declining capital spending, the downturn now also includes

plunging private consumption that is set to become the

main drag on growth. A budget deficit of 11% of GDP and

inflation running at close to 10% implies that economic

policy has little scope to boost demand. There are some

signs of improvement, however. The current account deficit

has narrowed dramatically driven by a sharp fall in imports.

There are also some tentative signs that the weaker real is

starting to help exports. Inflation decelerated more than

expected in March, although it is still far above target. The

deceleration is a result of the fading impact of regulated

price adjustments and the sharp recession. However, the

political turmoil has stalled most reform efforts. GDP fell by

3.8% in 2015 and the recession is expected to continue in 2016. The forecast is that GDP will fall by 3.5%.

An improvement in EM sentiment and a rebound in

commodity prices have pushed the BRL higher and the

currency is one of the best performing this year. Market

expectations that the political turmoil will result in President

Dilma Rousseff being forced to leave office has added fuel

to the BRL rally. Market expectations are that a removal of

Rousseff would put an end to the political uncertainty and

pave the way for a more market-friendly and reform-

oriented government. We share the view that Rousseff is

unlikely to last her full term. The main scenario is that the

impeachment process will result in Rousseff being stripped

of her role and be replaced by vice president Michel Temer.

The impeachment vote in the lower house of Congress on

April 17 will be close but the opposition is gaining ground

and moving closer to achieving the necessary two-thirds

majority. Should impeachment fail, a parallel process based

on allegations that bribes were used to finance Rousseff’s

re-election campaign in 2014 could result in annulment of her mandate and new presidential elections.

Our view is that markets are too optimistic on what will

come after Rousseff. A government led by Temer could be

more market friendly but he also runs the risk of being

forced out of office by corruption charges. Temer as

president may be more active in trying to rein in fiscal

spending but he would face a dire economic situation. The

political paralysis is likely to continue, making it difficult to

implement necessary economic reforms. The BRL rally

could continue for a little while yet, but the real should

retrace part of its gains as it becomes more obvious that the

great need for structural reforms will not be met. We expect the USD/BRL exchange rate to be 3.90 at the end of 2016.

Mexico

Mexico is a key EM country with a strong and quite

impressive reform agenda. Economic growth has been

holding up well on the back of decent domestic demand

growth, despite headwinds from a sluggish recovery in the

US. Indeed, real GDP growth is on track to rise slightly to

2.7% in 2016 from 2.5% in 2015, while inflation will remain

contained at around 3.0%, right on the inflation target. Yet,

24


despite an ambitious reform agenda, including energy sector reform, the MXN has lagged other EM currencies.

One key headwind for the MXN has been concern over the

effect of falling oil prices on the budget. The government

has announced sharp spending cuts to contain the budget

deficit, but that has also meant slowing growth. In addition,

the MXN has also been hurt by rating downgrade

speculations. The government will use part of Banxico’s

operating profits over the past year to inject capital into the

ailing national oil company, but Pemex problems (including

falling production, corruption, and a heavy corporate

bureaucracy) are unlikely to go away any time soon.

Nevertheless, we are cautiously optimistic that Mexico will

avoid a downgrade and that the MXN will be pulled along by

rising oil prices. We expect USD/MXN to reach 16.90 in 3Q

2016, compared to current 17.50.

Sub-Saharan Africa

South Africa

The ZAR depreciated by almost 26% against the USD in

2015. While that kind of move is unlikely in 2016, the

downward trend will continue, albeit at a slower pace.

Although commodity prices have stabilised and even

recovered some of their losses from last year, especially

gold and platinum, the South African economy and the ZAR,

in particular, are facing severe headwinds in the form

electricity shortages, dysfunctional labour-business

relations, and the worst drought on record. Calls for

President Jacob Zuma to step down, or to be forced out of

office have been rising over his failure to repay the cost of

upgrades to his home that was not related to security

enhancements. Zuma and his family’s connections to the

Guptas, a wealthy business family, have also been a very

controversial on allegations of state capture. In addition,

the ideological orientation of the “Tripartite Alliance” (the

ANC, the Congress of South African Trade Unions COSATU,

and the South African Communist Party SACP) is impeding

implementation of market-friendly reforms such as those

outlined in the National Development Plan (NDP). Lack of

progress on fiscal consolidation has lead to rating

downgrades, leaving South Africa at the cusp of “junk”

according to S&P and Fitch. Moody’s rates the government

one notch higher at “Baa2”, but with a “Negative” outlook.

We expect at least one of the three major rating agencies to downgrade South Africa to non-investment grade in 2016.

If Zuma were to be removed, the ZAR would likely

strengthen sharply. Yet, the ANC, fearing a disruptive

internal battle is standing behind Zuma making his removal

unlikely. USD/ZAR touched 17.9169 in a flash crash on

January 11, 2016. Although the exchange rate has retraced

some of the move since that record high, ZAR still remains

17% weaker than one year ago. Yet, in real effective

exchange rate (REER) terms, the ZAR is not as weak as the

nominal rate suggests. In fact the REER is close to its

“detrended” 54-year average value (i.e., the ZAR’s 54-year

depreciation trend has been removed). A severe crisis is not

our main scenario, but because of low prospects for

growth-enhancing structural reforms, continued electricity

shortages, and rising global and US interest rates, we

expect the ZAR REER to fall further, potentially by another

2–5 percentage points in 2016. In USD/ZAR terms, we think that the pair will end the year at 16.20 (currently 14.54).

25


Disclaimer

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Disclosures The analysis and valuations, projections and forecasts contained in this report are based on a number of assumptions and estimates

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Contacts ContactsEmerging Markets Research

Per Hammarlund Chief EM Strategist +46 8 506 23 177

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EB is a leading Nordic financial services group. As a relationship bank, SEB in Sweden and the Baltic countries offers financial advice and a wide range of financial services. In Denmark, Finland, Norway and Germany the bank’s operations have a strong focus on corporate and investment banking based on a full-service offering to corporate and institutional clients. The international nature of SEB’s business is reflected in its presence in some 20 countries worldwide. At 31 December 2015, the Group’s total assets amounted to SEK 2,496bn while its assets under management totalled SEK 1,700bn. The Group has around 15,500 employees. Read more about SEB at www.sebgroup.com.

With capital, knowledge and experience, we generate value for our customers − a task in which our research activities are highly beneficial.

SEB EM Research provides extensive analysis and trading recommendations such as Emerging Markets Explorer, a major publication comprising macroeconomic analysis and strategy as well as market analyses and investment recommendations. Other publications include EM Strategy Focus, Asia Strategy Focus, various Investment Guides as well as the weekly EM Outlook.

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