text: MORGAN STANLEY RESEARCH May 20, 2013 MORGAN ST ANLEY RESEARCH Global EM Investor GLOBAL EM M ACRO STRATEGY TEAM For research analysts, please see contact list at the back of this material. Dollar Dominance Chart of the Week: Short-Term Tactically speaking, EM currencies are approaching oversold territory Aggregate Momentum Index (SAMI) versus what has been a broadly strong USD. Yet we remain cautious on EM 100 risk and constructive on rates, given the still-prevalent divergences across Oversold markets. Global demand conditions remain weak, which belies resilience 80 seen in core equity markets – justified by even easier monetary policy. 60 Trades 40 Sell SGD/INR: We re-enter our short SGD/INR position. We think that India is likely to benefit from falling commodity prices and the recent restriction on 20 imports of certain goods. Meanwhile, China and global growth concerns remain Overbought 0 significant risks for SGD. The trade also has high carry, at around 5.5%. Dec-11 Apr-12 Aug-12 Dec-12 Apr-13 Switch into PETBRA'23 from PETBRA'19: Although on the sovereign side, we EM FX Momentum EM Credit Momentum position for underperformance in Brazil, we see a tactical opportunity in the new Source: Morgan Stanley Research, Bloomberg PETBRA'23 bonds, which offer more liquidity, a lower dollar price and 15bp pick-up in spread terms to the PETBRA'19s. Currencies: Sell SGD/INR Comments of the Week 47 Where Is the Value in EM Rates? We assess EM rate markets by utilising a local bond scorecard, our EMTrend model and our strategy views. Brazil, Israel 45 and India rank highest on our scorecard while South Africa, Turkey, Mexico and 43 Thailand rank lowest. Meanwhile, EMTrend shows that a sell-off in DM rates is a key risk to EM swap rates – particularly in 5y tenors and in CEEMEA – while 41 bonds should fare better, especially in Mexico, as inflows remain strong. 39 Reflation, Deflation and Tail Risk Hedges: We look at a fast-moving, market- 37 based indicator which summaries information about global reflation/deflation pressures. There are interesting divergences between the indicator and global 35 growth/asset prices. The indicator and our commodity model lead us to propose A-11 N-11 F-12 M-12 A-12 N-12 F-13 M-13 selling USD put/PLN or NOK call spreads as tail-risk hedges. SGD/INR Target Stop Sell ILS on Spikes: The BoI cut rates and introduced a USD purchasing Source: Morgan Stanley Research, Bloomberg programme designed to offset the balance-of-payments effect of rising domestic gas production. We think that the policy proposals will be sufficient to end ILS Credit: Switch into PETBRA'23 from outperformance, and see other reasons for ILS to start underperforming too, PETBRA'19 including low CPI and as our economists see a risk of further policy rate cuts. 300 bp We recommend selling ILS versus EUR and USD on periods of ILS strength. 250 Assessment Changes 200 Rates: We upgrade India to neutral/overweight from neutral, and downgrade Thailand to neutral/underweight from neutral. We also downgrade South Africa 150 to neutral from neutral/overweight. 100 Currencies: We downgrade PLN to neutral from neutral/overweight, and 50 upgrade BRL from neutral to neutral/overweight. We also upgrade CNY to overweight from neutral/overweight. 0 M-13 J-13 Asset Class Stance PETBRA'23 Target Stop Currencies Local Rates Sovereign Credit Corporate Credit Source: Morgan Stanley Research, Bloomberg HOLD ACCUMULATE HOLD ACCUMULATE Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor EM Cross-Asset Compass Rashique Rahman What's Changed Sell Reduce Hold Accumulate Buy As we have been all month, we stay cautious in the near term on EM risk and continue to advocate neutral-to-market US dollar strength and rising core rate market yields highlight the ongoing divergences prevalent across markets. beta in currency and credit portfolios, and an Accumulate stance for EM local debt. EM currencies are nearing oversold territory but tactically we remain cautious on EM risk, given the weak data and no We recommend being underexposed to commodity signs of a near-term turnaround. currencies and credits. We maintain an Accumulate overall stance on EM rates, As much as EM currencies have underperformed the dollar, though we acknowledge that risks are increasing and markets there are prospects that a broader risk-market pullback are starting to move in an idiosyncratic fashion again. would lead to an even more pronounced sell-off in EM risk. Indeed, any indication that the Fed might be considering tapering asset purchases any time soon would be taken as a What We Think negative, in our view. Furthermore, the managed slowdown in China as policy-makers seek to rebalance the economy Broad US dollar strength and core rate yield widening have may continue to take its toll on cyclically sensitive been dominant factors in markets. Far from signalling a commodities and also regional growth. We like buying INR renewed US-driven global recovery, these dynamics against SGD as a means of positioning for China rebalancing. highlight the striking divergences that remain prevalent across markets. Commodity price weakness, declining Our work on reflation/deflation signals suggests that there is breakeven inflation (outside Japan) and disappointing macro likely to be a disinflationary impulse in EM, reflected in data belie the resilience seen in core equity markets. measured inflation that serves to anchor local bond yields (see page 18). Global demand remains weak, as highlighted by declining Valuations in EM local bonds have become an overriding export growth and softer cyclically sensitive commodities. concern among investors, even as new money mandates – And the growth outturn in EM – most recently in Mexico – and fund inflows – continue to be strong. We highlight the has steadily disappointed to the downside. most attractive local bond markets based on a set of key Technically USD/EM is approaching overbought territory, criteria (see page 14). but, directionally speaking, we remain cautious overall on EM Within credit, Idiosyncratic risks continue to make us risk, given that there are no signs of a near-term turnaround cautious on the high yielders, and we instead maintain our from the macro deterioration. overweights on select mid-tier credits. Exhibit 1 EM Currencies Continue to Underperform * What's Next 180 110 This week's main risk event will be Chairman Bernanke's EMFX strength, Spread compression, Equity strength 108 JEC testimony on Wednesday, along with the release of the 160 106 minutes from the last FOMC meeting. As indicated earlier, 140 104 the prospect of the Fed tapering its purchases of assets as 102 part of its QE programme will likely have a negative market 120 100 impact. 98 100 The main event for EM this week will be the South African 96 Reserve Bank's policy meeting, at which rates are expected 94 80 92 to remain on hold by Morgan Stanley and consensus. The 60 90 chances of a rate cut have risen according to our May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12 Nov-12 May-13 economists, but it remain unlikely. China's HSBC Flash MSCI EM EM Credit Spread S&P 500 USD/EM Manufacturing PMI will also be important to gauge the Source: Morgan Stanley Research, Bloomberg; *All series Jan '10 =100 growth recovery in China. 2 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Risk Events of the Week Ref Date (EST) Time (EST) Ccy Event period MS Fcast Market Previous 20-May 8:00 PLN Avg Gross Wages (YoY) Apr 2.80% 2.20% 1.60% 20-May 8:00 PLN Employment (YoY) Apr -1.00% -0.90% -0.90% 20-May 8:30 CLP GDP (YoY) 1Q 4.30% 5.70% 20-May 8:30 CLP Current Account (USDm) 1Q -1800 -2880 20-May 17:00 COP Trade Balance (USDm) Mar $413 $386.4 20-May PHP Balance of Payments Apr $452M 21-May 3:00 ZAR Leading Indicator Mar 133.3 21-May 8:00 PLN Sold Industrial Output (YoY) Apr 3.60% 3.00% -2.90% 21-May 8:00 PLN Producer Prices (YoY) Apr -1.50% -0.60% 21-May 19:00 RUB Producer Prices (YoY) Apr 3.00% 3.40% 21-May 20:30 TWD Unemployment Rate - sa Apr 4.20% 4.17% 4.18% 22-May 3:00 HUF Avg Gross Wages (YoY) Mar 3.00% 2.70% 22-May 4:00 ZAR CPI (all items) (YoY) Apr 5.80% 5.70% 5.90% 22-May 5:00 MYR CPI YoY Apr 1.70% 1.70% 1.60% 22-May 8:00 BRL IBGE CPI IPCA-15 (MoM) May 0.42% 0.48% 0.51% 22-May 9:00 MXN Retail Sales (INEGI) Mar 1.60% -1.00% -2.60% 22-May 9:30 BRL Current Account - Monthly Apr -$6500 -$6873M 22-May 9:30 BRL Foreign Investment Apr $5000M $5739M 22-May 15:00 ARS Trade Balance Apr $510M 22-May ILS Leading 'S' Indicator (MoM) Apr 0.10% 22-May ARS Consumer Confidence May 44.06 22-May 19:00 RUB Industrial Production (YoY) Apr 1.90% 2.60% 22-May 20:00 SGD GDP (YoY) 1Q F -0.50% -0.60% 22-May 21:45 CNY HSBC Flash Manufacturing PMI May 50.4 50.4 23-May 1:00 SGD Industrial Production YoY Apr 1.60% -4.10% 23-May 1:00 SGD CPI (YoY) Apr 3.10% 3.50% 23-May 3:30 THB Foreign Reserves May-17 $176.3B 23-May 4:00 TWD Industrial Production (YoY) Apr -0.80% -0.52% -3.28% 23-May 7:00 BRL FGV CPI IPC-S May-22 0.38% 23-May 8:00 BRL Unemployment Rate Apr 5.50% 5.60% 5.70% 23-May 8:00 PLN NBP Publishes Minutes of Rate Meeting 23-May 9:00 MXN GDP Current $ YoY 1Q 3.90% 23-May 9:00 MXN Bi-Weekly CPI May-15 -0.32% 0.01% 23-May ZAR SARB Announce Interest Rate May-23 5.00% 5.00% 5.00% 23-May PEN GDP YoY 1Q 4.80% 4.90% 5.90% 23-May BRL Treasury Releases Federal Debt Data Apr 23-May 21:00 PHP Trade Balance Mar -$967M 23-May 21:35 CNY MNI Flash Business Sentiment Indicator May 24-May 3:00 CZK Consumer & Business Confidence May -5.3 24-May 4:00 TWD GDP - Constant Prices (YoY) 1Q F 1.50% 1.54% 24-May 4:00 PLN Retail Sales (YoY) Apr 3.20% 1.10% 0.10% 24-May 4:00 PLN Unemployment Rate Apr 13.90% 13.90% 14.30% 24-May 9:00 MXN Unemployment Rate Apr 4.65% 4.51% 24-May 9:00 CLP PPI (MoM) Apr -2.90% 24-May 10:00 MXN Current Account Balance 1Q -$4500M -$6490M 24-May 15:00 ARS Industrial Production (YoY) Apr 1.80% 0.20% Note: Italics indicates earliest date possible release date. Bold indicates a monetary policy meeting. Source: Bloomberg AXJ Weekly Publication, May 17; CEEMEA Weekly Publication, May 17; LatAm Weekly Publication, May 17 3 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Re-enter Trade: Sell SGD/INR AXJ FX Kritika Kashyap, James Lord With SGD now trading at the top of the trading band, Rationale fundamental trends in the economy have tilted the risk/reward We are re-entering our short SGD/INR trade, after hitting our in favor of a move towards the middle of the trading band. stop last week. INR underperformed on the back of some Risks poor trade data, but we doubt the move will last. The rationale for the trade remains intact, with India likely to benefit from Significant global risk-aversion could prompt outflows from the falling commodity prices, and recent restrictions on the import Indian equity market, and given India's reliance on capital of certain goods (such as gold). flows to fund its current account deficit, this would undermine the INR. Also, any decision by the Singapore government to China and global growth concerns remain significant risks for implement structural reforms and improve productivity and the SGD. A manufacturing slowdown in China places a lower the supply-side restrictions would be SGD supportive. number of AXJ currencies at risk, including TWD and SGD. The associated move lower in commodity prices benefits INR. Levels INR has been under sharp depreciation pressure since mid- We recommend a positioning via 3m forwards. This trade is 2011 due to its high twin deficits, which had led to a poor high positive annualized carry, at around 5.5%. macro backdrop of structurally low growth and high inflation. We target spot SGD/INR at 42.0, with a stop at 45.5. The As prices of India's largest imports – oil and gold – decline, entry is the current 3m forward rate of 44.3. Risk/reward for we think this reduces India's macro vulnerability through an this trade is around 4:1, when measured in terms of total improving trade balance and lower imported inflation. return. Meanwhile, Singapore is the most export-oriented economy in The trade complements our recommendation to buy INR/IDR, AXJ. Its highest export market share – 21% of total exports – given prospects for the ongoing balance-of-payments is to China (including Hong Kong), and so a slowdown in deterioration in Indonesia to weigh on the rupiah. China/global growth poses significant risks for SGD. Its exports are mainly in the form of electronics and machinery components, which are also under threat due to JPY weakness. Restrictive policy and subdued growth has led to a sharp flattening of the IRS curve over the past couple of months. Weak Growth, Flat IRS Curve S$NEER Is Trading at the Top of the Band 1.32 125 S$NEER Model SGD Strength 85 Top 1.3 120 Center SGD Weakness, Bottom 70 1.28 Steeper IRS Curve 115 1.26 110 55 1.24 105 40 1.22 100 1.2 25 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 95 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 USD/SGD SGD IRS 1s5s (bp) Source: Morgan Stanley Research, Bloomberg Source: Morgan Stanley Research, Bloomberg 4 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor New Trade: Switch into PETBRA'23 from Corporate Credit PETBRA'19 Vanessa Barrett, Kristina Obrtacova Rationale Although the new 10-year benchmark is inside the curve (see Exhibit 2), the bond offers liquidity and low dollar price, On the sovereign side, we continue to maintain our Brazil compared to the rest of the curve. We expect to see some underweight as we believe that it will be some time before we repricing tighter in the secondary market more generally, as see a meaningful impact of any reforms that could see Brazil PETBRA has traded as wide as the GAZPRU curve over the outperform (see Global EM Investor: Big Data, May 13, 2013). past few months. The new bonds, PETBRA'23, offer an 81bp Within our quasi-sovereign O&G framework, we have been pick-up over PEMEX'23, which were issued at the start of the monitoring Petrobras' pick-up versus the respective sovereign year. bonds (see LatAm: A Rising Class in Investment Grade, April 15, 2013). Year-to-date, we saw an outperformance of Risks Petrobras versus sovereign bonds, with Petrobras bonds With supply risks out of the way, the broader macro risks recording an average 7bp of spread widening while Brazil related to Brazil continue to weigh on valuations beyond the sovereign bonds are 30bp wider over the same period. sovereign bond space. The overhang of anticipation of large supply from Petrobras Levels has been weighing on the bond curve since the start of the year, given that, in the previous two years, the issuer came to We recommend investors switch into the new PETBRA'23 the market in the first month of the year. As a result, the total bonds, which offer more liquidity, a lower dollar price and a return of PETBRA bonds is lower than for similar-duration 15bp pick-up in spread terms to the PETBRA'19s. The current PEMEX and GAZPRU (see Exhibit 1). The record US$11 spread of PETBRA'23 is z+232bp and PETBRA'19 trades at billion issuance printed by Petrobras last week, offering short, z+218; we set the target for PETBRA'23 at z+200bp and stop- belly and long duration with both fixed and floating tranches, loss at z+260bp, which gives the trade a risk/reward of around met with strong investor demand. The new supply saw only 1.2. 5bp average spread widening across the rest of the curve and the new PETBRA'23 are currently 2bp tighter. Total Return Of Similar-Duration Bonds YTD Switch into PETBRA'23 from PETBRA'19 105 PETBRA'40 300 PETBRA'21 TR PEMEX'21 TR GAZPRU'22 TR PETBRA'43 PETBRA'41 103 250 PETBRA'21 PETBRA'20 PEMEX'38 PEMEX'44N PETBRA'23 PEMEX'44 PETBRA'19 PEMEX'41 PEMEX'35 200 PETBRA'18 101 PETBRA 5 7/8%'18 Z-spread PETBRA'16 PEMEX'21 PEMEX'19 PEMEX'23 PETBRA 3 7/8%'16 PETBRA'17 150 PEMEX'20 99 PEMEX'22 PETBRA 2%'16 PEMEX'18 100 97 PETBRA'15 PEMEX'15 50 95 0 2 4 6 8 10 12 14 16 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Modified Duration Source: Morgan Stanley Research, Bloomberg Source: Morgan Stanley Research, Bloomberg 5 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Trade Radar (All Open Trades) Cross-Asset Robert Habib, Simon Waever Local Markets More Compelling Recent Opened Trades Sell SGD/INR We re-enter our short SGD/INR after INR underperformed on MXN 1s10s the back of poor trade data last week. Yet, India is set to Flattener* Sell SGD/INR benefit from falling commodity prices, and recent restrictions Trade Score on the import of certain goods, while Singapore is vulnerable Buy 2015 BRL BE to a Chinese slowdown. Inflation Buy MXN 1s10s Flattener Increased flows into the Mexican local markets, especially given Fitch's upgrade, should keep long-term rates low. The Less Compelling short end of the curve is also pricing in many cuts, allowing the trade to have a positive 8bp (DV01-neutral). Reward / Risk Rates FX Credit Recent Opened Trades More Compelling Switch into PETBRA'23 from PETBRA'19 Buy SOAF 2022 Although on the sovereign side, we position for vs. SOAF 2041** Buy VIP '18** Buy BCOCPE'20 underperformance in Brazil, we see a tactical opportunity in the new PETBRA'23 bonds, which offer more liquidity, a lower Trade Score Buy SBERRU'21** Buy Peru 2019 vs. dollar price and 15bp pick-up in spread terms to the Brazil Jan-2019** PETBRA'19s. (Due to the lack of historical data for this bond, it is not included in the chart.) Buy KZOKZ'23 We see an opportunity for spread compression in Kazakhstan in KMG bonds, which underperformed similar-duration Less Compelling Gazprom bonds year to date. We see the new KZOKZ'23 bonds as the most attractive way to express this view. (Due to the lack Reward / Risk of historical data for this bond, it is not included in the chart.) Sovereign Credit Corporate Credit *Trade score is a simple sum of four components, with the maximum score for each component given in parentheses. Conviction (4): This is subjectively assigned based on the trade rationale, with four being the highest conviction level and zero the lowest. Directionality (2): Between zero and two, with two indicating a non-directional trade and zero indicating a directional trade. Carry (2): A score is given depending on the trade's three-month carry. Negative carry gets a value of zero. Positive carry, which is less than the stop-loss of the trade, gets one. Carry in excess of the stop-loss gets two. Z-Score (2): The difference of the current level of the trade and its mean, divided by the one-year standard deviation of weekly changes. In any case where mean > current > target, or where mean < current < target, a score of zero is awarded. Otherwise, a z-score above 4 is given a score of 2, one between 2 and 4 is given a score of 1 and one below 2 is given a zero. Trade Score is represented below each recommended trade (except for Hedges). 6 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Trades We Recommend Entry Notional Gross P&L Current Target Stop Trade Status Date Level ($m, DV01* or Delta**) bp US$k CREDIT Sovereign Credit Buy SOAF 2022 vs. SOAF 2041** 18-Feb-13 -26 -16 -51 -11 10x5 +5 64 Buy Peru 2019 vs. Brazil Jan-2019** 15-Apr-13 -4 -27 -44 16 10x10.5 +24 148 Corporate Credit Buy VIP '18** 26-Nov-12 473 346 325 400 10 +122 894 Buy SBERRU'21** 25-Mar-13 276 236 220 280 10 +42 371 Buy BCOCPE'20 29-Apr-13 262 237 220 290 10 +6 69 Buy KZOKZ'23 7-May-13 231 235 190 270 10 -11 (77) Switch into PETBRA'23 from PETBRA'19 NEW 20-May-13 233 234 200 260 10 - - RATES Buy 2015 BRL BE Inflation 18-Apr-13 5.53 5.69 6.20 5.00 10 +16 83 MXN 1s10s Flattener* 10-May-13 112 120 80 130 10 -8 (23) CURRENCIES Sell SGD/INR NEW 17-May-13 43.6 43.9 42.0 45.5 10 (58) Buy 3m USD/ MXN 1x2 Put Spread (K = atmf, 12.8) 26-Apr-13 12.14 12.32 10 Buy 1y USD/ CNY Put Spread (K = 6, 6.18) 26-Apr-13 6.22 6.20 10 ** Trade spreads (Entry, Current, Target and Stop) are displayed in z-spreads, all other Credit trades are displayed in yield (bp). Gross P&L in always in yield terms Gross P&L includes carry but excludes transaction costs. These are hypothetical, not actual, trades. Past performance is no guarantee of future results. Source: Morgan Stanley Research For a longer history of our recommended trades, see Recommended Trade Summary, April 23, 2013. Morgan Stanley & Co. Limited ("Morgan Stanley") is acting as financial advisor to Yandex N.V. ("Yandex"), in relation to the proposed formation of a JV between Yandex.Money and Sberbank of Russia, as announced on 19th Dec 2012. Yandex has agreed to pay fees to Morgan Stanley for its financial services. Please refer to the notes at the end of the report. 7 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Currencies Sell Reduce Hold Accumulate Buy In the CEEMEA region, our continued underweight stance towards the South Africa rand has worked nicely, with EM currencies have been very volatile recently, and we USD/ZAR punching through our 9.40 target. We suspect that continue to project a cautious stance. We think that USD/EM ultimately USD/ZAR will trend higher as the country's terms will keep heading higher, but any dovish comments from the US Federal Reserve could turn sentiment around. of trade continue to deteriorate amid falling gold prices. We also think the TRY will underperform, as the CBT continues As such, we continue to recommend defensive positioning, to foster TRY depreciation on a trade-weighted basis. The favoring those currency that benefit from falling oil and other TRY failed to rally post the upgrade from Moody's to give commodity prices (such as INR) and possible policy support Turkey an investment grade credit rating. This is not (such as CNY and BRL). surprising, given the falling carry on the TRY, CBT policy and the market environment. EM currencies have had a torrid time recently, with all those Elsewhere in CEEMEA, the resilience of the HUF continues under our coverage depreciating versus the USD, which, in to confound us. We have missed the market recovery, but turn, has been strong versus everything else too. Signs of we do not see justification for the rally to be sustained. More recovery in the US economy are being pounced upon as rate cuts look likely, with our economist, Pasquale Diana, evidence that the US Fed could taper asset purchases soon, recently revising his forecast for terminal rates down to 3.5%. thereby sending the USD higher. Carry is low on the HUF already, and sooner or later this, as Meanwhile, signs of disinflation are growing everywhere and well as the uncertainty over macro policy in general, could the near-term risk is that Chairman Bernanke uses this soon undermine sentiment towards the currency again. This week's testimony to push back against market speculation is not a high conviction view though. over any tapering of asset purchases in the context of In Asia, we continue to believe that INR will outperform given achieving its inflation objectives. If that happens, then EM its improving domestic macro dynamics and the benefits it currencies will probably recover. receives from falling oil prices. Meanwhile, the SGD should Certainly, our short-term market timing indicator suggests underperform as China's growth continues to slow. that EM currencies are approaching oversold territory. But In LatAm, MXN has corrected as we had expected. We see it we see a good chance that EM currencies will keep falling correcting further to 12.40 by month-end, on the back of the over the coming weeks, thanks to concerns over global continued USD rally and heavy positioning in the FX growth, an uncertain outlook for fixed income flows amid (measured using CFTC/IMM data) and bond markets. highly depressed yield levels in EM, and concern over However, we remain bullish the currency on the medium tapering at the US Fed. term. Commodity currencies like CLP, PEN and COP should Exhibit 1 also weaken from lower metal prices, in line with their SAMI Starting to Look Stretched respective central banks policies. CLP, in particular, is vulnerable to a slowdown in fixed income inflows. 100 102 90 Oversold BRL also sold off aggressively last week, reaching levels 101 80 where the BCB might choose to intervene via selling 100 70 currency swaps to limit FX weakness. Although inflation is 60 99 set to lower this quarter on a seasonal basis, it is improbable 50 98 that the BCB allows material depreciation from here, 40 97 especially given that it just started a hiking cycle. Hence, we 30 96 choose to upgrade BRL this week as we expect the currency 20 95 to outperform in an environment of weakness in broader EM. 10 Overbought 0 94 Jan-12 May-12 Sep-12 Jan-13 May-13 EM FX Momentum (LHS) USD/EM Source: Morgan Stanley Research, Bloomberg 8 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Exhibit 2 Relative Assessments Assessment Changes − o + 3m Perf vs USD* We have downgraded PLN, given the weakness of the EUR and INR -1.3% the prospect for further EM currency losses in the coming weeks. CNY 1.6% KRW -3.0% We have upgraded CNY, as we expect the currency to outperform BRL -3.2% in an environment of weakness in broader EM. MYR 2.6% We have upgraded BRL, as possible BCB intervention to the top- PHP -1.2% side should limit losses. PLN -3.2% COP -2.4% RON -1.7% ILS 1.1% PEN -2.5% MXN 3.1% TRY -2.3% CLP -1.5% HUF -1.8% TWD -1.2% CZK -4.8% THB -0.1% SGD -1.5% RUB -3.2% IDR -0.5% ZAR -6.0% Source: Morgan Stanley Research; *CEE performance is versus EUR 9 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Local Rates Sell Reduce Hold Accumulate Buy Hungary remains our top pick in EM local bonds, and the country continues to outperform even as other markets grab We maintain an Accumulate overall stance on EM rates, the lion's share of headlines. One of those markets was though we acknowledge risks are increasing and markets are Turkey, which benefited from the 'double whammy' of a starting to move in an idiosyncratic fashion again. larger-than-expected cut in policy rates and a second In CEEMEA, we downgrade South Africa to neutral ahead of investment grade upgrade. Although the upgrade doesn't this week's central bank meeting, given increased risks from come as a big surprise – risk premium on Turkish bonds has currency volatility. been low for over a year now – the bonds should remain In Asia, we upgrade India to neutral-overweight and supported in the near term from the twin tailwinds of inflows downgrade Thailand to neutral-underweight. and rate cuts. South Africa will be the focus of attention in our region this We continue to have a relatively bullish stance on EM rates week. April inflation is released on Wednesday and a lower- (Accumulate), though we are mindful that our markets are than-expected reading will increase anticipation of a rate cut not all moving in the same direction any more, and by the SARB when it meets on Thursday. Market idiosyncratic drivers are coming back to the fore. A selective expectations are relatively low, with around 30bp of cuts approach to rates is probably warranted in the near term. EM priced over the next six months, and the recent sharp sell-off currencies are generally weaker and in some markets in ZAR has probably prevented those expectations from correlations between rates and fx have increased. A further increasing further. The renewed weakness in the currency tail risk to rate markets globally is increased expectation of a has concerned us as well, and we have reduced the country slowdown in the pace of asset purchases by the US Fed. to neutral from neutral-overweight. Exhibit 1 We make no changes to our views on LatAm local bonds this Risk Premium on Turkish Bonds Already Low week. Brazil continues to price in a more aggressive hiking scenario than Morgan Stanley economists' expectations. 18 12 Still, we think the market is bound to remain volatile and 16 10 positioning is unlikely to increase sharply in the near term, 14 8 given the confusion around policy-makers' monetary policy stance. On the other hand, the other LatAm heavyweight, 12 6 Mexico, continues to benefit from an improvement in policy. 10 4 Although positioning in the market is high, we expect Mexico 8 2 to remain one of the key beneficiaries of foreign inflows into EM and we maintain our neutral-overweight stance. 6 0 4 -2 In Asia, we've made two changes to our relative assessments. We are bullish on Indian bonds and upgrade 2 -4 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 the market to neutral-overweight as we expect further easing from the RBI as inflation drops sharply, and some pick-up in Real yield (RHS) CPI yoy 5y yield inflows on the back of relaxation in foreign ownership Source: Morgan Stanley Research, Bloomberg restrictions. On the other hand, we are bearish on Thailand bonds which we downgrade to neutral-underweight, as we see risks of overheating in the economy, which the market isn't currently pricing. At the same time, there is a risk that the BoT might cut rates to further weaken the currency. 10 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Exhibit 2 Assessment Changes Relative Assessment and Recent Performance We upgrade: India to neutral-overweight from neutral, as we think − o + 3m Perf of 5y Bonds, b the RBI will continue to ease as inflation declines sharply. HUF -110 INR -58 We downgrade: Thailand to neutral-underweight from neutral, RUB -2 given risk of overheating in the economy, which we think the market MXN -58 isn't currently pricing. ILS -60 We also downgrade South Africa to neutral from neutral-overweight, BRL +4 as an increase in currency volatility is likely to impact rates TRY -95 negatively. RON -120 NGN +76 ZAR -26 PHP -89 KRW -10 MYR -16 IDR +18 PLN -84 THB -24 CZK -60 COP +13 PEN -9 CLP -63 Source: Morgan Stanley Research 11 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Credit Sovereign Sell Reduce Hold Accumulate Buy is in line cumulate with our recent downgrade of Ukraine to market- Buy Corporate Sell Reduce Hold Accumulate Buy weight in our portfolio (see assessment changes in box Accumulate opposite). Venezuela has shown some small positive signs, Despite long-awaited IG status for both Turkey and the such as the apparent thaw in relations between the Philippines this month, already tight spreads mean the government and the large food supplier Polar, but as impact in the near term is likely to be limited. highlighted in Venezuela: Change on the Horizon, April 24, Idiosyncratic risks continue to make us cautious on the high 2013, there are still too many hurdles and too much potential yielders and we instead maintain our overweights to select volatility to make the bonds appear attractive. mid-tier credits. Exhibit 1 We maintain our preference for corporates versus sovereigns Relative Assessment and 3m Performance in EM credit, focusing our allocation on high yield, namely BB − o + CDS 3m perf. bp corporates. INDO -6 KAZ -14 Sovereign Credit LIT -0 ROM -31 EM credit continues to see its YTD total return oscillate around TURK -24 zero. With a move wider in US Treasuries over the past two CRO -14 weeks but no equivalent spread tightening, returns were again PER -5 pushed into negative territory, with low-beta largely underperforming. As highlighted in our spring outlook (Global EGY +9 EM Spring Outlook, March 21, 2013), we continue to see the HUN -32 year as one of sluggish returns for EM Credit. Weekly fund RUS -14 flows reinforce this by once again coming in very weak at only SOAF -10 $US31 million into hard currency funds (Weekly Fund Flows & UKR +3 Technicals, May 16, 2013). ARG* +483 Both Turkey and the Philippines are now officially Investment COL -17 Grade credits following the widely expected Moody's upgrade MEX -19 of Turkey to Baa3 on May 17 and S&P's upgrade of the VEN +148 Philippines at the beginning of the month. At the same time, CHL -1 we note that the markets have treated both Turkey and the MAL -2 Philippines as IG credits for a while. In fact, our SovRank PHI -17 model shows the current CDS spreads and country BRA +0 fundamentals imply a BBB- rating for Turkey and a BBB rating for the Philippines. Current Prior Source: Morgan Stanley Research; *We allocate all exposure to the Par bond. We have been overweight Turkey, with the potential upgrade to IG as one of the positive drivers for spread compression. Assessment Changes (May 13) However, with spreads at recent lows, we believe that we are We downgrade UKRAINE to a market-weight position: With an now closer to fair value. On the other hand, Philippine bond IMF deal seemingly pushed out to the autumn, the catalyst for spreads are among the tightest in the markets, and we spread compression in the near term has been removed. At the consider the bonds to be very expensive, despite the strong same time, funding needs remain high this year and we thus expect macro backdrop. We therefore maintain our underweight future supply to keep upwards pressure on yields. allocation. We upgrade KAZAKHSTAN to a neutral/overweight position: Finally, the week also saw S&P confirmed the B rating of With the recent supply absorbed by the market, favorable Ukraine while maintaining a negative outlook. Focus was positioning, an increased resistance to oil price volatility and again on the reliance on the markets to fund themselves. This underperformance YTD, we think Kazakh spreads look attractive. 12 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Corporate Credit Last week, EM corporates issued US$19 billion in bonds, taking the May supply to over US$35 billion so far. The Last week saw spreads moving sideways, with both record US$11 billion issuance printed by Petrobras, offering corporate and EM sovereign spreads ending the week short, belly and long duration with both fixed and floating relatively unchanged. On a regional basis, Asia outperformed, tranches, met with strong investor demand. The total amount while LatAm was weaker due to Mexican corporates. On a raised by EM corporates in the first five months of this year sector basis, utilities continued to outperform, catching up to now stands at US$166 billion, which amounts to 60% of last their recent underperformance, and M&M spreads lagged the year's total issuance. rest of the sectors. BB rated corporates, our preferred category in EM credit, underperformed the broader EM credit last week in spread terms. 13 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Where Is the Value in EM Rates? Mihail Bozinov, Robert Habib, Kritika Kashyap Our EMTrend model (see EM Profile: Introducing EMTrend – A Scenario Analysis for EM Rates, March 7, 2013, for We assess EM rate markets by utilizing a local bond details) shows that given the current low levels of yields, scorecard, our EMTrend model, and our strategy views. EM rates are particularly sensitive to a sell-off in DM rates. Brazil, Israel and India rank highest on our scorecard while While the model sees 2y EM IRS trading more or less South Africa, Turkey, Mexico and Thailand rank lowest. sideways over the next six months, 5y IRS has bigger We remain bullish on bonds in Hungary, Israel and Mexico, scope to sell off, particularly in CEEMEA. move India to overweight and stay neutral on Brazil. We However, EMTrend is more bullish on local bonds, downgrade South Africa and Thailand to underweight. forecasting a further small rally in short-dated Mexican and EMTrend shows that a sell-off in DM rates is a big risk to EM Polish bonds, as foreign inflows, which we expect to remain swap rates at the moment, particularly in 5y tenors and in strong, are an important driver of local bond performance. CEEMEA, while bonds should fare better, especially in Mexico, as inflows remain strong. The interactive version is The Local Bond Scorecard available here. Exhibit 1 EM Local Bond Scorecard – Data EM local bonds have done well this year, on the whole, MP exp Real yield Positioning DM correl Credit BRL 0.22 -0.75 -2.18 0.10 0.0 outperforming external bonds by a wide margin. However, COP 0.18 -0.17 0.22 -0.03 0.0 with the rally now largely behind us and in light of the recent CZK -0.07 0.29 na 0.56 0.0 uptick in DM rates, the question on investors' minds is HUF -0.10 1.17 -0.41 0.23 0.0 IDR 0.00 -0.95 -0.54 -0.50 0.0 whether there is still any value left in local rates, and if so ILS 0.30 0.09 na -0.11 0.0 where? In this note we aim to answer this question utilizing INR -0.05 0.15 na -0.48 0.0 a local bond 'scorecard', our proprietary EMTrend model for KRW 0.10 0.29 na 0.40 0.0 local rates, and our subjective strategy views. MXN -0.31 -1.15 -0.54 0.15 1.0 MYR -0.06 -0.56 -0.54 -0.21 0.0 Our local bond scorecard is most bullish on local bonds in PEN 0.00 0.34 -0.06 0.13 0.0 RUB 0.50 -1.96 0.36 0.01 0.0 Brazil, Israel and India and most bearish on bonds in South THB -0.10 0.34 0.53 0.35 0.0 Africa, Turkey, Mexico and Thailand. TRY -0.25 0.21 0.22 0.41 1.0 ZAR -0.30 -1.02 -1.27 0.17 0.0 In CEEMEA, we are bullish on Hungary and Israel, which Avg 0.00 -0.18 -0.36 0.10 0.13 score highly, and Russia, which ranks roughly in the Std 0.22 0.82 0.76 0.31 0.34 middle, and we turn more cautious on South Africa, which Source: Morgan Stanley Research, EPFR, Bloomberg has a low rank. We've created a local bond scorecard that takes into In Asia, we like India, which is ranked highest in Asia, are account a few different metrics that bond investors neutral on Indonesia and Malaysia even though they too traditionally consider and standardized the results into have positive marks on the scorecard, and are bearish on relative Z-scores, so that the different metrics can be Thailand, which the has lowest overall score in EM. combined. In LatAm, in contrast to the results of the scorecard, we The first metric is the difference between market and maintain our bullish view on Mexican bonds and a neutral Morgan Stanley economics policy rate expectations on a view on Brazil. Flows are likely to continue to support the 6m horizon – markets that are pricing less than what our Mexican local market, in our view, although we economists expect are rated highly and vice versa. acknowledge heavy positioning makes it susceptible to a The second metric is 10y bond implied real yields, or more sell-off in US Treasuries. Yet, confusion about monetary precisely the difference between the current 10y real yield and policy in Brazil, the BCB's recent hiking cycle, and high its 12m average. Markets with high and rising real yields (due risks of structural inflationary pressures rising should to most likely falling inflation) are relatively more attractive. continue to limit foreign interest on the Brazilian market. 14 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor The third criterion is positioning. Admittedly, reliable and CEEMEA timely data on (relative) investor positioning is hard to come The local bond scorecard supports our overweight by. The best data we have are EPFR's monthly survey of positioning in Hungary and Israel. Money markets do price EM investors benchmarked to the widely followed GBI EM indices, which includes most but not all EM local markets. a lot of rate cuts in Hungary, but there really isn't any sign Here we look at the difference in positioning in 1Q13 and in that the NBH is going to pause anytime soon with inflation 2012. Markets where positioning has declined score higher. at all-time lows. And we like rates in Israel, where we see a potent combination of low inflation and a central bank The fourth criterion is correlation with DM rates. We determined to weaken the currency with further rate cuts. calculate the correlation between weekly changes in 10y EM and DM (UST or DBR) bond yields in 2013. We choose We are also overweight rates in Russia, which ranks in the to give a positive score to countries with lower/negative middle of the table, and would recommend adding on correlation, given investors' concerns of a more sustained weakness, as although inflation is still high, the data should rise in DM rates. turn over the next few months and we expect the CBR to The fifth and final metric is a credit score, whereby we give take an increasingly dovish stance. countries that we think have a higher than 50% probability South Africa is ranked fourth from the bottom. This in of a credit upgrade/downgrade over the next three months combination with renewed currency volatility makes us a score of 1/-1. Mexico and Turkey (upgrade) are the only slightly more cautious on the local market, and we countries that meet this criterion. accordingly downgrade it to neutral. Finally, we are keeping Exhibit 2 our neutral position on Turkey, which is ranked third last. EM Local Bond Scorecard – Z-Scores We are aware that valuations are very stretched but the MP exp Real yld Posit DM correl Credit AVG main driver of rates there is the CBT's desire to weaken the BRL 1.02 -0.70 2.39 -0.02 0.00 0.54 currency and address domestic growth and credit ILS 1.38 0.32 0.00 0.69 0.00 0.48 imbalances via other means. The recent credit upgrade INR -0.22 0.40 0.00 1.87 0.00 0.41 IDR 0.01 -0.95 0.24 1.94 0.00 0.25 should also support the market in the near term. HUF -0.44 1.64 0.07 -0.45 0.00 0.16 MYR COP -0.26 0.83 -0.47 0.01 0.24 -0.76 1.01 0.41 0.00 0.00 0.11 0.10 LatAm PEN 0.01 0.63 -0.39 -0.12 0.00 0.03 The local bond scorecard views Brazil as the most KRW 0.47 0.57 0.00 -0.99 0.00 0.01 RUB 2.29 -2.17 -0.94 0.26 0.00 -0.11 attractive market in EM, on the back of low positioning as CZK -0.31 0.56 0.00 -1.53 0.00 -0.25 well as the aggressive hikes priced in. Indeed, as ZAR -1.36 -1.03 1.20 -0.23 0.00 -0.28 TRY -1.13 0.48 -0.75 -1.02 1.00 -0.28 mentioned in Economics and Strategy: Brazil – Dovish MXN -1.40 -1.19 0.24 -0.19 1.00 -0.31 Hikes (April 19, 2013), our Brazil economist, Arthur THB -0.44 0.63 -1.16 -0.85 0.00 -0.36 Carvalho, only sees the BCB hiking three more times by Source: Morgan Stanley Research, EPFR, Bloomberg 25bp to 8.25% (with risks to the downside). Yet, despite the The results of the scorecard are summarized in Exhibit 2, possibility of gains in the short end, the DI market is bound ranked by average Z-score. Brazil ranks No. 1 due to the to remain volatile. And positioning as measured by EPFR market's aggressive pricing of tightening and the sharp has materially decreased this year, given the confusion decline in positioning in 1Q. Among LatAm, Colombia also around policy-makers' monetary policy stance, to Mexico's gets a slightly positive mark on account of policy benefit. We do not see this changing near term, and remain expectations and low correlation with DM. broadly neutral on Brazil. In CEEMEA, Israel ranks highest on account of market On the other hand, Mexico is unattractive in our pricing, rising real yield and low DM correlation, followed by scoreboard, and vulnerable to a correction given high Hungary, which benefits from rising real yields and low positioning, the 35bp priced into the short end of the TIIE positioning. Most CEEMEA markets actually have a curve, and its sensitivity to US Treasuries. Indeed, we negative overall score. acknowledge that the increase in positioning makes it In Asia, India ranks highest due to its negative correlation particularly vulnerable to a back-up in core rates, especially with DM and rising real yield. Indonesia and Malaysia also given the increased foreign ownership of MBonos (to 59% score highly, mainly on account of their low correlation with of total) and increased MXN-denominated Toshin assets DM in recent months and low positioning. 15 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor (after adjusting for exchange rates; see Exhibit 3). EMTrend – Scenario Analysis for EM Rates However, we expect the flows into EM to remain very We've updated our EMTrend model (see EM Profile: strong (see EM Strategy Comment: Weekly Fund Flows & Introducing EMTrend – A Scenario Analysis for EM Rates, Technicals, May 16, 2013) and support MBonos. Hence, March 7, 2013, for details) in view of forecasting the most we keep our slight overweight position. likely path for EM local rates based on their historical Exhibit 3 relationship to a set of macroeconomic and financial Exposure to MXN: MBono Foreign Ownership (% of variables and their projected changes. For the interactive Total) and Toshin MXN-Denominated Assets version, please see EMTrend: EM Rates Scenario Builder. (JPYbn*) We aim to get a sense of the general direction of EM rates, 450 60% while allowing the user to incorporate his individual forecasts for chosen variables, and run scenario analysis. 400 50% The variables were specifically chosen for each security, 350 and each set attempts to encompass the most important 300 40% drivers for each rate. 250 30% Exhibit 4 200 EM Local Rates: Actual vs. Forecasts 150 20% 2y Current 2m F'cast Diff 2013E F'cast Diff 100 BRL 8.62 8.84 22 9.33 71 10% CLP 4.49 4.65 16 4.85 36 50 CZK 0.51 0.86 35 1.01 50 0 0% HUF 3.74 5.29 156 5.16 143 J-03 J-04 J-05 J-06 J-07 J-08 J-09 J-10 J-11 J-12 J-13 ILS 1.39 1.51 12 1.67 28 Toshin MXN denominated assets (JPYbn*) Foreign Ownership of Mbonos (%) KRW 2.57 3.06 49 3.23 67 *MXN-denominated Toshin assets are measures using a constant January 2003 MXN/JPY. MXN 4.12 4.00 -12 4.06 -6 Source: Morgan Stanley Research, Bloomberg, Banxico, Toshin MBONO 3.82 3.75 -7 3.63 -19 PLN 2.51 2.76 25 3.23 72 AXJ ZAR 4.97 5.58 61 5.62 65 India has received the highest mark among AXJ markets on 5y Current 2m F'cast Diff 2013E F'cast Diff the scorecard, with which we agree and move our position BRL 9.31 9.26 -5 10.19 88 on the market to overweight. We think the RBI will continue CLP 4.69 5.01 32 5.26 57 to ease as inflation declines, while the government's recent CZK 0.77 1.27 50 1.57 80 measures on investment limits and withholding taxes HUF 3.83 4.91 108 5.13 130 ILS 1.98 2.60 62 2.91 93 should increase foreign inflows. KRW 2.63 3.27 64 3.46 83 Indonesia and Malaysia also score highly but mainly on MXN 4.59 4.81 22 5.04 45 account of their low correlation with DM rates, and we MBONO 4.07 4.44 37 4.53 46 prefer to be slightly more cautious on these markets. We PLN 2.70 3.73 103 4.45 176 ZAR 5.61 6.75 115 6.79 119 are neutral on Indonesian local bonds as we see their high Source: Morgan Stanley Research estimates, Bloomberg yield and low correlation with wider rate markets attractive enough to offset currently high inflation. We are neutral on In particular, given the very low yields at the moment, we find Malaysia as well, as we see limited upside after the post- that most EM local bonds are very sensitive to US Treasury election relief rally given our expectation for unchanged (German Bund) moves. And our US Treasury team sees an policy rates and a pick-up in correlation with DM rates. important risk that US Treasuries end the year higher, near 2.25% for the 10-year, driving EM yields higher as well Thailand ranks lowest in AXJ and EM overall. We too are according to this model. Indeed, based on our base-case slightly bearish on the market and move to an underweight forecasts for the macro and financial variables used, our position. We see increasing risks of overheating in the model's results suggest that the aggregate EM 2y IRS will economy that we think the market is not pricing. Although in trade more or less sideways for the next six months (with the near term, there is a chance that the BoT cuts rates in some notable exceptions), while the EM 5y IRS has, on order to curb currency strength. average, some scope to sell off further. 16 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Such notable exceptions – namely Hungary, Poland and Exhibit 5 South Africa – are the direct result of the market pricing EM 2y IRS Actual vs. Predicted (%) aggressive easing (the latter in an environment with 15 increasing inflation and a very weak currency) and higher DM rates. Taking Hungary as an example, the model 13 suggests that if the 10y Bund yield remains relatively 11 unchanged, the NBH decides to cut rates to 3.50% as expected by our Hungary economist, Pasquale Diana (see 9 CEEMEA Monitor, May 17, 2013), and idiosyncratic risk 7 premium lowers (as measured by the 5y CDS) by year-end, the 2y swap rate should be close to 4.30 (instead of 5.20 5 above). 3 Given our expectations for increased flows into the EM Feb-04 Mar-05 Apr-06 May-07 Jun-08 Jul-09 Aug-10 Sep-11 Oct-12 Nov-13 local debt space this year (see EM Macro Strategy EM 2Y IRS Fitted 2Y Comment: Still Flowing, December 20, 2012), our EMTrend Simple average of Brazil, Chile, Czech Republic, Hungary, Israel, Korea, Mexico, Poland and South Africa 2y swap rates. model also forecasts the 2y MBono to rally further by the Source: Morgan Stanley Research estimates, Bloomberg end of the year, despite our forecast for an increase in DM Exhibit 6 rates. Indeed, confirming our slightly overweight stance on Mexican bonds, we believe that flows will continue to be EM 5y IRS Actual vs. Predicted (%) supportive for MBonos this year, especially given that we 16 expect lower inflationary pressures for the year. 14 12 10 8 6 4 2 Feb-04 Mar-05 Apr-06 May-07 Jun-08 Jul-09 Aug-10 Sep-11 Oct-12 Nov-13 EM 5Y IRS Fitted 5Y Simple average of Brazil, Chile, Czech Republic, Hungary, Israel, Korea, Mexico, Poland and South Africa 5y swap rates. Source: Morgan Stanley Research estimates, Bloomberg 17 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Reflation, Deflation and Tail-Risk Hedges Juha Seppala Exhibit 1 Google Searches for the Term 'Deflation' (Max = We look at a fast-moving, market-based indicator which 100) summarizes information about global reflation/deflation pressures. This indicator has been on a deflationary trend since April 8, 2011. The indicator leads EM inflation and co-moves with both USD/EM and a wide dollar index. There have been and currently are interesting divergences between the indicator and global economic growth and asset prices. The indicator and our commodity model lead us to propose Source: Google Trends selling USD put / PLN or NOK call spreads as tail-risk Exhibit 2 hedges. Geographical Distribution of 'Deflation' Searches Reflation/Deflation Indicator There has been a recent spike up in Google searches for the term 'deflation'. As a matter of fact, during the week of April 14 the number of searches was the highest since the week of September 25, 2011, when the world was in the middle of a 'double-dip' scare (see Exhibit 1 but please note that the May data are only partial). In addition, the geographical distribution of the searches is unusually widely spread. They are elevated in every continent save Africa (see Exhibit 2). By contrast, Google searches for the term 'reflation' are at the lowest levels since August 2012. As an alternative measure for keeping track of reflation/deflation pressures, Exhibit 3 displays another Source: Google Trends indicator that is more market-based. The indicator has been Exhibit 3 calculated by taking an equally weighted average of: (i) Reflation/Deflation Indicator annual growth rates of copper, gold and oil prices; (ii) levels of US and average EM 2y breakeven inflation rates; and (iii) 85 China and average G4 countries' IRS curves 1s2s spread. 75 Each variable is normalized so that the historical max 65 corresponds to 100 and the historical min corresponds to 0. 55 The indicator reached its min (maximum deflation) in December 2008 and its max (maximum reflation) in 45 December 2009. The second-highest level was recorded in 35 June 2008 and the third-highest peak was on April 8, 2011. And, as a matter of fact, the indicator has been trending 25 down ever since. The previous turning points can easily be 15 interpreted as maximum commodity inflation pressures Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- (summer 2008), maximum fear of global depression (4Q08), 06 07 07 08 08 09 09 10 10 11 11 12 12 Source: Morgan Stanley Research, Bloomberg and maximum optimism about global rebound (4Q09). But what began the most recent deflation trend? 18 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor The most obvious candidate is the surprise decision of the Exhibit 4 European Central Bank to raise its key policy rate from 1% to Reflation/Deflation Indicator vs. USD/EM 1.25% on April 7, 2011. Exhibits 4 and 5 document the 70 85 subsequent movements in FX: the reflation/deflation indicator versus USD/EM and the wide dollar index, DXY, 65 87 respectively. The co-movement is quite striking. 60 89 Does the indicator lead anything? One variable which might 91 55 be expected to lag the indicator is the average EM inflation. 93 This is confirmed in Exhibit 6 and also in statistical tests. One 50 95 cannot reject the null hypothesis that EM inflation does not 45 Granger cause the indicator with a 20% significance level, 97 40 but one can reject the null hypothesis that the indicator does 99 not Granger cause EM inflation with a 0.5% significance 35 101 level. In plain English, the indicator leads EM inflation but EM 30 103 inflation does not lead the indicator. Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Reflation/Deflation Indicator USD/EM (RHS, inverted) It is also worth looking at the indicator against global Source: Morgan Stanley Research, Bloomberg economic activity and equity prices, shown in Exhibits 7-9. Exhibit 5 Overall, the behavior of the indicator seems to coincide with the general movement in global economic activity and asset Reflation/Deflation Indicator vs. Dollar Index prices, but there are some important divergences. In 70 72 particular, from October 2007 to June 2008 the indicator 65 74 continued to go up while the equity prices and global 60 economic activity plummeted. 76 55 Similarly, in retrospect, the behavior of the indicator from 50 78 October 2009 to April 2010 seems to have been 'overly 45 reflationary', as the relationship between asset prices and 80 economic activity diverged significantly but finally corrected 40 82 starting in December and finalizing by April. 35 30 84 Finally, what can we say about the above-mentioned Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 deflation trend which began on April 8, 2011? Since then, the Reflation/Deflation Indicator DXY (RHS, inverted) US equity markets and the currency have done very well – Source: Morgan Stanley Research, Bloomberg the S&P500 has rallied by 25% and the dollar index by 11%. Exhibit 6 On the other hand, MSCI-EM has sold off by 13%, USD/EM Reflation/Deflation Indicator vs. Average EM by 9%, CRB by 22%, the global PMI has come down by 5 Inflation units and EM inflation by almost 2%. That's quite a 80 9 divergence again. Is this a permanent decoupling or is one of 70 8 them going to cry uncle again? If so, which one? 60 7 The deflationary market signals that our indicator highlights 6 50 drive our overall market strategy at present. Indeed, with 5 40 commodity prices under pressure, we think that certain 4 30 currencies are vulnerable, including the AUD, CLP, ZAR and 3 20 2 RUB. So far, and as we discuss elsewhere in this 10 1 publication, the most obvious mispricing is in CLP. Overall 0 0 though, the deflationary signals in markets make us more Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- bullish on the USD and concerned about the prospects for 07 07 08 08 09 09 10 10 11 11 12 12 13 Reflation/Deflation Indicator EM Inflation (RHS) EM, and we continue to highlight our caution on the market. Source: Morgan Stanley Research, Bloomberg 19 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Exhibit 7 Related to this, four weeks ago, we highlighted our global Reflation/Deflation Indicator vs. Global PMI commodities model's most recent predictions (see Global Commodity Boom Revisited, Part 1: FX, April 18, 2013). The 90 70 80 65 model is now predicting that the CRB index will sell off 10% 70 60 in the near future. In addition, due to the pick-up in global 60 55 PMI and expectations about increased liquidity, especially 50 from Japan, the model is also predicting a 20% rebound 50 40 45 starting in 2H13. This would also be consistent with our 30 20 40 global economics team's forecast of the global economy 10 35 moving from "twilight to daylight in 2H13" (see Spring Global 0 30 Macro Outlook, March 12, 2013). Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- 07 07 08 08 09 09 10 10 11 11 12 12 13 Reflation/Deflation Indicator Global PMI (RHS) Tail-Risk Hedges Source: Morgan Stanley Research, Bloomberg In Global Commodity Boom Revisited, Part 1: FX, we Exhibit 8 analyzed the relationship between the movements in the Reflation/Deflation Indicator vs. S&P-500 wide commodities index and the major currencies. The main 90 1800 result, repeated in Exhibit 10, reveals that the most 80 commodity-sensitive currencies, based on R2 above 0.3, are 1600 70 AUD, SEK, GBP, CAD, NOK and PLN. 60 1400 Exhibit 10 50 Statistics for b in the Regression: FX(t)/FX(t-3m)-1 = 40 1200 a + b*[CRB(t)/CRB(t-3m)-1] 30 1000 Coefficient White Std Err t-Stat R2 AUD 0.4339 0.0570 7.6123 0.3743 20 SEK 0.3762 0.0454 8.2863 0.3295 800 GBP 0.2764 0.0445 6.2112 0.3156 10 CAD 0.2624 0.0354 7.4124 0.3111 0 600 NOK 0.3470 0.0519 6.6859 0.3032 Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- PLN 0.4414 0.0581 7.5972 0.3001 06 07 07 08 08 09 09 10 10 11 11 12 12 SGD 0.1500 0.0215 6.9767 0.2929 Reflation/Deflation Indicator S&P-500 (RHS) RUB 0.2964 0.0443 6.6907 0.2870 HUF 0.4147 0.0560 7.4054 0.2678 Source: Morgan Stanley Research, Bloomberg MXN 0.2824 0.0616 4.5844 0.2618 Exhibit 9 KRW 0.2828 0.0630 4.4889 0.2519 Reflation/Deflation Indicator vs. MSCI-EM USD -0.2313 0.0372 -6.2177 0.2448 TWD 0.1454 0.0192 7.5729 0.2444 90 1400 CZK 0.3508 0.0447 7.8479 0.2437 ZAR 0.4499 0.0649 6.9322 0.2434 80 1300 NZD 0.3616 0.0561 6.4456 0.2420 1200 MYR 0.1177 0.0210 5.6048 0.2343 70 INR 0.1760 0.0360 4.8889 0.1980 1100 EUR 0.2480 0.0461 5.3796 0.1851 60 1000 BRL 0.4148 0.0715 5.8014 0.1848 50 CLP 0.2743 0.0712 3.8525 0.1714 900 40 RON 0.2897 0.0510 5.6804 0.1616 800 ILS 0.1645 0.0310 5.3065 0.1332 30 CHF 0.1913 0.0457 4.1860 0.1114 700 PEN 0.0814 0.0260 3.1308 0.0994 20 600 TRY 0.2980 0.0685 4.3504 0.0918 10 IDR 0.2307 0.0718 3.2131 0.0857 500 COP 0.1612 0.0730 2.2082 0.0527 0 400 THB 0.0686 0.0223 3.0762 0.0371 Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- May- Nov- CNY 0.0181 0.0070 2.5857 0.0368 06 07 07 08 08 09 09 10 10 11 11 12 12 PHP 0.0377 0.0341 1.1056 0.0100 Reflation/Deflation Indicator MSCI-EM (RHS) ARS 0.0336 0.0807 0.4164 0.0011 JPY -0.0144 0.0646 -0.2229 0.0007 Source: Morgan Stanley Research, Bloomberg Source: Morgan Stanley Research 20 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor Exhibit 11 4.98%, implying a maximum profit to maximum loss ratio of Cumulative Return of Currencies and CRB approximately 5:1 (see Exhibit 13, spot reference: 3.24). Commodity Index (April 8, 2011 = 100) Another would be to sell a 3m USD put / NOK call spread 105 with strikes at 6 and 6.25. This would earn an upfront 100 premium of 3.67%, implying a maximum profit to maximum loss ratio of approximately 6:1 (see Exhibit 14, spot 95 reference: 5.84). 90 Both of these are attractive tail-risk hedges against commodity 85 and/or euro sell-offs within the next three months. Without 80 taking a stand on the probability of the tail risks being realized, 75 in today's low-volatility environment (see EM Profile: How to 70 Value FX Vol in an Era of Low Volatility, April 26, 2011), we Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 believe that global portfolio investors should make tail-risk CRB AUD SEK GBP CAD NOK PLN hedges a part of their asset allocation decision. When risks are Source: Morgan Stanley Research, Bloomberg considered to be low, it is cheap to hedge against them. But, Exhibit 12 more importantly, the era of low vol is also exactly the time Correlations between Currencies, Commodities and when the potential tail risks can do the most damage. Euro Exhibit 13 CRB Food Oil Copper Gold Euro AUD 0.66 0.46 0.58 0.72 0.04 0.49 Sell USD Put / PLN Call Spread Payoff Diagram SEK 0.67 0.46 0.45 0.63 -0.14 0.75 GBP 0.66 0.71 0.43 0.70 0.24 0.62 5.0% CAD 0.74 0.65 0.58 0.84 0.04 0.58 NOK 0.74 0.59 0.52 0.76 0.09 0.88 4.0% PLN 0.82 0.71 0.47 0.83 -0.20 0.89 3.0% Source: Morgan Stanley Research, Bloomberg Of these currencies, the largest regression coefficient (that 2.0% is, the most commodity-sensitive currency) is PLN. This is 1.0% quite surprising as Poland is a net commodity-importing 0.0% country. However, correlation doesn't mean causation and it is quite likely that both variables are driven by a common -1.0% factor, say, expectations about future global economic -2.0% growth. 3.15 3.2 3.25 3.3 3.35 3.4 3.45 3.5 3.55 Payoff This previous study used weekly data from January 1999 to Source: Morgan Stanley Research April 2013. Exhibit 11 shows the behavior of the CRB Exhibit 14 commodity index and the above six currencies since April 8, Sell USD Put / NOK Call Spread Payoff Diagram 2011. 4.0% Using the same data, we look at correlations between 3.5% different commodity components and also the euro in Exhibit 3.0% 12. PLN is the most correlated currency to CRB and Food, 2.5% and the second-most correlated to copper. It is also the most 2.0% correlated currency against the euro, while NOK is the 1.5% 1.0% second-most correlated currency against CRB and against 0.5% the euro. 0.0% Given that, in the near future, the biggest potential risks are -0.5% arguably sell-offs in commodities and the euro, tail-risk -1.0% 5.7 5.8 5.9 6 6.1 6.2 6.3 6.4 6.5 hedges using these currencies should be attractive. One Payoff alternative is to sell a 3m USD put / PLN call spread with Source: Morgan Stanley Research strikes at 3.5 and 3.3. This would earn an upfront premium of 21 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor EMFX: Sell ILS on Spikes Meena Bassily, James Lord ILS has been the top-performing EM currency over the past six months, as investors have positioned for gas The Bank of Israel has cut rates and introduced a USD production in the Tamar gas field. As USD/ILS went through purchasing program designed to offset the balance-of- 3.60, and the ILS basket (EUR, USD) neared 4.10 in early payments effect of rising domestic gas production. April, we saw the BoI begin to show more concern regarding While the scale of proposed interventions looks small the currency strength and its impact on competitiveness, and compared to prior periods of intervention, we think the policy it purchased USD in small amounts on several occasions to proposals will be sufficient to end ILS outperformance. help stem the appreciation trend. This did not work, as the We see other reasons for ILS to start underperforming too, market quickly tested the BoI's willingness to prevent further including low CPI and as our economists see a risk of further ILS strength. policy rate cuts. The BoI has taken a more aggressive stance, and we We recommend selling ILS versus EUR and USD on periods think that the market will pay attention: Last week, in an of ILS strength. unscheduled policy meeting, the BoI decided to cut rates by 25bp and introduce a USD purchasing program designed to List of EM interveners gets longer: Growth and trade have entirely offset the balance-of-payments effect of rising remained weak across most EM economies, and on average domestic gas production on the exchange rate. The plan is to inflation is falling. While EM currencies have generally buy about US$2.1 billion over the rest of 2013, covering 75% performed badly versus USD, they have still appreciated in of the improvement in the current account it expects for this trade-weighted terms this year. Currency resilience has in part year (US$2.8 billion), considering the other effects on the been driven by trends in G10 FX, but also by the influx of global financial account from gas production (such as FX payments liquidity and reallocation of portfolios into EM fixed income, and by gas companies). not by underlying fundamentals. This mismatch has prompted several EM central banks to pursue policies geared to a weaker Exhibit 2 exchange rate – be it via rate cuts, verbal intervention or direct Proposed Interventions Lower than Before intervention. This diverse array of central bank responses to 4500 5.0 currency appreciation has been a key input in our currency USDmn ILS USD 2.1bn 4000 purchase 4.9 strategy this year, and the Bank of Israel (BoI) has been the Strength 3500 planned, 4.8 latest joiner to the group of interveners. As such, our trading 3000 averaged over 4.7 strategy on ILS has changed. rest of year 2500 4.6 Exhibit 1 2000 4.5 ILS Has Been Outperforming for Some Time 1500 4.4 108 3.2 1000 4.3 106 500 4.2 3.4 104 0 4.1 3.6 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 102 BoI Intervention (LHS) ILS vs Basket (RHS) 100 3.8 Source: Morgan Stanley Research, Bloomberg, Bank of Israel 98 4.0 Not a large amount of intervention, though the signal is 96 4.2 strong: The announced plan to buy US$2.1 billion over the 94 rest of 2013 equates to an average purchase of US$262.5 92 4.4 million per month for the remainder of the year. This looks Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 small when compared to previous periods of intervention in ILS/EM USD/ILS (RHS, reversed) 2009/11; however, global macroeconomic conditions are Source: Morgan Stanley Research, Bloomberg very different now. Back then, ILS appreciation was linked to 22 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor an upswing in global growth following the credit crisis, 0.8%Y for April (see Exhibit 3). Our economists see inflation aggressive rate hikes by the BoI (275bp in total) and EM pressures remaining subdued for the remainder of the year, currencies in general appreciating strongly against USD. and accordingly see scope for further rate cuts – which may Clearly, ILS appreciation this time round is not linked to any be dependent on the level of ILS (for more on monetary such dynamics – with global growth faltering, the BoI cutting policy, see again Israel Economics: Better Late than Never, rates and EM currencies generally struggling against USD. May 13, 2013). In addition, the change in governor over the summer may bring about some uncertainty in the market, Indeed, this past phase of ILS appreciation has been driven though we do not see this as a major risk for the currency. more explicitly by the expected impact of gas production on Israel's external accounts. Neutralize this and the We recommend selling ILS versus EUR, USD on spikes: outperformance of ILS should slow, in our view. This is what All these factors, in combination with the strong performance the BoI has done in planning to purchase US$2.1 billion; and build-up in positioning on ILS over the past six months, therefore, ILS outperformance should come to an end, in our argue for further currency weakness, in our view. We believe view. that investors should add to short positions in ILS into strength. Our preferred way to position for ILS weakness is Also, the BoI has stated that it will continue to operate against the EUR, USD basket since the focus from the BoI against fluctuations it deems as not being in line with on economic conditions could mean interventions are more fundamental economic conditions. This gives flexibility to the closely tied to moves in the basket. We recommend selling US$2.1 billion figure, and, as our economist Tevfik Aksoy ILS on moves down to 4.15 on the basket, and 3.60 versus points out (see Israel Economics: Better Late than Never, USD. May 13, 2013), the BoI can clearly buy more USD if it deems it necessary and as it has done in the past. As such, we see Exhibit 4 the latest moves by the BoI and the signal that it has Trade Balance and Gas Impact communicated as sufficient, and we think that the market will 60 8% take this move more seriously. As such, we expect to see 12m rolling, USDbn gradual weakness in ILS versus the basket from here. 40 7% 20 6% Exhibit 3 5% Inflation Running below Target Band 0 4% 6 -20 3% 5 -40 2% BoI Target 4 -60 1% Band 3 -80 0% 2 00 01 02 03 04 05 06 07 08 09 10 11 12 13 1 Total Fuel Imports Total Imports exFuel Total Exports Fuel Imports, %GDP (RHS) 0 Source: Morgan Stanley Research, Bloomberg, Haver Analytics -1 Not all bad news for ILS: Clearly, gas production has the -2 scope to have other positive effects on ILS in the medium Jan-06 Jan-08 Jan-10 Jan-12 term. To name but a few, the build-up in FX reserves from Israel inflation y/y % Avg of inflation forecasts 1 USD purchases and the formation of a SWF (expected in MS 2013 end of year forecast 2018) help to improve Israel's external vulnerability metrics Source: Morgan Stanley Research, Bloomberg, Bank of Israel somewhat, which is ILS positive from a credit risk point of Subdued inflation also argues for a weaker ILS: There view. Indeed, greater predictability of energy supply and are other factors that may put ILS under some pressure over current account improvements formed part of the rationale the coming months. For the first time since 2007, CPI has for Fitch's recent affirmation of Israel's local currency rating breached the lower end of the BoI's target band, printing at at A+ with stable outlook. 23 MORGAN STANLEY RESEARCH May 20, 2013 Global EM Investor EM Strategy and Economics Teams EM Fixed Income and Foreign Exchange Strategy New York Rashique Rahman Team Head, EM Macro Strategy firstname.lastname@example.com +1 212 761 6533 Juha Seppala Global FXEM Quantitative Strategist email@example.com +1 212 761 1949 Robert Habib EM Strategy email@example.com +1 212 761 1875 London Paolo Batori, CFA European Head of EM Strategy firstname.lastname@example.com +44 (0)20 7677 7971 & Global Head of Sovereign Credit Strategy Vanessa Barrett Chief EM Credit Strategist firstname.lastname@example.com +44 (0)20 7677 9569 Mihail Bozinov CEEMEA Rates Strategy email@example.com +44 (0)20 7677 1150 James Lord CEEMEA Macro Strategy firstname.lastname@example.com +44 (0)20 7677 3254 +44 ( Kristina Obrtacova EM Corporate Credit Strategy email@example.com +44 (0)20 7677 7597 Robert Tancsa Sovereign Credit Strategy firstname.lastname@example.com +44 (0)20 7677 6671 Simon Waever Credit Relative Value, EM Analytics firstname.lastname@example.com +44 (0)20 7425 1640 Meena Bassily CEEMEA Macro Strategy firstname.lastname@example.com +44 (0)20 7677 0031 Hong Kong Viktor Hjort Head of AXJ Credit Strategy/ email@example.com +852 2848 7479 Fixed Income Research Nishant Sood AXJ Credit Strategy firstname.lastname@example.com +852 2239 1597 Kritika Kashyap AXJ Rates Strategy email@example.com +852 2239 7179 EM Economics Manoj Pradhan Global email@example.com +44 (0)20 7425 3805 Tevfik Aksoy Head of CEEMEA Economics email@example.com +44 (0)20 7677 6917 / Turkey, Israel Michael Kafe South Africa, Nigeria, Ghana, Kenya email@example.com +27 11 587 0806 Andrea Masia South Africa, Nigeria, Kenya firstname.lastname@example.com +27 11 282 1593 Pasquale Diana Poland, Hungary, Czech, Romania firstname.lastname@example.com +44 (0)20 7677 4183 Jacob Nell Russia, Kazakhstan, Ukraine firstname.lastname@example.com +7 495 287 2134 Alina Slyusarchuk Russia, Kazakhstan, Ukraine, Baltics firstname.lastname@example.com +44 (0)20 7677 6869 Gray Newman LatAm email@example.com +1 212 761-6510 Luis Arcentales Chile, Mexico email@example.com +1 212 761-4913 Arthur Carvalho Brazil firstname.lastname@example.com +55 11 3048 6272 Daniel Volberg Argentina, Colombia, Peru, Venezuela email@example.com +1 212 761-0124 Helen Qiao China email@example.com +852 2848 6511 Sharon Lam Korea, Taiwan firstname.lastname@example.com +852 2848 8927 Yuande Zhu China, Hong Kong email@example.com +852 2239 7820 Yin Zhang China email@example.com +852 2239 7818 Jason Liu Korea, Taiwan email@example.com +852 2848 6882 Chetan Ahya Asia ex-Japan, India firstname.lastname@example.com +852 2239 7812 Deyi Tan ASEAN email@example.com +65 6834 6703 Seen Meng Chew ASEAN firstname.lastname@example.com +65 6834 6739 Derrick Kam Asia ex-Japan firstname.lastname@example.com +852 2239 7826 Jenny Zheng Asia ex-Japan firstname.lastname@example.com +852 3963 4015 Upasana Chachra India email@example.com +91 22 6118 2246 Morgan Stanley entities: London/South Africa – Morgan Stanley & Co. 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