On emerging market bubbles and sovereign risk

Two ideas about emerging markets seem to be evident these

days. One has to do with the risk of bubbles in emerging

markets; the other has to do with the risk that emerging

markets might suffer contagion from deteriorating sover-

eign creditworthiness in developed countries. These two

ideas lead to a question: could deteriorating sovereign risk

in developed countries provide the needle that pricks a na-

scent emerging market bubble?

February 2010

2

Asset price gains in emerging markets have been particularly strong

recently but Citi analysts remain unconvinced that emerging markets

are bubbling over. They highlight that although 5-year credit default

swap (CDS) spreads have fallen sharply from their peaks during the

crisis, they are still considerably higher than their pre-crisis troughs.

Meanwhile, despite the sharp rise in emerging markets equity prices

over the past 14 months, there is little evidence of the characteristics

exhibited by previous equity market bubbles — the rise in emerging

market indices thus far is a fraction of that seen during previous bub-

bles, valuations are below levels seen in a typical bubble, emerging

markets are de-equitising whereas bubbles tend to encourage signifi-

cant equitisation.

While equity and debt markets have rallied substantially, growing

concerns are being expressed about sovereign creditworthiness.

Sovereign rating trends show that ratings downgrades in emerging

markets have predominated in the past two years. The only non-

emerging market downgrades over the past 12 months have been

in Ireland, Greece and Iceland; while the only non-emerging market

negative outlooks are in Greece, Portugal, Iceland and New Zealand.

Yet most of the market’s concern recently has indeed focused on ris-

ing sovereign risk in developed countries, not in developing coun-

tries. Since, historically at least, developed countries are supposedly

“risk-free” and developing countries aren’t, the question arises: to

what extent are emerging markets asset prices threatened by a dete-

rioration in developed country sovereign risk?

Citi analysts note that up until now, the deterioration in sovereign

creditworthiness that has been evident in developed countries has

occurred entirely in places — Greece, Dubai for example — that are

“peripheral” in the global scheme of things. As long as creditwor-

thiness concerns stay at the periphery of the developed world, they

think it is reasonable to expect that investors will have reason to re-

main inclined to sell exposure to vulnerable developed countries in

favour of exposure to emerging economies. The only real worry will

come, conceivably, if sovereign risk became more visible in core de-

veloped countries — the US, UK, Japan, Germany, which make up the

world’s definition of “risk-free”. The only way this could fail to desta-

bilise emerging markets is if the very definition of “risk free” were to

somehow migrate from developed countries to developing countries,

something Citi analysts do not see happening any time soon.

For the time being then, Citi analysts believe rising sovereign risk

in developed countries poses little threat to the idea that a bubble

could be building in a number of emerging asset markets — albeit

that they do not believe bubbles are especially evident now. But this

is not to say that emerging markets asset prices lack vulnerability.

For the foreseeable future, it may just as well be monetary policy in

the developed world, rather than fiscal policy, that poses the biggest

near-term threat. The withdrawal of stimulative monetary conditions

in the developed world could be a bigger challenge for emerging mar-

ket investors this year. Emerging markets have suffered in the past

when US monetary policy has been tightened — notably in 1994, when

monetary tightening and a sharp sell-off helped to set the stage for

Mexico’s tequila crisis. Yet the tightening in US monetary conditions

that year was extreme: Fed Funds rose by 250 bps to 5.5% during

calendar 1994, and the US 10-year yield rose by some 180 bps during

the same period. Since Citi analysts are not forecasting such a move,

and since a Treasury sell-off seems widely expected in the market,

US monetary tightening may not be catastrophic, particularly if it is

taking place against a background of strong recovery. An additional

factor for the market to consider is what will be happening to short-

term real US interest rates. Historical data indicates that capital

flows to emerging markets have tended to be supported when real

US rates are negative; while threats to emerging market capital flows

only really become serious when real interest rates turn substantially

positive. Since real short-term US interest rates are expected to stay

negative or very close to zero, the risks here may also be contained

for the time being.

On emerging market bubbles and sovereign risk

3

Anticipating modest GDP growth and inflation

• With lower-than-expected activity at the end of 2009, Citi analysts

have revised down their GDP forecast for 4Q09 to 0.5% QoQ from

0.8% QoQ. This lower starting point for 2010 is a major reason for

the downward revision of the 2010 GDP forecast by 0.2 points to

1.3%.

• Despite this downward revision to growth, Citi analysts have

raised their 2010 inflation forecast by 0.2 points to 1.4%. The main

sources for the revision are higher energy prices and a stronger-

than-earlier-expected increase in administered prices. However,

Citi analysts are sticking to their base scenario of modest GDP

growth and low inflation.

• The European Central Bank (ECB) may implement a gradual exit

from its non-standard measures in 2010. For 1H10, Citi analysts

expect the ECB to end the unlimited funding facility in April, but

overnight rates are likely to stay low. In 2H10, there may be a with-

drawal of liquidity which may lead to an increase in overnight rates

by around 70 bps. However, the ECB is likely to wait on policy rate

hikes until early 2011.

• Overall, global economic recovery, a robust corporate earnings

recovery, attractive valuations, and improving demand for UK and

European equities are likely to drive positive returns over the next

12-18 months.

• Citi analysts believe investors may wish to focus on companies

which can deliver in 2010; shift up quality, growth and cap curves

over the coming 12-18 months. In terms of sectors, they favour

Basic Resources, Banks and Food & Beverage.

Financial conditions more supportive of a sustainable upturn in growth

• Despite lingering obstacles to a strong recovery, gradually

strengthening demand and much improved financial conditions

are beginning to support a sustainable upturn. Indeed, layoff ac-

tivity appears to be diminishing steadily and renewed gains in la-

bour income have begun to supplant government supports.

• However, while housing and export markets are reviving, business

investment prospects are mixed despite rising profits and healthy

margins. Citi analysts therefore believe that the financial recovery

remains far from complete.

• While Federal Reserve (Fed) officials are passively winding down

support measures, Citi analysts believe that lifting interest rate

expectations and actively exiting from maximum accommodation

will require compelling proof that recovery is self-sustaining and

that key financial roadblocks are cleared.

• In terms of sectors, several industry groups (such as Energy, Cap-

ital Goods and Consumer Services) still have rising revision trends

that are not approaching historical peaks, and may offer positive

trading potential. Conversely, despite improving fundamentals,

Materials, Transportation, Insurance, Semiconductors, Food &

Beverage and Tobacco’s earnings-per-share (EPS) revisions look

worrisome.

United States Euro-Area

DJ EURO STOXX 50S&P 500

Performance data as of 26 February 2010Source: Reuters

Performance data as of 26 February 2010Source: Reuters

-1%

-21%

50%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%38%

-33%

-8%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

YTD 1 Y 3 Y YTD 1 Y 3 Y

4

Asia Emerging Markets

MSCI Emerging MarketsMSCI Asia Pacific

Japan

Bank of Japan likely to stand pat through 2010

• Japan’s GDP growth could likely return to cruising speed of 1.5%-2%

in the second half of 2010 under a combination of a continued up-

ward trend in exports, the newly-introduced support measures for

households and a modest pickup in business and housing invest-

ment.

• Meanwhile, excessive economic slack, coupled with an outright

fall in unit labour costs, could likely exert strong downward pres-

sure on inflation in years to come. Citi analysts expect the Bank of

Japan (BoJ) to maintain the current policy rates until late-2011.

Meanwhile, policymakers appear unlikely to deliver such policy

measures as the zero interest rate policy, quantitative easing and

an increase in outright JGB purchases.

Asia Pacific

Region may continue showing strong performance

• Citi analysts continue to remain optimistic about Asia’s growth

this year given strong balance sheets of governments, households

and corporates, high capital ratios of banks and prospects for a

technological catchup.

• However, they caution that inflation momentum in Asia has picked

up pace in recent months, especially in India, Vietnam and the

Philippines.

• Citi analysts expect the first half of 2010 to fare better than the

second half as economic growth indicators remain strong, while

year-on-year comparisons remain attractive against the challeng-

ing backdrop of the first half of 2009. The North Asian markets of

Hong Kong, Korea and Taiwan are likely to be the region’s leaders

over this time, while South East Asian markets are broadly expect-

ed to lag. Although growth appears strong in China and India, high

equity market valuations remain the key challenge for investors.

Slower year for Latin American equities in 2010

• Economic recovery in Latin America is expected to continue in

2010, with Citi analysts forecasting 3.5% GDP growth, led by strong

expansion in market-friendly countries like Brazil, Chile and Peru.

• Meanwhile, CEEMEA* remains the weakest link in Emerging Mar-

kets with respect to growth and inflation. This is the one part of

the world where there is still some downward pressure on policy

interest rates, given the fact that monetary policy in a number of

countries had to be tightened during the crisis to limit the risk of

capital flight.

• Most Latin American currencies are likely to continue benefiting

from a weak USD and a global recovery in the short term, but the

picture could become more mixed over the medium term as a va-

riety of policy and political concerns kick in. Over in CEEMEA, Citi

analysts expect the South African Rand (ZAR) and Russian Rouble

(RUB) to continue to benefit from strong commodity prices and im-

proved external accounts.

• With valuations fairly high, Citi analysts expect a much slower year

for Latin American equity markets in 2010, with an expected total

return of 10-15%. They continue to favour the outlook for Brazilian

equities on expectations of a strong recovery in economic activ-

ity, and also hold a positive view on Chile due to robust economic

growth prospects and record low interest rates.

• Better-than-expected earnings outlook and attractive valuations

lead Citi analysts to anticipate 20%–25% returns in CEEMEA in

2010. In particular, they are overweight Turkey and Russia as both

markets offer reasonable valuations and accelerating economic

growth.

-2%-6%

57%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

1%

87%

-5%-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Performance data as of 26 February 2010Source: Reuters

Performance data as of 26 February 2010Source: Reuters

YTD 1 Y 3 Y YTD 1 Y 3 Y

5

Euro

• Euro area economic data continue to improve relative to expec-

tations as evidenced both by the Citi Economic Surprise Index

and rising consensus forecasts.

• Citi analysts observe that improving risk appetite continues to

correlate with generalized US dollar weakness versus the Euro

and they estimate that strong sentiments are likely to continue

to weigh on the US dollar in the near term.

Sterling

• Citi analysts expect parity between the Euro and the Sterling in

a 6 to 12 months period given that the structural part of the mas-

sive fiscal deficit is large and that the cost of years of fudging

fiscal rules in the boom years means that even when the bust is

over the fiscal deficit will remain large.

• In the near term, the Sterling could move sideways given eco-

nomic and policy uncertainty plus the potential for a ratings

downgrade if policymakers get it wrong

Strong recovery expected in 2010

• Citi analysts revised outlook for Russian growth to 6.2% from 3% in

2010. We believe the economy will already have turned to growth

in 1Q2010, supported by a pick-up in household consumption. We

forecast a 7% increase in household consumption and expect real

wages to grow by about 6%, due mainly to private sector salary

indexation. Taking into account the usual lag between the start

of a recovery and investment pick-up, we expect to see a more or

less stable upward trend in investment around 4Q10.

• In the short-run we believe rates will continue to fall, while the ru-

ble is likely to strengthen in the second half of the year. We believe

the authorities are likely to accumulate reserves in 1Q10, resisting

nominal ruble appreciation and bringing domestic interbank rates

down further. Starting from 24 February, the CBR reduced refi-

nancing rate to 8.50% from 8.75%, and the repo rate was cut from

6% to 5.75%. We do not rule out further cuts in March if inflation

remains on a downward trend. We think stronger domestic de-

mand and inflation will force the CBR to allow Ruble appreciation

in 2H10. We therefore believe that the Ruble is likely to strengthen

to about 34 against the basket by the end of 2010.

• We believe inflation will remain contained over the coming months,

but could accelerate on the back of loose fiscal and monetary pol-

icy in 2H10. CPI inflation moderated to 8%YoY, according to our

estimates.

• We think Russian equity market has good growth prospects. Cur-

rent valuations still seem to be quite low, and sustainable growth

of the economy will contribute to further increase of market value

of companies. Furthermore, Citi analysts expect commodity pric-

es to grow up and this can be important driver of equity market

performance.

Russia and Ruble Other Currencies

MICEX

-3%

99%

-20%-20%

0%

20%

40%

60%

80%

100%

120%

1M YTD

-4,1%

-1,3%

-4,1%

3,5%

-3,3%

0,0%

-5,3%

6,0%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

USD/RUR USD/EUR

EUR/RUR

USD/GBP

Performance data as of 26 February 2010Source: Reuters

Performance data as of 26 February 2010Source: Reuters

YTD 1 Y 3 Y

6

High-grade corporate debt

expected to outperform

US Treasuries

• Citi analysts anticipate volatility to remain low and rates to remain

range bound in the near term.

Corporate Bonds

• As fundamentals improve, Citi analysts expect spreads to tighten

an additional 25% in 2010. With a nod to the significant shift in gov-

ernment yield curves, corporate debt is expected to outperform

other high-grade asset classes. As for High yield bonds, de-lever-

aging, the pickup in demand and much improved financing condi-

tions imply a sharp drop in default rates during 2010 and suggest

opportunities, but on a highly selective basis.

Euro Bonds

• Citi’s outlook is less optimistic in the UK given the nation’s fiscal

burden and percolating inflation pressures. However, they have a

more positive view on the government markets in the Euro area,

where interest rates are likely to move only incrementally higher.

Citi analysts do not expect European Central Bank (ECB) rate

hikes to occur before early 2011 and anticipate the government

curve to steepen modestly.

Emerging Market Debt

• Citi analysts are constructive on Asia and Latin America credits as

improved liquidity and risk appetite persist.

Bond markets

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Sources: Citi analysts materials:.Citi Monthly Outlook February 2010; Citi Russia and CIS Macro Weekly; MSCI; Reuters.