Global Investing

Brazil’s finance minister Guido Mantega, one of the most shrill critics of Western money-printing, has decided to repeal the so-called IOF tax, he imposed almost three years ago as a measure to fend off  hot money flows.

Well, circumstances alter cases, Mantega might say. And the world is a very different place today compared to 2010. Back then, the Fed was cranking up its printing presses and the currency war (in Mantega’s words) was raging; today the U.S. central bank is indicating it may start tapering off the stimulus it has been delivering. Nor is investors enthusiasm for emerging markets what it used to be.  Brazil’s currency, the real, is plumbing four-year lows against the dollar and local bond yields have risen 30 basis points since the start of May. Brazil’s balance of payments situation meanwhile, is deteriorating, which means it needs all the foreign capital  it can get, hot money or otherwise. And currency weakness spells inflation — bad news for Brazil’s government which faces voters next year.

The IOF did work — Brazil’s local debt markets received just over $10 billion last year, Bank of America/Merrill Lynch calculates — a third of 2010 levels, and much of the cash that was already invested, preferred to stay put (given the IOF is paid upon exiting the country).

So will Mantega’s latest gambit work? So far, the real’s reaction has been muted and some analysts even reckon on short-term losses as funds that were staying in to avoid paying the 6 percent levy, are now free to leave.

Analysts at BofA/ML estimate a 2 percent currency benefit versus the dollar as well as a bond rally as real yields for foreigners will now be higher. Brazilian global bonds (denominated in reais but listed and traded overseas) however could lose out — these enjoyed a surge in demand as investors tried to get exposure to the currency without paying the IOF. BofA-ML reckon yields here could rise as much as 150 bps.

The fierce sell-off that hit emerging market local currency debt last month was possibly down to low levels of currency hedging by investors, JPMorgan says.

Analysts at the bank compare the rout with the one May 2012, caused by exactly the same reason — higher U.S. yields. There was a difference though — back then EM currencies dropped more than 8% on the month but EM local bonds, unlike last month, were little changed.

Gauging hedging levels is usually a tricky business. But JPM uses the results of its monthly client surveys to analyse the differing moves:

Morocco fears its stock market is on the verge of being re-classified as a frontier market when  index provider MSCI announces its annual rejig of equity indices this month.

Maybe it should pray for relegation instead. A report at the end of last week by Citi notes the boom in frontier market equities — they have risen 15 percent since the start of this year, a stark contrast to their better known, more liquid emerging market cousins which have fallen around 5 percent so far this year. In fact the performance of the frontiers — comprising less liquid, smaller markets from Kenya to Kazakhstan — has been more akin to the U.S. or Japanese equity markets which have earned investors double-digit returns this year.

Citi notes that the seven best returning markets in the world this year are all in the so-called frontiers, while the nine worst laggards are from the emerging world. Check out the graphic below. It shows how markets such as Kenya, Bulgaria and the United Arab Emirates have rallied more than 40 percent this year.

The received wisdom is dollar strength = weaker emerging market currencies. See here for my colleague Mike Dolan’s take on this. But as Mike’s article does point out, all emerging markets are not equal. It follows therefore that any waves of dollar strength and higher U.S. yields will hit them to varying degrees.

ING Bank says in a note sent to clients on Tuesday that emerging currency gains in recent years have been closely tied to foreign investments into domestic bond markets. Recent years have seen a torrent of inflows into local debt, driving down yields on the main GBI-EM index and significantly boosting its market value. Hence, it makes sense to examine how the GBI-EM’s biggest constituents might fare under a scenario of a surging dollar and Treasury yields (In the two years before a Fed tightening cycle commences, 5-year Treasury yields can trade 120-150 basis points higher, ING analysts point out).

In almost every one of the emerging markets examined by ING, spreads over U.S. Treasuries have tightened dramatically since the start of 2012. Ergo, they are vulnerable to correction.

Surprising as it may seem, the Egyptian pound has got some fans.  The currency has languished for months at record lows against the dollar and the headlines are alarming — the lack of an IMF aid programme, meagre hard currency reserves, political upheaval. So what’s to like ?

Analysts at Societe Generale say that just looking at the spot exchange rate of the pound is missing the bigger picture. Instead, they advise buying 12-month non-deliverable forwards on the pound — essentially a way of locking into a fixed rate for pound against the dollar in a year’s time depending on where you think it may actually trade. They write:

The implicit yield at this point is 21 percent for the 12m NDF, which we think is quite attractive. The way to think about Egypt NDFs is to approach them as a distressed asset. The risk/reward is quite attractive, and a lot of the bad news has been priced in. Yes, there have been serious delays in the programme negotiations with the IMF and that has clearly been a negative for the overall country view, but I would like to point out that the actual 12m NDF level has hardly budged in the process. This to me suggests that the valuation looks particularly good.

There seems to be no end to the rip-roaring bond rally across emerging Europe.  Yields on Turkish lira bonds fell to fresh record lows today after an interest rate cut and stand now more than a whole percentage point below where they started the year.

True, bonds from all classes of emerging market have benefited from the flood of money flowing from central banks in the United States, Europe and Japan, with over$20 billion flowing into EM debt funds since the start of 2013, according to EPFR Global. Flows for the first three months of 2013 equated to 12 percent of the funds’ assets under management.

But the effect has been most marked in emerging European local currency bonds — unsurprising, given economic growth here is weakest of all emerging markets and central banks have been the most pro-active in slashing interest rates.  Emerging European yields have fallen around 50 basis points since the start of the year, compared to a 20 bps average yield fall on the broader JPMorgan index of emerging local bonds, Thomson Reuters data shows.

Indians have reacted to the latest gold prices falls by — buying more gold. And why not? Aside from Indians’ well known passion for the yellow metal (yours truly not excluded) gold has by and large served well as an investment: annual returns over the past five years have been around 17 percent, Morgan Stanley notes.

Now, gold’s near 20 percent plunge this year has wiped some $300 billion off Indians’ gold holdings, Morgan Stanley estimates in a note (households are believed to own about 15,000 metric tonnes of gold). So is the gold rush in India over?

Possibly. Indian gold imports have doubled to around 3 percent of GDP in the past five years. That rise is partly down to greater wealth which translates into more wedding jewellery purchases. But the more unpleasant side of the equation is India’s inflation problem. Look at the following charts from MS that shows how negative real interest rates have encouraged savings in gold rather than financial instruments:

India’s finance minister P Chidambaram can be forgiven for feeling cheerful. After all, prices for oil and gold, the two biggest constituents of his country’s import bill, have tumbled sharply this week. If sustained, these developments might significantly ease India’s current account deficit headache — possibly to the tune of $20 billion a year.

Chidambaram said yesterday he expects the deficit to halve in a year or two from last year’s 5 percent level. Markets are celebrating too — the Indian rupee, stocks and bonds have all rallied this week.

But are markets getting ahead of themselves?  Jahangiz Aziz and Sajjid Chinoy, India analysts at JP Morgan think so.

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

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

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

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

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

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