Local rates: Buffered by term premia & real rates

Briefing

•Valuations, subdued inflation and only a modest rise in DM yields in 2019 (vs 2018) should be supportive for EM local debt. However, lingering CNY/China growth concerns suggest that FX/credit spill-overs will keep risk premia elevated in the near term.

•For full-year 2019, we project superior returns for GBI-EM (6%) over EMBI GD (4%). However, most of the GBI-EM outperformance is likely to be back-loaded, once the EMDM growth differential has stopped contracting and US fiscal impulse has peaked.

•We expect EMBI to outperform GBI-EM in 1H, and EM HC to outperform US HY; bullish duration (LC) in Russia, India and China; and bearish duration in Colombia, Chile and Poland.

Another challenging year ahead, but past worst

FX, not inflation, weighed on EM rates in 2018, and this pressure is unlikely to ease until Q2 2019. However, the pressure points are set to shift away from US yields to weaker China growth/CNY. That said, in the face of still strong fiscal stimulus in the US, and potential for re-pricing in Bund yields, one should not expect UST yields to turn into a tailwind anytime soon – we forecast average G2 yields (70% US, 30% Germany weighted) to rise by 25bp in 2019 (from current levels) vs 50bp in 2018 YTD.

Competitive valuations...: 2018’s value destruction (-7.6% in GBI-EM and -5.3% in EMBI) has made valuations across all three spectrums of EM debt competitive: duration, credit and FX. On our fair-value metric, EMBI spreads are too wide, some of the most rich currencies have now corrected (e.g. TRY) and 10y GBI-EM yield is mildly cheap compared with rich valuations between Q4 2017 and Q2 2018. Valuations alone may not be enough, but the rise in term premia does offer a cushion to absorb some of the external shocks.

…but, softening EM growth is a near-term risk. We expect the trade tensions and ongoing softening of Chinese activity to weigh on EM growth over the next couple of quarters, pushing down the EM-DM growth differential (y/y) by 80bp between Q3 2018 and Q1 2019, a continuation from this year’s compression trend. This does not bode well for EMFX, and could easily result in further re-pricing of risk premia. Our analysis suggests a 5% FX weakening and 25bp CDS widening could push up EM local rates by c.30bp. In short, timing is important in this high-beta asset class, and we do not appear to be there yet.

Start 2019 on a defensive note; prefer hard currency debt over local currency. For full-year 2019, we expect average EM FX to end flat, implying better total return prospects for GBI-EM (6% returns forecast for 2019) over EMBI GD (4%). However, we believe the bulk of the EM outperformance is likely to occur in 2H19, once the US fiscal impulse has peaked, EM-DM growth differential has bottomed and China stimulus (to whatever degree) starts feeding through to the data and domestic market sentiment. Therefore, we recommend starting the year on a defensive note, i.e. sticking to duration in markets that are positively, not negatively, affected by slower global growth, i.e. Asia (ex-Indonesia) within global EM LC debt, and prefer hard currency debt over local currency debt.

Inflation unlikely to rock the boat, but watch the FX

Valuations competitive vs start of

2018...

…but risk premia could easily resurface amid weaker EM growth – through further FX weakening and spreads widening

What to do?

Anatomy of the 2018 sell-off

EM 10y yields, on a GBI-weighted basis, rose by 110bp YTD (70bp ex Turkey). The bulk of this rise was a re-pricing of tightening expectations, and not as a result of inflation or inflation expectations. In numbers, the average 2y yield (ex Turkey) rose by 45bp, while the CPI for the same basket softened by 30bp, and the policy rate rose by only 15bp YTD.

The rise in policy tightening expectations (Figure 139) was mostly a result of weakening currencies or political/geopolitical events in selected EM markets (e.g. Russia, Brazil, Turkey). For instance, with the exception of Turkey, Russia and Mexico, inflation expectations barely recorded any change, resulting in a sharp repricing of the front-end real rates (Figure 140). Curves also steepened as UST yields rose and credit spreads widened (See Box 13 on EM Term Premia).

During this growth- (and hence credit) induced weakness in some high-yielding bond markets, EM rates divergence in 2018 was quite pronounced. Yields in markets with lower external risks (i.e. lower sensitivity to external rates) were broadly flat (i.e. KRW, THB, PLN, CNY average), while high yielders, such as IDR, ZAR, RUB, BRL and MXN, recorded sharp moves (Figure 141). A portfolio flows drought also exacerbated pressure on some of these flows-hungry high-yielding markets (Box 11 connects portfolio flows to bond yields linkage in EM debt markets).

FX depreciation and credit spreads widening, not inflation, triggered re-pricing of EM local debt in 2018

Figure 139: Contribution to GBI-EM yields (ex-Turkey)

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Has value been re-built?

After a steep re-pricing between March and November 2018, aggregate GBI-EM 10y yield screens as mildly cheap (even if one excludes the rise in Turkish yields). Our cointegration-based fair-value estimate – which estimates EM bond yields as a function of real risk-free rates, inflation, credit and currency risk (see model details here) – for GBI EM yield suggests that the aggregate yield is 12bp too high (0.4 standard deviations, Figure 142). This modest cheapness is in sharp contrast with early 2013 and early 2015, when yields were over 1.5 standard deviations too low, or even compared with the beginning of 2018.

Real yields are still the strongest anchor. CPI inflation in EM (GBI-weighted, ex Turkey) is at 4th percentile of its 15-year range. Post-GFC, inflation has not been a source of EM debt re-pricing (especially since 2015), and that is unlikely to be the

GBI-EM weighted 10y yield is mildly cheap on our fair value model vs rich valuations at the beginning of 2018

Figure 142: GBI-EM yields modestly high vs estimated FV

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Source: Haver, Bloomberg, UBS estimates *GBI weighted (ex Turkey)

Figure 143: 10y real yields in EM*

*(deflated by CPI y/y, 3mma). Source: Bloomberg, UBS

Which markets are rich, and which are cheap?

To establish ‘fair value’ for EM 10y yields on a cointegration-based fair-value metric, we input UBS forecasts for 2019 CPI, US/EU real/nominal rates and a slightly higher credit risk/financial conditions, to capture the future trajectory in individual bond markets, and find that once we take into account a potential 25bp re-pricing (higher) of G2 rates and EM credit spreads, aggregate EM yield is no longer attractive (in fact, it screens as 25bp too low) (Figure 144). Yields in Turkey, India, Russia and Mexico screen as too high. Indonesia and Brazil yields, in contrast to their historically high real yields, screen as rich (Figure 146). Yields in small open economies of Europe are also too low, i.e. HUF, PLN and CZK – just as Bund yields are.

Figure 144: What is cheap, what is rich?

Source: UBS, Bloomberg, Haver

We model EM 10y yields as a function of 2019 forecasts of real risk-free rates, inflation, credit and currency risk; yields in Turkey, India, Russia and Mexico screen cheap, while Brazil, Poland, and Indonesia screen as the richest