Box 2: How far are we from capitulation in EM equities?

Figure 30: 5-year total returns across asset classes (nonannualised) : USD funded EM returns have been weak

Figure 31: EM currencies and an equal-weighted index of AUD and CAD vs USD: Common drivers

Source: MSCI, Bloomberg, Datastream, UBS

Source: Bloomberg, UBS. Note: USDEM is based on a simple average of spot returns on 20 EM currencies vs USD.

Figure 32: Five-year Sharpe ratios for MSCI EM funded in different currencies

Source: MSCI, Datastream, UBS. Note: Based on weekly total returns.

Figure 33: Five-year Sharpe ratios for GBI EM funded in different currencies

Source: Datastream, UBS. Note: Based on weekly total returns.

Figure 34: EM export growth y/y vs EM nominal effective exchange rate (MSCI EM weighted) y/y

Source: Haver, UBS. EM aggregates are based on a simple average for 19 countries.

Figure 35: EM FX cross-country dispersion of returns

15%

Dispersion of returns (Equal-weighted)

China deval

13% GFC

7%

5%

3%

Source: Haver, UBS. Cross-country dispersion is based on y/y returns on NEERs of 23 EM currencies.

But at a time like this, when dispersion among EM currencies is higher than at the GFC, taper tantrum, or the CNY weakening episode in 2015 (Figure 35), it is important to examine the aggregates. For most of 2018, the pain has been concentrated in EMEA and LatAm currencies, with volatility in Asian currencies remaining low (Figure 36). As the change in US back-end rates next year is likely to be only 20bp compared with 80bp this year, we believe that on a total-return basis, the high-yielding currencies of the GBI EM debt benchmark are likely to do better than those in the Asia-heavy MSCI EM equity benchmark (Figure 37).

With a lower delta in US yields, EM’s high yielders should yield a better total return; weak trade and CNY to sustain pressure on Asia

EM fixed income: Heading into 2019 on a defensive note, but local debt to outperform through the year

The asset class where valuations have genuinely become attractive is local duration. The spread between GBI-weighted EM yields and an average of US and Europe (G2) yields is at the 93rd percentile of its post-crisis distribution in nominal terms, and at the 91st percentile in real terms (Figure 38). There is enough cushion at EM back ends to withstand a modest repricing of the US curve. To be fair, credit spreads have also driven a repricing in local debt, and these are unlikely to drop aggressively, but lower currency volatility amid a better-priced Fed should help.

High real rates, steep curves make EM duration attractive

Figure 38: EM real yields relative to G2 real yields*

Source: Bloomberg, UBS *Based on 36-month exponential headline inflation.

Figure 39: 2018 YTD total return attribution for GBI EM

Source: Datastream, UBS

Just the yield spread over developed market debt should make for decent total returns in local currency debt next year. However, currencies have always made or broken this asset class; so far in 2018, currencies have given a negative performance of 8.7%, which has made for a total return of -7.6% (Figure 39). But the lower delta at the US back end next year will make all the difference for the performance of both currencies and duration. As such, we expect relative stability for GBI-weighted EM currencies against the USD next year. As a base case, we estimate total returns for GBI EM in the range of around 5-6% next year. Similar to EM equities and broader FX, these returns will likely be backloaded in 2019.

Valuations have also adjusted considerably in EM credit, especially relative to US and European HY markets. However, the valuation gap is driven more by a narrower set of countries – Venezuela, Argentina, Turkey and Lebanon – which has explained nearly 35% of the year-to-date widening in spreads. Spreads in most other major credit markets remain relatively tight (Figure 40).

Figure 40: Percentiles of EMBI spreads in 5y distributions

100%

90% 5y percentile of top-20 countries by weight

80%

70%

60%

50%

40%

30%

20%

10%

0%

Source: Datastream, UBS

We expect 5-6% total returns in GBI EM next year; these returns should be back loaded in 2019

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In the context of weaker growth next year, limited capital inflows and potentially greater pressure on EM’s fiscal positions (Figure 42), our Macro Balance Sheet Risk Score2, the core of our EM credit valuations, is likely to slowly deteriorate towards a level of 10.5-10.6 (Figure 41). Taking a neutral view on global risk appetite and commodity prices, this should be consistent with spreads widening modestly by 20bp next year vs the 68bp widening year to date.

Along with slight drift wider in US rates, this still makes for a total return of about 4% in EM hard currency sovereign debt. In total return terms, this is less than what we are expecting in local currency debt. However, based on our view that a weaker USD and GBI EM stability is likely to be back-loaded in 2019, we go into 2019 with a modest preference for hard over local currency debt.

Corporate spreads, which have widened with a much lower beta to sovereigns in this round of credit weakness than in the past (Figure 43), could be at greater risk next year as energy growth stalls, and USD/CNY volatility, a key input for this asset class, picks up somewhat. We expect a widening of 30-50bp in this asset class, with an expected total return of 3.5%.

A grind wider of 20-30bp in sovereign spreads is the base case; corporate spreads should widen by 30-50bp amid higher USD/CNY volatility