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FOR PROFESSIONAL INVESTORS ONLY AND NOT FOR PUBLIC DISTRIBUTION
The recovery in developed economies:
a mixed blessing for Latin America?
William De Vijlder, Vice - Chairman of BNP Paribas Investment Partners
Cartagena, Colombia, 3 April 2014
For professional investors only and not for public distribution I 03/04/2014 I
Overview
● Introduction
● The framework
● Trade flows
● The final frontier
● This time is different
● Making waves
● Preferred habitat
● The exchange rate
● Domestic fundamentals and policy reaction
● Conclusion and lessons learned
2
For professional investors only and not for public distribution I 03/04/2014 I
INTRODUCTION
3
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The ‘new normal’ has grown old and we’re entering a new era
● Developed economies are doing better
● Emerging economies are addressing structural issues
● Monetary policy divergence on the rise
● From liquidity driven to earnings driven markets
● Valuation opportunities less and less numerous
● Use active management to boost returns
4
For professional investors only and not for public distribution I 03/04/2014 I
THE FRAMEWORK
5
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6
Faster DM growth
EM exchange rate vàv USD
EM exports
EM inflation
Faster EM growth
DM: developed economies EM: emerging economies
Source: BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I
Faster DM growth
7
Gradual US monetary policy normalisation
Rise DM yields
EM exchange rate vàv USD
EM exports
EM inflation
Faster EM growth
DM: developed economies EM: emerging economies
Required risk
premium
stable
EM interest
rates, bond
yields, equity
markets
Source: BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I
Faster DM growth
8
Gradual US monetary policy normalisation
Rise DM yields DM market volatility
VIX, MOVE
EM exchange rate vàv USD
EM exports
EM inflation
Faster EM growth
DM: developed economies EM: emerging economies
Required risk
premium
stable
Required risk
premium
up
EM interest
rates, bond
yields, equity
markets
Source: BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I
Faster DM growth
9
Gradual US monetary policy normalisation
Rise DM yields DM market volatility
VIX, MOVE
EM exchange rate vàv USD
EM exports
EM inflation
Faster EM growth
DM: developed economies EM: emerging economies
Required risk
premium
stable
Required risk
premium
up
EM interest
rates, bond
yields, equity
markets
Source: BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I 10
TRADE FLOWS
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Significant differences. Degree of openness on average not that high
Export structure in % of GDP. Source: IMF, United Nations
For professional investors only and not for public distribution I 03/04/2014 I 12
Country exposure sees considerable differences
Export structure in % of GDP. Source: IMF, United Nations
Real GDP growth forecasts in %
Source: Consensus Economics forecasts as of 10 Feb 2014
2014
2015
USA
2.9
3
Eurozone
1
1.4
UK
2.7
2.4
Japan
1.6
1.3
China
7.5
7.3
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Big differences in terms of export composition by sector
Source: Uncomtrade database
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THE FINAL FRONTIER
For professional investors only and not for public distribution I 03/04/2014 I 15
Emerging equities trade well below their long term average on a CAPE
basis
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… and, based on CAPE, emerging equities also look cheap
against developed markets
1.40
Emerging/Developed Shiller
1.20
1.00
0.80
0.60
0.40
0.20
In local currency
In US dollars
0.00
1999200020012002200320042005200620072008200920102011201220132014
Source: Datastream, Shiller, BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I 17
However, sustained outperformance will require confidence
on the outlook for earnings growth vis à vis developed
markets
Earnings Growth gap improved for EM
100%
EM Earnings Growth (YoY) - nominal
terms
80%
DM Eanrings Growth (YoY) - nominal
terms
60%
40%
20%
0%
-20%
-40%
-60%
-80%
07
08
09
10
11
12
13
Source: Datastream, IBES, BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I 18
LATAM is slightly more expensive than Asia and EMEA
Country
MSCI
PE
EPS Grow th
Rev Grth
PB
w eight
14E (X)
15E (X)
14E (X)
15E (X)
14E (X)
15E (X)
14E (X)
Brazil
10.0%
12.8
11.3
18.3
12.0
8.5
8.6
2.9
Chile
1.5%
15.9
13.3
16.7
12.7
6.2
7.7
2.0
Colombia
1.1%
12.9
14.5
-2.7
20.3
-2.4
11.7
2.0
Mexico
5.0%
17.3
17.4
10.7
18.0
8.8
11.1
2.9
Peru
0.4%
11.4
9.8
15.3
16.4
10.6
14.4
2.0
ASIA
64.3%
13.6
11.8
12.6
14.9
11.3
11.3
2.4
EMEA
17.5%
12.8
11.8
6.7
8.5
5.9
7.1
2.4
LATAM
18.1%
14.1
13.1
13.8
13.8
7.5
9.4
2.7
GEMS
13.4
12.0
11.3
13.2
9.4
10.0
2.4
US
16.1
14.5
8.2
11.4
EUROPE
14.1
12.6
9.9
11.9
JAPAN
13.4
12.2
8.2
10.2
Source:Deutsche Bank,IBES, Bloomberg
For professional investors only and not for public distribution I 03/04/2014 I 19
Emerging debt valuation is attractive compared to DM
corporate debt of equivalent rating. Spread volatility is also
lower
EM sovereign vs. US & EU corporate debt
1500
in bps
1300
1100
900
700
500
300
100
01/00 02/01 03/02 04/03 05/04 06/05 07/06 08/07 09/08 10/09 11/10 12/11 01/13
Rating adj. US corp. spread
Rating adj. EU corp. spread
EMBI spread
Source: Datastream, Moody’s, Bloomberg, BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I 20
THIS TIME IS DIFFERENT
For professional investors only and not for public distribution I 03/04/2014 I 21
The emerging markets fundamentals today look far better than in
1997-98
“This reflects the fundamental reforms these EMEs have put in place over the past 15
years, as well as the hard lessons learned from past periods of market stress. Among
the positives are:
– The absence of the type of fixed exchange rate peg regimes that often were
undermined violently in the past during periods of stress;
– Improved debt service ratios and generally moderate external debt levels;
– Larger foreign exchange reserve liquidity cushions;
– Clearer and more coherent monetary policy frameworks, supporting what are now
generally low to moderate inflation rates;
– Generally improved fiscal discipline;
– Better capitalized banking systems, supported by strengthened regulatory and
supervisory frameworks.”
Source: William Dudley, Remarks at the Roundtable Discussion in Honor of Terrence Checki: Three Decades of Crises: What Have
We Learned?, Federal Reserve Bank of New York, March 2014
For professional investors only and not for public distribution I 03/04/2014 I 22
MAKING WAVES
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“Flow”: the mechanics of Quantitative Easing
Price of
risky
assets
demand
supply
In an integrated world economy,
the price of risky assets can/will
rise globally, albeit to varying
degrees
Waves of QE
Quantity
Source: BNPP IP
For professional investors only and not for public distribution I 03/04/2014 I 24
“Ebb”: tapering and moving from data-contingent forward
guidance to qualitative guidance
The success of datacontingent forward
guidance
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The normalisation of volatility
US monetary policy normalisation  volatility structurally higher
For professional investors only and not for public distribution I 03/04/2014 I 26
Risk aversion, global asset prices and Fed tightening signals, Jan Groen &
Richard Peck, Liberty Street Economics, Federal Reserve of New York
● The global sell-off last May of emerging market equities and currencies of
countries with high interest rates (“carry-trade” currencies) has been attributed to
changes in the outlook for U.S. monetary policy
● We conjecture that shifts in risk aversion coincide with exceptionally large changes
in implied volatility measures. An “exceptionally large” change in this case is
defined as when overall implied volatility is at least two standard deviations
above or below its mean over the previous sixty days.
For professional investors only and not for public distribution I 03/04/2014 I 27
Risk aversion, global asset prices and Fed tightening signals, Jan Groen & Richard Peck, Liberty
Street Economics, Federal Reserve of New York
“These currencies (carry trade) are those
among the sample of forty-five dollar
exchange rates that have the largest interest
rate differential with one-month U.S. rates.
The non-carry currencies are those with
interest rates that are similar to or lower than
U.S. rates. The carry-trade return is how
much the basket of carry currencies
appreciated relative to non-carry currencies
over a month on a given day. The model
results show that the drop in carry
currencies has been accentuated by the
increase in global risk aversion since
May. Nearly half of the depreciation of
carry currencies relative to non-carry
currencies that occurred between the
May 22 testimonial and early July was
due to increased risk aversion, according
to the model’s estimates
For professional investors only and not for public distribution I 03/04/2014 I 28
Risk aversion, global asset prices and Fed tightening signals, Jan Groen & Richard Peck, Liberty
Street Economics, Federal Reserve of New York
“the next chart …
attributes essentially all
of the percentage
changes in June and
July to increases in
global risk aversion. By
late August, risk-aversion
shocks from May no
longer affected prices
according to the model”
So once investors have
learned to live with
prospect of policy
normalisation, risk of
turmoil and disruption
is lower
Source: Risk aversion, global asset prices and Fed tightening signals, Jan Groen & Richard Peck, Liberty
Street Economics, Federal Reserve of New York, March 2014
For professional investors only and not for public distribution I 03/04/2014 I 29
PREFERRED HABITAT
For professional investors only and not for public distribution I 03/04/2014 I 30
“In my view, the fact that our large scale asset purchase
programs affect the size of term risk premia globally is
important.
This set of monetary policies affects financial asset prices in a
different way compared to changes in short-term interest rates,
and we should be humble about what we claim about
understanding the importance of this distinction.”
William Dudley, Remarks at the Roundtable Discussion in Honor of Terrence Checki: Three Decades of Crises: What Have We
Learned?, Federal Reserve Bank of New York, March 2014
For professional investors only and not for public distribution I 03/04/2014 I 31
Climbing the risk ladder
Expected
return
Preferred habitat
A
B
C
Target
return
Risk
Source: BNPP IP
For illustrative purpose
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A post QE world: a feeling of unease, having climbed the risk
ladder
Increased sensitivity to bad news especially when
valuations and prices have moved up a lot
Expected
return
Target
return
Preferred habitat
A
High « Feeling of
unease »
B
C
Low « Feeling of
unease »
Source: BNPP IP
For illustrative purpose
Risk
For professional investors only and not for public distribution I 03/04/2014 I 33
On the international spillovers of US Quantitative Easing
ECB Working Paper 1557 June 2013, Marcel Fratzscher, Marco Lo Duca and Roland Straub
● QE1 policies during the first phase in 2008-2009 have triggered a substantial
rebalancing in global portfolios, with investors shifting out of EMEs and
other AEs and into US equity and bond funds.
● By contrast, Fed policies during the second phase in 2010 (QE2) induced a
portfolio rebalancing in the opposite direction, pushing capital into EMEs.
● Equally importantly, we find that Fed operations, such as the purchases of
Treasuries and MBS through its two LSAP programs, exerted substantially
larger effects on portfolio decisions and asset prices, than Fed
announcements of these programs.
For professional investors only and not for public distribution I 03/04/2014 I 34
On the international spillovers of US Quantitative Easing
ECB Working Paper 1557 June 2013, Marcel Fratzscher, Marco Lo Duca and Roland Straub
● In addition, our findings indicate that Fed policies exerted larger effects on asset prices than on
capital flows.
● However, these Fed policy measures have significantly exacerbated the pro-cyclicality of
capital flows to EMEs – raising outflows even further in periods when capital flees EMEs, and
magnifying inflows when these are already large. By contrast, Fed policies have functioned in a
counter-cyclical fashion for investment flows into US equity and bonds funds.
● Finally, we do not find evidence that policy-makers succeeded in insulating their
countries from spillovers of QE policies by limiting exchange rate flexibility or imposing
controls on capital account openness. These policies might have amplified the pro-cyclical
impact of Fed interventions.
● Instead, an important determinant of the sensitivity of capital flows to Fed policy during
the crisis has been the institutional quality of countries, suggesting that the impact of
QE policies are partly linked to pull factors in recipient countries, and specifically to risk
and a flight-to-safety phenomenon.
For professional investors only and not for public distribution I 03/04/2014 I 35
On the international spillovers of US Quantitative Easing
ECB Working Paper 1557 June 2013, Marcel Fratzscher, Marco Lo Duca and Roland Straub
● The findings of the paper have a number of implications for policy.
● First, some of the results may be interpreted as lending support to concerns expressed by
policymakers in EMEs. In particular, EMEs have been adversely affected by pro-cyclical effects
of QE policies, inducing capital outflows from EMEs when capital is scarce and pushing capital
into EMEs, driving up asset prices and exchange rates, when they already experience high
capital inflows through other sources.
● Yet, the findings also indicate that foreign policy-makers are not innocent bystanders. The
empirical results show that part of the effect of QE policies on foreign economies is related to
risk, and that sound domestic policies and strong domestic institutions help insulate
countries from US monetary policy spillovers. Thus there may indeed be a case both for
domestic policy reforms as well as for more coordination at the global level in order to deal with
policy spillovers and externalities.
For professional investors only and not for public distribution I 03/04/2014 I 36
THE EXCHANGE RATE
For professional investors only and not for public distribution I 03/04/2014 I 37
The Behavior of Currencies during Risk-off Episodes
Reinout De Bock and Irineu de Carvalho Filho, IMF WP, January 2013
● Right after the onset of the risk-off episode, high yield currencies and those
whose returns have a higher beta with respect to the VIX or the AUDJPY
exchange rate tend to have larger depreciations relative to the U.S. dollar.
● Stronger current account balances and net foreign asset positions are factors
related to smaller risk-off depreciations or larger appreciations.
● Overvaluation in two out of three CGER (= IMF Consultative Group on
Exchange Rates) models is a factor related to larger risk-off depreciations.
● Country-specific factors remain essential in determining currency movements
within a risk-off episode.
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The Behavior of Currencies during Risk-off Episodes
Reinout De Bock and Irineu de Carvalho Filho, IMF WP, January 2013
● Looking at individual currencies, the Swiss franc and the Japanese yen tend to
appreciate relative to the U.S. dollar during risk-off episodes
● Because most other currencies depreciate relative to the U.S. dollar during
risk-off episodes, the Swiss franc and the Japanese yen appreciate even more
on a trade-weighted basis
● On the other hand, a wide range of currencies, including those of
Australia, Brazil, Canada, Chile, Colombia, India, Indonesia, Korea,
Malaysia, Mexico, New Zealand, Peru, Philippines, Singapore, South
Africa, Sweden, Turkey, Ukraine, and United Kingdom, tend to depreciate
during risk-off episodes, for at least some horizon window.
This provides guidance for investors (“where to hunt, what to avoid?”) and policy
makers (what to do to improve the domestic fundamentals?)
For professional investors only and not for public distribution I 03/04/2014 I 39
DOMESTIC FUNDAMENTALS AND POLICY
REACTION
For professional investors only and not for public distribution I 03/04/2014 I 40
How Sovereign Is Sovereign Credit Risk?
Francis A. Longstaff, Jun Pan, Lasse H. Pedersen, Kenneth J. Singleton, American Economic Journal, April, 2011
● We study the nature of sovereign credit risk using credit default swap data for an extensive
cross-section of developed and emerging-market countries.
● We show that sovereign credit risk tends to be much more correlated across countries than are
equity index returns for the same countries.
● Our results suggest that the source of these higher correlations is the dependence of
sovereign credit spreads on a common set of global market factors, risk premiums, and
liquidity patterns.
● Specifically, we find that the sovereign spreads are driven primarily by US equity and highyield factors. Also, sovereign spreads are significantly related to the volatility risk
premium embedded in the VIX index.
For professional investors only and not for public distribution I 03/04/2014 I 41
How Sovereign Is Sovereign Credit Risk?
Francis A. Longstaff, Jun Pan, Lasse H. Pedersen, Kenneth J. Singleton, American Economic Journal, April, 2011
● Turning now to the principal components analysis … for the 2000–2010 sample period …The
results show that there is strong commonality in the behavior of sovereign CDS spreads.
In particular, the first PC explains 64 percent of the variation in sovereign CDS spreads during
the entire sample period.
● To explore further the interpretation of the first PC, we compute a time series for the first PC.
The correlation of this first PC index with US stock market returns is −74 percent, and the
correlation with changes in the VIX index is 61 percent. The correlation between stock market
returns and changes in the VIX index is −75 percent. Thus, the principal source of variation
across almost all sovereign credit spreads appears to be very highly correlated with the
US market as measured by US stock market returns or by US equity market volatility.
For professional investors only and not for public distribution I 03/04/2014 I 42
How Sovereign Is Sovereign Credit Risk?
Francis A. Longstaff, Jun Pan, Lasse H. Pedersen, Kenneth J. Singleton, American Economic Journal, April, 2011
● Finally, there are strong interrelationships between sovereign credit spreads even after
including the local economic, and global financial market, risk premium, and
investment-flow variables in the regression. The coefficient for the regional credit spread is
significant for 16 of the countries. Of these significant coefficients, 14 are positive in sign.
Similarly, the coefficient for the global credit spread is significant for 18 of the countries, and 15
of these significant coefficients are positive in sign.
● These results are consistent with the presence of regional or global factors that affect all
sovereign credit spreads, but are not captured by the other explanatory variables.
For professional investors only and not for public distribution I 03/04/2014 I 43
Modelling the time varying determinants of portfolio flows to emerging
markets
ECB working paper 1468, September 2012, Marco Lo Duca
● The analysis shows that the regression coefficients display substantial time
variation.
● Major changes in the importance of the drivers of the flows coincide with
important market events/shocks.
● Overall, investors pay more attention to regional developments in
emerging markets in periods when market tensions are elevated.
● However, extreme tensions generate panics, i.e. periods when changes in
uncertainty and risk aversion drive flows, while regional developments
play only a marginal role.
For professional investors only and not for public distribution I 03/04/2014 I 44
The risk of negative feedback loops
●
At some point over the next few years, central banks in the advanced economies will both increase shortterm interest rates and reduce their holdings of government and other bonds. How this policy shift will
unfold is not known, and uncertainty about the policy path could unsettle global bond markets.
●
Downward pressures on some EM currencies could be accentuated, increasing the local currency cost of
servicing dollar debt. Higher long-term rates, currency depreciation and more volatile markets could make
even more difficult the choices that EM central banks face on their policy rate, on the exchange rate, on
the long-term interest rate and on the best use of their balance sheet.
●
The present paper argues that a large rise in borrowing by EM non-financial corporations on
international capital markets over the past three to four years has also indirectly eased local bank
lending conditions for other borrowers at home. This link merits close attention.
Source: BIS Working Papers No 441 The global long-term interest rate, financial risks and policy choices in EMEs
by Philip Turner February 2014
For professional investors only and not for public distribution I 03/04/2014 I 45
The risk of negative feedback loops
●
As they have borrowed more, EME corporations have also acquired assets on a large scale. The value of
assets of EM corporations is often harder to measure than liabilities, and off-balance-sheet exposures
escape detection.
●
Issuance by EM non-bank corporations on such a scale, and a possible “stop” at some point in the future,
could affect the domestic banking systems in EMEs through at least three channels:
– EM corporations have typically borrowed from local banks. When extremely easy external financing
conditions allow such firms to borrow cheaply from abroad, local banks have to look for other customers – so that
domestic lending conditions facing most local borrowers actually ease more than the expansion in total domestic
bank credit aggregates suggest. A tightening in external financing conditions would reverse this … small firms
might then find it harder to get finance even if total domestic bank credit continues to rise.
– wholesale funding markets for banks. When EM corporations are awash with cash thanks to easy external
financing conditions, they will increase their wholesale deposits with local banks. This is also reversible.
– hedging of their forex or maturity exposures, often via derivative contracts with local banks. Even if the local
banks hedge their forex exposures with banks overseas, they still face the risk that local corporations will not be
able to meet their side of the contract.
Source: BIS Working Papers No 441 The global long-term interest rate, financial risks and policy choices in EMEs
by Philip Turner February 2014
For professional investors only and not for public distribution I 03/04/2014 I 46
Sudden stops and early warning signals
●
“First, the early indicators used to detect crises ahead of time seem to perform relatively well if the
purpose is to predict crises in a given time window; however, they are much less efficient in predicting the
exact starting date of the crisis.
●
Overall, the main economic variables that are found to predict crises are the ratio of short-term
debt to international reserves, the growth rate of credit to the private sector, the over-appreciation
of the nominal effective exchange rate (with respect to trend) and contagion from other countries.
●
Different indicators signal crises at different lags, some being very short-term (e.g. the short-term debt to
reserves ratio or financial contagion), others with a longer lag (e.g. the lending boom variable or the
degree of exchange rate over-appreciation). This suggests that when a country faces liquidity
problems or financial contagion from crises in other emerging markets, policy reaction must be
particularly quick (a few months at most).
Source: ECB Working Paper 713, January 2007, Balance of payment crises in emerging markets – how early were the ‘early’
warning signals?, Matthieu Bussière
For professional investors only and not for public distribution I 03/04/2014 I 47
CONCLUSION AND LESSONS LEARNED
For professional investors only and not for public distribution I 03/04/2014 I 48
Lessons learned
1.
Risk aversion, global asset prices and Fed tightening signals
– Once investors have learned to live with prospect of policy normalisation, risk of turmoil and disruption is lower
2.
On the international spillovers of US Quantitative Easing
– Sound domestic policies and strong domestic institutions help insulate countries from US monetary policy
spillovers
3.
The Behavior of Currencies during Risk-off Episodes
– Country-specific factors remain essential in determining currency movements
4.
How Sovereign Is Sovereign Credit Risk?
– Sovereign spreads driven primarily by US equity, high-yield and VIX
5.
Time varying determinants of portfolio flows
– When tension is elevated, regional drivers become more important, but extreme tensions generate panics
6.
The risk of negative feedback loops
– Need for clarity on corporate FX mismatch and impact on domestic banking system
7.
Sudden stops and early warning signals
– Role of debt build-up, credit growth, currency overvaluation, contagion
For professional investors only and not for public distribution I 03/04/2014 I 49
The transition process triggered by US monetary policy
normalisation appears inherently unstable
● Positive impact on trade balance
● Attractive valuation of emerging equities, bonds and currencies
But
● Will the Fed end up being behind the curve?
● Quality of Fed communication?
● How much will US rates and yields increase?
● Will there be a flight back towards the preferred habitat?

● Need to conduct sound domestic economic policies
For professional investors only and not for public distribution I 03/04/2014 I 50
You can’t stop the waves, but you can influence how they impact you
For professional investors only and not for public distribution I 03/04/2014 I 51
Blog
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●
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●
FR http://williamdevijlder.bnpparibas-ip.com/francais
Twitter
● Follow William De Vijlder onTwitter: @DeVijlder
Recent videos (access via blog)
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The seven drivers of the Great Rotation
Why the price of gold concerns everybody
What are the limits to quantitative easing?
Increasing monetary policy divergence creates opportunities
Will US treasury yields reach 4% by the end of 2014?
How does disinflation impact the market outlook?
Let me be your guide - Is forward guidance making investing more easy?
What makes the US dollar attractive in 2014?
When inflation expectations become unanchored it will be too late
For professional investors only and not for public distribution I 03/04/2014 I 52
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