Greed and Fear:
Reassessing Emerging
Markets’ Fair Value
Friday, December 2nd 2005
Marco Annunziata
Managing Director
Head of Research and Strategy
Unicredit Banca Mobiliare
1
Global Outlook
2
Overview: Key issues
 Eurozone’s growth outlook slightly stronger (or rather less weak…)
…but slowing in 2007 on tighter fiscal policies and slowing world growth
Expect ECB to hike a cumulative 50bp through March, on hold thereafter
 US growth on track, decelerating to potential (3 ½ %)
Housing market could deflate consumption
Fed to keep hiking: 4.25% by end-05, level off at 4.75% in mid-06
Bond yields to follow…but how soon?
 FX markets: USD to rise before it falls again vs EUR
3
UBM Outlook
WORLD
USA
JAPAN
CHINA
EUROZONE
GERMANY
ITALY
FRANCE
WORLD*
USA
JAPAN
CHINA
EUROZONE
GERMANY
ITALY
FRANCE
GROSS DOMESTIC PRODUCT
ACTUAL
2003
2004
2005
2.6
4.1
3.4
2.7
4.2
3.7
1.4
2.7
2.3
9.4
9.5
9.3
0.7
1.8
1.4
-0.2
1.1
1.1
0.4
1.0
0.2
0.9
2.1
1.6
2.0
2.3
-0.3
1.2
2.1
1.0
2.6
2.1
CONSUMER PRICE INDEX
2.1
2.4
2.7
3.5
0.0
-0.1
3.9
2.0
2.1
2.2
1.7
2.0
2.1
2.0
2.1
1.8
* OECD (ex high-inflation countries)
Eurozone&Germany numbers assume a 3% VAT hike in 2007
Eurozone CPI numbers assume "the Dutch effect" in Jan 2006
4
UBM FORECASTS
2006
3.5
3.5
2.1
8.9
1.8
1.6
1.2
1.9
2007
3.5
3.3
2.0
8.7
1.6
1.1
1.2
2.1
2.1
2.7
0.6
2.4
1.9
1.6
2.0
1.5
1.8
2.0
0.7
3.2
2.0
2.0
1.7
1.4
FX and Brent Forecasts
FX Forecast
Spot
Euro/Usd
Usd/Yen
Usd/Chf
Cable
Euro/Yen
Euro/Gbp
Euro/Chf
FWD
1.18
118
1.31
1.71
139
0.69
1.54
1.17
120
1.32
1.72
140
0.68
1.55
Mar-06
1.13
123
1.35
1.67
139
0.68
1.53
FWD
1.18
117
1.30
1.71
138
0.69
1.54
Jun-06
1.15
119
1.33
1.69
137
0.68
1.53
FWD
1.19
114
1.28
1.71
135
0.69
1.53
Dec-06
1.23
110
1.25
1.78
135
0.69
1.54
Brent Forecasts ($pb)
Q4-05
Q1-06
Q2-06
Q3-06
Q4-06
57
58
54
60
57
5
2005
2006
average average
55
57
Interest Rates Forecasts
Bond Forecasts
US Fed Funds
UST 2-year
UST 10-year
ECB Refi Rate
Bund 2-year
Bund 10-year
Update


Actual
4.00
4.36
4.47
Dec-05
4.25
4.50
4.60
Change
25
14
13
Mar-06
4.50
4.52
4.75
Change
50
16
28
Sep-06
4.75
4.72
4.65
Change
75
36
18
2.00
2.75
3.44
2.25
2.80
3.60
25
5
16
2.50
2.85
3.65
50
10
21
2.50
2.80
3.75
50
5
31
28-Nov-05
We forecast only a mild increase in benchmark yields
The market is already pricing fully Fed Funds at 4.75% and ECB rate at 2.50%
for Sep-06
6
Emerging Markets Outlook
7
Current Spreads have bottomed out
EMBI+ Current Values (with Min, Max and Average since 01/01/2000)
2000
1800
1600
1400
1200
1000
800
600
704
617
566
550
400
200
382
237
514
318
273
179
143
133
0
EMBI+
Last
Min
Africa
Max
Asia
Average
Europe
Latin
America
Non Latin
Source: Bloomberg/JPMorgan
8
Almost all EM Spreads have tightened
over the past year
USD Bonds

Source: Bloomberg/JPMorgan
9
Slovakia
Lithuania
Czech Republic
Hungary
Poland
Colombia
Croatia
Bulgaria
Malaysia
Romania
South Africa
Mexico
Composite
(thin bars indicate the spread tightening)
Turkey
Tightening potential for NE Eurobonds is
very limited
Brazil

Venezuela
Source: Bloomberg/JPMorgan
EUR Bonds
500
450
400
350
300
250
200
150
100
50
0
Argentina
Egypt
Malaysia
Poland
South Africa
Bulgaria
Morocco
Russia
Mexico
Peru
Turkey
Ukraine
EMBI +
Colombia
Panama
Venezuela
Philippines
Brazil
Argentina
Nigeria
Ecuador

USD denominated bonds have
outperformed EUR bonds
Europe has underperformed
Peru
700
600
500
400
300
200
100
0
Philippines
1000
900
800
EM Total Returns YoY
11% in USD and 7% in EUR
Middle East
Latin
Europe
Composite
Asia
Non Latin
Latin America
Asia
Composite
Middle East
Non Latin
Europe
Africa
Africa
EUR
USD
USD
USD
USD
USD
EUR
EUR
EUR
USD
EUR
EUR
USD
EUR
0.0%
5.0%
10.0%
15.0%
source: Bloomberg/JPMorgan
10
EM have outperformed other credits in 2005
60
All variables are normalised to zero on 01/01/05
bp change since reference date
40
20
0
-20
-40
-60
-80
USA10
EU10
EMBI+ Spread
BBB swap spread
-100
01/05
02/05 03/05
04/05
05/05
06/05
11
07/05
08/05
09/05
10/05
11/05
EM Total Returns YoY
for the largest components of the EMBI+
others
17%
Brazil
23%

Venezuela
7%
The EMBI+ is highly
concentrated on a few issuers:
6 countries represent over
85% of the index
Philippines
Turkey
9%
Mexico
19%
Russia
17%
Venezuela
Russia
Philippines
8%
Brazil
Turkey

2005 total returns both in USD
and EUR are high
Mexico
0%
USD
EUR
12
5%
10%
15%
Source: Bloomberg/JPMorgan
20%
Are current levels justified
Supportive factors vs risks
 EM benefit from several supporting factors:







Low volatility making funding cheaper
Improved fundamentals (Fiscal, debt, CA, rating upgrades)
Reduced borrowing needs (2006 pre-financing has started early)
Still high risk appetite
Currency appreciation
Strong commodity prices and robust world growth
Widened investor base
 But also faces important risks:






Historically low spreads
Increasing benchmark yields and tighter Fed/ECB monetary policy
Upcoming elections and reduced margin for policy mistake
Bond bubble might still burst instead of deflating
Oil price might switch from support to threat
Pipeline of inflows remains positive but low
13
Supportive Factors
Low Volatility
VIX and EMBI+
38
750
700
33
650
Volatility is down, EMBI+ is tighter
28
600
550
500
23
450
400
18
350
300
13
250
8
200
01/03 04/03 07/03 10/03 01/04 04/04 07/04 10/04 01/05 04/05 07/05 10/05
Vix Index (LHS)
EMBI+ (RHS)
Source: Bloomberg, JPMorgan, CBOE
14
Supportive Factors
Credit quality has generally improved
Bulgaria
Czech Republic
Hungary
Poland
Rom ania
Russia
Slovakia
Turkey
Ukraine
Brazil
Mexico
Venezuela
Philippines
S&P
Fitch
Fitch
Fitch
S&P
Fitch
Moody's
S&P
Moody's
S&P
Fitch
Moody's
Fitch
Moody's
Fitch
S&P
Fitch
Moody's
S&P
Fitch
Moody's
S&P
Moody's
S&P
Fitch
Moody's
S&P
Fitch
LTFC Rating
BBB
BBB
A
ABBB+
BBB+
Ba1
BBBBaa2
BBBBBB
A2
A
B1
BBBBBBBa3
BBBBBaa1
BBB
B2
B+
BBB1
BBBB
Upgraded from
BBBBBBAABBB
BBB
Ba3
BB+
Baa3
BB+
BBBA3
ABa3
B+
B+
B+
B1
B+
B+
Baa2
BBBCaa1
B
B+
Ba2
BB
BB+
dow n
up
On (date)
27-ott-05
17-ago-05
26-ago-05
16-gen-04
10-giu-99
19-nov-99
02-m ar-05
06-set-05
25-ott-05
31-gen-05
03-ago-05
12-gen-05
11-ott-05
03-gen-97
13-gen-05
11-m ag-05
21-gen-05
12-ott-05
17-set-04
28-set-04
06-gen-05
31-gen-05
07-set-04
12-ago-05
14-nov-05
16-feb-05
17-gen-05
12-giu-03
Outlook
Positive
Stable
Date
27-ott-05
17-ago-05
Negative
Positive
Positive
Positive
Stable
Stable
Stable
Stable
Positive
Stable
Positive
Stable
Stable
Positive
Positive
Positive
Positive
Stable
Stable
Stable
Stable
Stable
Negative
Negative
Negative
12-gen-05
22-m ar-05
12-ott-05
02-m ar-05
06-set-05
25-ott-05
31-gen-05
31-gen-05
12-gen-05
11-ott-05
11-feb-05
13-gen-05
11-mag-05
08-giu-05
12-ott-05
08-nov-05
11-ott-05
06-gen-05
31-gen-05
07-set-04
12-ago-05
14-nov-05
13-lug-05
11-lug-05
11-lug-05
Source: Bloomberg
15
Supportive Factors
The external vulnerability is lower
90.0
External Debt % of GDP
80.0
2003
70.0
2005
External indebtedness has
decreased in the last couple of years
2006
60.0
Current account balances have
improved in most of the countries
50.0
40.0
30.0
20.0
10.0
0.0
TURKEY
BRAZIL
MEXICO
VENEZUELA PHILIPPINES
RUSSIA
20
CA % of GDP
15
Only exceptions: Turkey (due to oil
and strong import) and Russia
(Dutch disease and strong rise in
import).
2003
2005
2006
10
5
0
Russia CA surplus is still high.
-5
-10
TURKEY
16
BRAZIL
MEXICO
VENEZUELA PHILIPPINES
RUSSIA
Supportive Factors
External debt issuance
External Debt Net Issuance (mn $)
40000
2004
2005
2006
30000
20000
10000
0
RUSSIA
VENEZUELA
MEXICO
BRAZIL
TURKEY
-20000
PHILIPPINES
-10000
Net issuance of external debt is generally supportive for most of the countries considered:
•Brazil, Mexico, Venezuela, and Philippines show no strong need to access primary market.
•Russian sovereign issuance is virtually disappearing, while the government is thinking
about capping corporate access to external debt.
•Turkey plans to increase net issuance.
17
Supportive Factors
High risk appetite for EM bonds
10-year US Treasury up, EMBI+ down
EMBI+
370
350
330
310
290
Begining of Q1-05
Begining of Q2-05
Begining of Q3-05
Begining of Q4-05
In Q1 05
In Q2 05
In Q3 05
In Q4 05
Last
270
250
230
3.50
3.75
UST 10Y
4.00
4.25
4.50
4.75
5.00
Source: Bloomberg/JPMorgan
Appetite for risk has increased despite rising UST yields
The EMBI+ has reached a new all time low on Nov. 28th at 236bp
18
Supportive Factors
Inflows should remain high
400
Net Financial Flows to EM Economies by Region
(in USD bn)
350
2003
2005f
300
2004
2006f
250
200
150
100
50
0
Private flows
Latin
America
Europe
Africa/Middle Asia/Pacific
East
Source: IIF, Capital Flows to Emerging Market Economies Sep-24 05
19
Supporting Factors
Real and nominal exchange rates
Differential between nominal and
real effective exchange rate
highlights pressures Central banks
have to face to maintain the chosen
currency regime.
Differential between REER yoy and NEER yoy
20
0
-20
-40
Venezuela under pressure?
TURKEY
MEXICO
BRAZIL
VENEZUELA
PHILIPPINES
RUSSIAN FEDERATION
-60
-80
-100
1995
1997
1999
2001
2003
2005
Since 1995, we’ve seen a
contraction of this differential,
meaning that the likelihood of a
currency risk has been generally
reducing.
The graph highlights the latest
Turkish crisis in 2001, the Russian
one in 1998-99 and the recovery
from the general Peso crisis in the
mid-90’s.
Going forward, the only currency that might come under stress is the
Venezuelan Bolivar, but this would not entangle a generic contagion effect.
20
From supportive to risk?
High Commodity Prices

fuel and energy balance / GDP
goods balance / GDP
CA / GDP
20%
15%
10%

5%
0%
-5%
-10%
-15%
Mexico
…nevertheless, the appreciation that
the currencies under consideration
underwent in the last year helps
lowering the burden of the negative
“oil bills” in Turkey and Philippines.
Brazil
15%
150
10%
100
5%
50
0%
-
-5%
-50
-10%
-100
-15%
-150
-20%
-200
FX appreciation (avg.2005 vs. avg. 2004)
energy balance in 2004 (bn $ - RHS)
21
Venezuela
Russia
Philippines
Turkey
Turkey

Philippines
Russia
Venezuela
Mexico
25%
These big-6 are either neutral or even
favoured by high oil prices: the fuel
and energy items shows a nil or
positive contribution to the total
balance of goods, the only exceptions
being Turkey and Philippines.
The few negative balance of goods
(Turkey, Philippines and Mexico) in
turn, are further compensated by the
balance of services, so that the only
country seriously affected by the “oil
bill” remains Turkey…
Brazil
30%
Potential threat
Decoupling of EM Spreads and BMK yields
EMBI+ and BMK
10
The relation between UST yields
and EMBI+ has inverted in Q3-05
1000
9
900
Bund 10-year (LHS)
8
Correlation between 10-year UST
and EMBI+ was roughly 60% in
2004 versus –40% in 2005
800
US Treasury 10-year (LHS)
7
700
EMBI+ Rebalanced (RHS)
Sep-05
6
Sep-05 is the turning point, with
the market radically changing its
expectations on Fed monetary
Policy and UST yields
600
5
500
4
400
3
300
In Q1-05
14.6%
2
200
In Q2-05
43.5%
In Q3-05
-45.8%
In Q4-05
-29.1%
01/02
07/02
01/03 07/03
01/04
07/04
Correlation 10-year UST and EMBI+
01/05 07/05
Source: Bloomberg, JPMorgan
Change US Treasury 10-year
EMBI+
Bund 10-year
EUR EMBI+
in 2005
+26
-121
-19
-9
In Q1-05
+27
+26
-2
-2
In Q2-05
-53
-82
-48
-8
In Q3-05
+27
-54
-1
-12
In Q4-05
+9
-5
+26
+3
22
Upcoming Elections:
Risks of slippage ahead of the vote

Improvement in fundamentals is also partly due to the substantial capital inflows in EM
since 2004 and to the global environment that has contributed to these inflows

Borrowers should remain cautious, as the prices of their bonds reflect not only the
intrinsic quality of the borrower but also that of the improved global environment…

… therefore, they should not become complacent about their macro or monetary
policies and the implementation of structural reforms, especially ahead of elections
(Mexico: Jul-06, Presidential + Parliamentary ; Brazil: Nov-06, Presidential +
Parliamentary ; Venezuela: 2006, Parliamentary ; Russia: Q2/Q3-08 Presidential, Q407/Q1-08 Parliamentary)

If anything,
EBV + TMP(Fed, ECB) + RBY => less margin for mistake
with
EBV: Expensive Bond Valuations
TMP(Fed, ECB): tighter monetary policies from both the Fed and the ECB
RBMK: Rising Benchmark Yields
23
In the end it is all about money
 Between Greed and Fear, the Sharks of Finance have made up
their mind:
EM total returns are among the highest
EM fundamentals have improved
EM borrowing needs are lower
Global risk appetite is still high
Investor base has widened
Fed Fund Rate at 4.75% is fully priced and the new Fed Chairman
should have little incentive to surprise the market
 We forecast only moderately higher benchmark yields






H1-06 appears safe for EM, with some volatility building in Q2 due to
market expectations regarding the end of the monetary policy
tightening cycle in the US and EU
H2-06 could be more volatile depending on global liquidity and more
importantly: local politics.
Market conditions remain favourable but more fragile
24