A monthly guide to investing in emerging market financial assets

Investing in emerging markets

Chief Investment Office GWM  —  September 2018

When the global meets the local

Equities: Credit: Currencies: Focus: Economy:

Mind the valuation Fork in the road, Shaky conditions, Turkey not out of Policy rate hikes
gap opportunities on long list of risks the woods yet; in crisis scenarios
the wayside contagion limited - How much is
nonetheless enough?

ab This report has been prepared by UBS AG, UBS Financial Services Inc. (UBS FS), and UBS Switzerland AG.
Please see important disclaimers and disclosures at the end of the document.
Contents
Editorial
Investing in emerging markets When the global meets the local.................................................................. 3

Editors-in-Chief
Global investment views.......................................................................... 5
Alejo Czerwonko
Michael Bolliger
Emerging market investment strategy
Seizing opportunities, cutting risk................................................................ 6
Project management
Mercedes Zhang
Focus
Editors Turkey not out of the woods yet; contagion limited nonetheless.................. 8
Abe De Ramos
Economy
Editorial deadline Policy rate hikes in crisis scenarios: How much is enough?........................... 9
28 August 2018
Equities
Desktop Publishing Mind the gap............................................................................................. 10
Srinivas Addugula*
USD bonds strategy
Contact Fork in the road, opportunities on the wayside........................................... 11
wmrfeedback@ubs.com
Currencies
Shaky conditions, long list of risks.............................................................. 12

Emerging market electoral monitor...................................................... 13

Emerging markets publications............................................................. 14

Important disclosure
* An employee of Cognizant Group. Please note there may be changes to our house view and tactical asset allocation
Cognizant staff provides support services strategies prior to the next edition of Investing in Emerging Markets. For all up-
to UBS. dated views, please refer to the latest UBS House View.

UBS CIO GWM September 2018  2

Editorial
When the global meets the local
The outlook for emerging markets (EM) will be influenced by
whether their recent underperformance is being driven by
these markets’ vulnerability to global factors, like rising rates
and dollar strength, or by structural local failings.
One school of thought argues that EM fundamentals are
being negatively affected by shrinking global liquidity. The
Fed has been hiking policy rates for over two years as the US
economy grows briskly and policy makers strive to normalize
monetary conditions, while the European Central Bank is on
the path to reducing its stimulus too. A related global head-
wind for EM is the strength of the US dollar. Over the last
decade, there has been a strong and stable negative correla-
tion between the greenback and all emerging market assets.
To the extent that the US economy continues to outpace most
others, interest  rate  differentials and corporate profitability
support capital inflows into the US market from other alter-
natives.
On the other side of the debate is the idea that EM underper-
formance is driven by an accumulation of individual structural
concerns:
• China has to de-lever its economy while maintaining a so-
cially and political acceptable rate of growth. In addition,
China  is  involved  in the early stages of a currency war
with the US. The poor performance of the Chinese equity
market and the CNY year-to-date are a reflection of these
challenges.
• The rest of Asia, with the exception of India, falls into the
Chinese food chain, and is at risk with a greater than antic-
ipated slowdown of the Chinese economy. While growth
in India is strong and expected to remain so, reforms have
been delivered at a slower than expected pace, and next
year’s election could bring about a backlash of populism.   der an IMF program will test the country’s socio-political
• Turning to South Africa,  after a number of challenging
years under ex-president Zuma, the governments of pres-
ident  Ramaphosa  brought new optimism for  reforms in
the country. However, the African National Congress re-
mains deeply divided and progress has been slow.   true looking at the rear view mirror. Looking ahead, howev-
• Turkey faces  serious balance of payments challenges, as
well as  rising diplomatic tensions with the US. Perhaps
most importantly, Turkey has to contend with a slow re-
Mark Haefele Jorge Mariscal
Global Chief Head of
Investment Officer EM Investment Office
sponse and potential difficulties in the ability of the Cen-
tral Bank and Finance Ministry to do what it takes to avert
a full-fledged financial and banking crisis.
• Russia’s strong external balance sheet makes the country
resilient to global monetary tightening and a strong USD.
However, the country faces increased sanctions from the
US and Europe. An anti-western bias in president Putin’s
foreign policy and expansionary geopolitical ambitions im-
pose and elevated risk premium to Russian assets. There is
no change in sight to these factors.
• In Latin America, Brazil and Mexico are at the cross roads
of an important ideological shift. Last July, Mexico elected
Andrés Manuel López Obrador (AMLO) as president, and
awarded him unprecedented political power in Congress
and state governments. His campaign program featured a
larger and more interventionist state, and many of the na-
tionalistic formulas tried with little success in Latin Ameri-
ca and elsewhere in the 70s. 
• Brazil will hold presidential elections in October-Novem-
ber this year. While the election is till wide open, recent
polls indicate a potential second round face off between
a right-of-center candidate with authoritarian tendencies,
and a far left candidate from the Workers Party. The out-
come makes uncertain that the next government will ad-
dress fiscal reform needed to stabilize debt dynamics in
that country.
• Finally, we note that while in both Argentina and Colom-
bia pro-market candidates have been elected, opposition
remains large enough to threaten the success of these
governments. This is  particularly  the case for Argentina
where the bitter measures to stabilize  the economy un-
fabric. Chile has opted decisively for a pro-market regime,
but even there strong social divisions will not make the job
easy for president Piñera.
In our view, arguments from the first school of thought hold
er, the Fed’s tightening cycle is largely priced in, parts of the
global economy other than the US can recover, and medium
term the US dollar will trade weaker, all of which could turn
current headwinds into a tailwind for EM. 
UBS CIO GWM September 2018  3
Editorial

And although those who emphasize the many  idiosyncratic
challenges faced by EM are also partially right, the bulk of EM
countries enjoy manageable balance of payment and fiscal
dynamics, large coffers of foreign exchange reserves, low in-
flation, and high real interest rates. Over the last 10 years, the
large EM economies have reduced their dependency on exter-
nal funding by growing their domestic bond markets. Despite
domestic challenges, aggregate macroeconomic conditions in
EM are not in bad shape.
This month we leave our EM asset allocation largely un-
changed, reflecting a neutral appetite towards risk as we
get a better sense of what the bilateral relationship between
China and the US will look like. Our  Focus  sections moni-
tors the contagion channels of Turkey’s ongoing crisis, while
the  Economy  section addresses the question of how high
real yields should be in EM in times of stress.
As usual, we hope you enjoy the reading.

Political undercurrents cloud the horizon

That being said, global political trends hold us back from Warm regards,
adopting a more pro-risk stance. Anti-establishment senti-
ment has been spreading through developed and emerging
countries alike.

These movements have a strong policy component of protec-

tionism and populism. The same anti-globalization phenome-
non that led to Donald Trump’s election is at work in the UK,
and Italy. But also in the Philippines’s Duterte, Russia’s Putin,
Mark Haefele
Mexico’s AMLO, Brazil’s Bolsonaro, and even in the less secu- Chief Investment Officer
lar, anti-West shift in Middle East politics in recent years. This
anti-establishment phenomenon has local and, as in the case
of Trump’s war on trade, global consequences.

Our view is that the anti-globalization movement will at

best slow down, but not reverse the forces of globalization.
However, the attempts to shape the world by what Francis Jorge Mariscal
Emerging Markets Chief Investment Officer
Fukuyama calls the “politics of identity” (a movement to vin-
dicate the interest of segments of society left behind by glo-
balization) will nonetheless create local and global headwinds
to asset prices in the form of policies that are anti-markets.
Our neutral position on global and EM equities, for example,
reflects our concern with trade wars. As long as these an-
ti-globalization efforts continue, investors will have to keep
an eye on the local, as well as the global.

UBS CIO GWM September 2018  4

Global investment
views
Asset allocation
The deteriorating situation in Turkey has led to weakness in
emerging market (EM) assets and European financials over the
month. Countries in the region have limited direct trade linkages
or financial exposure to Turkey, and we see the contagion as
being largely sentiment-driven. While global economic growth
remains on a strong footing, trade tensions are still in focus, as
the US has announced it is considering a 25% tariff on an addi-
tional USD 200bn of Chinese imports, raising the prospect of
retaliatory measures. We expect trade tensions between the US
and the rest of the world to increase further before new trade
deals can be arranged. We maintain a largely neutral exposure to
risk assets, as our moderate overweights in global equities and
EM sovereign bonds are balanced by counter-cyclical positions.
Equities
The US reporting season on second-quarter earnings delivered
strong growth of 25% y/y. These fundamentals, coupled with
robust economic growth, supported US and global equities over-
all. Still, trade tensions linger. September is likely to bring more
news flow on the imposition of additional US tariffs on 200bn of
Chinese imports. With the USD being strong and Chinese eco-
nomic data weakening somewhat lately, EM equities are facing a
challenging environment. Against this backdrop, we hold a mod-
est overweight on global equities versus US government bonds.
Bonds
We maintain our overweight on EM sovereign bonds in USD
against US government bonds. The increase in spreads over the
month has been largely sentiment-driven due to concerns on Tur-
key, which represents only 3.8% of the well-diversified Bloomb-
erg Barclays EM Hard Currency Agg bond index. The yield of
5.8% is attractive and EM economic surprises have recovered
from their lows. We are overweight 10-year US Treasury bonds
versus USD cash, as we think this part of the curve has largely
priced in the rate-hiking cycle and the carry is attractive.
Foreign exchange
In our FX strategy, we are overweight the Japanese yen (JPY)
versus the Taiwanese dollar (TWD). The long JPY position should
benefit either from rising Japanese inflation prompting the BoJ
to allow yields to move further upwards, or a downturn in
global financial markets creating demand for the JPY's safe-
haven function. Meanwhile, Taiwan is exposed to risks arising
from US trade policy disputes.
UBS CIO GWM September 2018  5
Emerging market
Michael Bolliger
Head of EM Asset
Allocation

investment strategy
Seizing opportunities, cutting risk

(see What we are watching below). We see a growing number of

Emerging market assets remain under pressure due to senti-
ment shocks and a more uncertain outlook for fundamentals.
We may be standing at a fork in the road, leading to either a
recovery or a further deepening of the crisis. We advise con-
sidering dislocations as buying opportunities, for example in
credit, while cutting exposure to markets with a deteriorating
risk-reward profile.
opportunities in segments where the contagion across emerging
markets has resulted in dislocations that seem unrelated to funda-
mentals. Our outlook is most benign for sovereign and corporate
bonds in US dollars, with a non-annualized return expectation of
3–4% over the next six months. We maintain our neutral alloca-
tion in emerging market equities, currencies, and bonds in local
currencies.

Where we invest
Emerging market assets have been hit by a number of headwinds
We remain neutral on emerging market equities until earnings
in recent weeks: contagion from the crisis in Turkey, the US-China
and macro indicators improve, trade tensions abate, and the US
trade dispute, new US sanctions against Russia, ongoing currency
dollar’s strength fades. Our long-term outlook remains construc-
pressure, and weaker economic data from China.
tive, but investors should focus on the following ideas for now:
This has resulted in widening spreads and negative performance
1. We recommend favoring value cyclicals over expensive growth
across emerging market asset classes: This year through late Au-
stocks, and seeking income protection through selective expo-
gust, sovereign bonds are down almost 4% and corporate bonds
sure to countries and sectors where dividend yields are high
2.5%, while currencies are down 5% against the US dollar and
(over 4%) and balance sheets are solid. Russia, UAE, Qatar,
equities have fallen 7.5%.
and Saudi Arabia meet these criteria, with a dividend yield of
4–7% and strong financial positions. In terms of sectors, we
While more benign valuations will eventually present a buying op-
prefer energy, financials, telecoms, and materials, all of which
portunity, it is important to closely monitor market developments
offer about 4% yield.
that could further weigh on asset prices in the months ahead

Tactical asset allocation deviations from benchmark*

underweight neutral overweight Most Preferred Least Preferred

EM equities total •• China •• Taiwan

•• Thailand •• Malaysia
Equities

EM Asia
EM LatAm
EM EMEA
EM sovereign bonds (USD) •• Sovereign bonds (index-level) •• Corporate bonds (index-level)
EM sovereign bonds IG (USD) •• High yield sovereigns •• Investment grade sovereigns
Bonds in USD

EM sovereign bonds HY (USD) •• Select LatAm corporates •• Asian bonds

•• GCC sovereign and
EM corporate bonds (USD)
quasisovereign bonds ()
EM corporate bonds IG (USD)
EM corporate bonds HY (USD)
instruments

EM currencies / money market

•• SGD •• TWD
currency
Local

EM government bonds
EM inflation-linked bonds

new old

Source: UBS, as of 23 August 2018. Green/Red arrows indicate new upgrades/downgrades. Grey up/down arrows indicate increase/reduction to existing positions.
* Please note that the bar charts show total portfolio preferences. Thus, it can be interpreted as the recommended deviation from the relevant portfolio benchmark for any given asset class and sub-asset
class. These charts were formulated at the Emerging Markets Investment Committee. These preferences are designed for global investors. For models that are tailored to US investors, please see our flagship
publication, UBS House View.

UBS CIO GWM September 2018  6

Emerging market investment strategy
2. China remains our preferred equity market in Asia. After a
20% correction from its January 2018 peak, valuation is at-
tractive at 11x 12-month-forward P/E, with superior earnings
growth prospects of 15%. Recent easing measures should
mitigate headwinds to growth, and trade tensions with the
US seem largely priced in. China should outperform Tai-
wan where we expect low-single-digit earnings growth and
downside to valuation at 13.6x P/E.
What we are watching
We may well be standing at a fork in the road, leading to either
our base-case scenario of a recovery in asset prices or to our risk
case of a further deterioration. We advise keeping a strategic
exposure to emerging market assets but trimming risk exposure
within the region. The following factors need close monitoring:
• Business cycle dynamics: Business and consumer sentiment
in emerging markets continued to soften, with purchasing
managers’ indices for July dropping in most countries. But
economic activity remains healthy overall and has been lit-
tle affected by the recent headwinds – an important support
amid tighter liquidity conditions globally.
• Chinese policy stimulus: Authorities in China have respond-
ed to softening economic growth and a depreciating yuan by
pulling several policy levers, though the stimulus hasn’t been
sufficient to turn the situation around. We believe policymak-
ers can and will do more, with caution, if and when needed.

• Liquidity conditions: Developments in Argentina and Tur-

key have forced policymakers to significantly tighten liquidity
conditions. While the full economic impact is not yet visible,
a contraction looks highly likely. Elsewhere, currency weak-
ness, higher commodity prices, and closing output gaps have
reduced central bankers’ room for maneuver, resulting in rate
hikes in some countries. Meanwhile, the US Federal Reserve
is poised to continue to normalize monetary policy, which
could further strengthen the US dollar in the near term and
weigh on capital flows to emerging markets. The European
Central Bank and the Bank of Japan will likely move toward
normalization too. In this environment, India, Indonesia,
the Philip-pines, and South Africa are especially vulnerable,
in our view.

• Sentiment crisis: We think the risk is high that the Turkish

crisis and US-China trade tensions will spill over to the real
economy, affecting both emerging and developed markets.
The recent US visit of a Chinese delegation to attempt to
resolve the trade dispute was welcomed by financial markets,
and underpins our outlook for a negotiated solution rather
than a full-blown trade war. Yet the road to an agreement
is long and winding, and tensions are likely to increase first
before they eventually disappear. A further, rapid deprecia-
tion of the Chinese renminbi (versus the US dollar) could also
weigh on market sentiment.

UBS CIO GWM  September 2018   7

Focus
Turkey not out of the woods yet; contagion limited nonetheless
Despite last week’s apparent calm as the Turkish financial industry came to
a halt for the Eid al Adha feast, the country’s financial and economic woes
are far from over. In our view, the status quo is unlikely to prevail, and the
Turkish outlook seems binary at this juncture.

On the one hand, a relief rally from currently depressed Turkish asset val-
uations will take place if authorities tighten monetary and fiscal policies
significantly (see next page for an analysis of how much monetary tighten-
ing would be “enough”), requests external financial assistance (IMF and/or Jorge Mariscal Alejo Czerwonko, Ph.D.
other friendly nations), and/or manage to de-escalate tensions with the US. Head of Strategist
EM Investment Office
On the other hand, however, additional pain is in store if Turkish policy-
makers do not act decisively. Consequences could include another major
leg down in Turkish assets, a full-fledged economic crisis, mounting stress
on the banking sector’s balance sheet, and corporate defaults. Capital
controls could be used as a temporary measure to stop capital flows in a
more extreme scenario, a last resort solution given the country’s reliance
on external funding.

So how should investors react to risks from Turkey? We are watching three
main potential avenues of contagion.

First, the euro. The currency fell against the US dollar in early August as
worries over Turkey intensified. That reflected concerns that a deepening
crisis in Turkey could slow the ECB’s move towards withdrawing ultra-easy
monetary policy. Overall we believe European exposure to Turkey is too
small to trigger a U-turn in ECB policy – less than 3% of Eurozone exports
go to Turkey. But the Turkish issue has flared up at a time when the euro
was already vulnerable due to relatively weaker Eurozone growth momen-
tum and political risks linked to Italy.

Second, the European banks. Spanish banks have USD 83bn in Turkish
loans outstanding. Turkey has also borrowed USD 38bn and USD 17bn
from French and Italian lenders, respectively. This is not nearly enough to
endanger the solvency of the Eurozone banking system. A renewed set-
back in Turkish markets could weigh on euro high yield credit, however.
European banks account for 12% of this market, the second largest sector.

Finally, broader emerging market assets. Turkey accounts for just 0.5% of
the MSCI EM Index, 3.3% of the JPM EMBI Div Index (just one of 67 issuing
countries), and 3.7% of the JPM CEMBI Div Index (one out of 41 featured
countries in this case). Overall, although additional stress from Turkey may
trigger market jitters in the more externally vulnerable EMs (Argentina,
South Africa, Indonesia, for instance), asset class-level EM exposure could
experience temporary weakness, but should be able to weather the storm.

The bottom line is that developments in Turkey need to be monitored as

the domestic situation will not remain static. In our view, it will either get
better, or worsen significantly from here. In the latter case, although, after-
shocks would likely be felt in global markets, we don’t currently see these
as major risks for global and well-diversified EM investors.

UBS CIO GWM September 2018  8

Economy
Policy rate hikes in crisis scenarios: How much is enough?
Tilmann Kolb
An 18% money market rate of return looks irresistible at first glance, but Analyst
it quickly loses luster when inflation is above 15% and rising. The prob-
lem with high-yielding currencies is that there is usually a good reason
for the high yields. Turkey is a prime example: Its economic imbalances,
geopolitical conflicts, and hurdles in rolling over external debt mean in-
vestors are increasingly avoiding exposure to Turkish assets. The lira crisis
in August has added a hefty risk premium to short-term rates despite the
attempts of the central bank (CBRT) to stabilize the currency, as earlier
rate hikes proved insufficient. But at what point are money market rates
high enough again to lure investors back? We can look at past periods of
stress to determine what may be an appropriate central bank response.
Fig. 1: Russia - adequate monetary policy response
Money market yield in RUB (in %), policy rate (in %), inflation (in % y/y),
Russia – Credible monetary policy, high real rates expected inflation in 12m (in % y/y), realized real rate (in %),
Russia’s experience in late 2014 can serve as an example. Amid strong de- and expected real rate (in %)
preciation pressure on the ruble due to falling energy prices and international 50
sanctions against the country, implied money market rates soared above 40%
during the peak of the crisis (see Fig.1). The Russian central bank hiked its pol- 40
icy rate from 8% to 17% within three months, the last hike being 650 basis
30
points when the crisis was in full swing. Subsequently, money market yields
followed the policy rate again starting January 2015 – i.e., the central bank 20
was able to ensure that the monetary transmission mechanism worked. Fig.
1 also shows that expected real rates* on ruble money market instruments 10
spiked during the crisis, and in the aftermath realized real rates** were consis-
tently around 5–6%, as inflation came in lower than expected while the policy 0
rate was kept high.
–10
Jul-14 Jan-15 Jul-15 Jan-16 Jul-16
Turkey – More is needed
Fig. 2 illustrates the situation in Turkey. We see a similar spike in the money mar- RUB money market yield Inflation expectations
ket yield in August, but a relatively minor central bank response (an implicit hike Policy rate Realized real rate
of 150bps) after the crisis had hit. The expected real rate increased to roughly Inflation Expected real rate

7%, similar to levels reached in Russia. But here’s the caveat: Turkish prices have
risen significantly more in recent years than what markets had expected. This un-
dermines the credibility of the CBRT’s inflation target of 5% +/–2%. Combined
with the central bank’s so-far subdued response in hiking policy rates, we doubt
if the CBRT will be as successful as its Russian counterpart in linking money
market rates with the policy rate, the slowdown in inflation, and the lowering
of inflation expectations.
Source: Bloomberg, JPM, UBS, as of 22 August 2018
Fig. 2: Turkey – will it follow the blueprint?
Money market yield in TRY (in %), policy rate (in %), inflation (in % y/y),
expected inflation in 12m (in % y/y), and expected real rate (in %)
35

30
We think the CBRT will hike rates in line with market expectations of around
500bps and commit to keep interest rates elevated for an extended period, 25
to achieve two objectives: First, a strong hike will demonstrate its resolve to
20
tackle inflation and assuage worries that it can’t act against political resis-
tances. Second, higher rates will cool down the economy further and reduce 15
inflationary pressures. This would make Turkish rates more viable investments
10
again for international investors. Inflows may return, allowing the lira to sta-
bilize, which in turn reduces the risk investors face with local investments. 5
However, monetary policy tightening will not be sufficient without additional
0
measures from the government, in our view.
Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18

* expected real rate calculated as the difference between average futures-implied TRY money market yield Inflation expectations
yields and expected inflation Policy rate Expected real rate
** realized real rate calculated as the difference between futures-implied yields and Inflation
actual inflation Source: Bloomberg, JPM, UBS, as of 22 August 2018

UBS CIO GWM September 2018  9

Equities
Mind the gap
Corinne de Boursetty,
The valuation gap between emerging market (EM) equities and their de- CFA
veloped markets (DM) peers is close to historical lows, exceeding its ten-
year average discount of 20%. It is reasonable to expect a reversal, but,
in our view, EM weakness is likely to continue in the short term amid
negative earnings momentum, China macro slowdown, rising US sanc-
tions risks (Russia, Turkey), lower commodity prices and ongoing trade
war concerns. A sustainable relief rally will only happen if we see one of
these factors reverse, potentially in 4Q.

Fig 1: Country preferences in EM equities

We stay neutral on MSCI EM until we see an improvement in earnings and (relative to MSCI EM Index)
macro indicators, trade tensions de-escalate and the US dollar weakens. We
remain positive on the EM growth story in the long term, as the EM-DM Turkey

growth differential should reaccelerate later this year or next. South Africa
Russia

EMEA
Poland
Performance recap: Another tough month marked by Turkey’s EM
Hungary
contagion fears Czech Republic
The MSCI EM Index is down 7.5% this year, underperforming the developed Peru
market benchmark by 12%. P/E derating accounted for roughly 65% of this Mexico

LatAm
correction, currency weakness the other 35%. Colombia
Chile
EM equities sold off 3.5% over the past month with Turkey’s external financ- Brazil
ing vulnerabilities acting as a powerful trigger for the broad based sell-off. Thailand

Despite a 20% correction from its January peak, valuations are just in line Taiwan
Philippines
with the 10-year average, so still vulnerable to deteriorating earnings and
Malaysia
Asia

market sentiment. The 2Q earnings season is about half way though with
South Korea
results broadly in line versus already decreased consensus earnings estimates Indonesia
(-3.5% over the past 3 months). India
China
Focus on value and income protection MSCI EM
Within our style strategy, we recommend to focus on value stocks over –1.5 –1 –0.5 0 0.5 1 1.5
growth by getting selective exposure to cyclical sectors such as financial, new old
energy and materials or via the MSCI EM value index. The EM value index
trades at an unjustified 45% P/E discount to its growth counterpart despite Note: All positions are relative to the MSCI EM index. EM regional asset
allocation shown is not part of the Global Tactical Asset Allocation (TAA)
similar earnings growth. We also advise to get selective exposure to EM Source: UBS, as of 28 August 2018
companies with high dividend yields (exceeding the EM average of 3%) and
solid balance sheets via the MSCI EM High dividend yield index which offers Fig. 2: Country performance breakdown in EM
ca 5% yield. By country
40
Most and least preferred markets 30
Our most preferred market is China due to its solid earnings outlook at a 20
10
reasonable valuation; our least preferred is Taiwan given its earnings de- 0
terioration and large export exposure to the US. We also remain positive –10
on Thailand and negative on Malaysia. We keep our neutral stance on the –20
–30
countries in EMEA and Latin America, due to a combination of earnings and –40
socio-political risks. –50
–60
–70
China
India
Indonesia
Korea
Malaysia
Philippines
Taiwan

Emerging markets
Developed markets
Thailand
Brazil
Mexico
Russia
South Africa
Turkey
Asia
Latin America
EMEA

Rerating FX TR USD
EPS (LC) Div.

Source: UBS, Datastream, Bloomberg as of 24 August 2018

UBS CIO GWM September 2018  10

USD bonds strategy
Fork in the road, opportunities on the wayside

Emerging market (EM) bonds have been hit by a number of headwinds in

recent weeks, including the contagion from the crisis in Turkey, the escalating
trade dispute between the US and China, new US sanctions against Russia,
ongoing pressure on EM currencies, and weaker macroeconomic data from
China. Spread levels are high enough for us to maintain our overweight to
the asset class, and we see a growing number of opportunities in market seg-
ments where contagion across emerging markets has resulted in dislocations
that seem unrelated to fundamentals. That said, risks remain high and we are
monitoring a range of signposts to gauge the way forward. Michael Bolliger Tilmann Kolb
Head of EM Asset Analyst
Allocation
Persistent headwinds have pushed EM sovereign bonds down by 4.5% and cor-
porate bonds by 2.8% this year through mid-August. Over the next six months,
we expect non-annualized returns of 3–4% due to a higher interest rate carry and
a moderate tightening of spreads. We see a growing number of opportunities in
certain market segments.

What we are watching

For EM credit as an asset class, we may well be standing at a fork in the
road, leading to either our base-case scenario of a recovery in bond prices
or to our risk case of a further deterioration. We are closely watching the
following factors:

Liquidity conditions: Idiosyncratic developments in Argentina and Turkey

have forced policymakers in certain markets to meaningfully tighten liquid-
ity conditions. The impact on the real economy will likely become visible in
the months ahead; we expect a significant deterioration. Currency weakness,
higher energy prices, and closing output gaps resulted in policy rate hikes
in a number of countries. Externally, the Federal Reserve will likely continue
to tighten US monetary policy conditions, which could fuel further US dol-
lar strength and weigh on capital flows to emerging markets. The European
Central Bank and the Bank of Japan will also likely move toward tighter policy
conditions. India, Indonesia, the Philippines, and South Africa could be the
next to feel growing pressure.

Sentiment: The risk that US-China trade tensions and the crisis in Turkey will
spill over to the real economy is high. The recent news about a Chinese delega-
tion traveling to the US for a fresh attempt to resolve the trade dispute was wel-
comed by financial markets, and underpins our thesis of a negotiated solution.
Yet the road to an agreement is long and winding, and tensions are more likely
to increase first. More decisive action by Turkish policymakers will also be needed
to stabilize financial conditions in the country.

Business cycle: Business sentiment indicators in emerging markets contin-

ued to soften, with purchasing manager indices for July dropping in most
countries. However, real economic activity remains robust and has been little
affected by the aforementioned headwinds so far. This is important to offset
the effects from tighter global liquidity conditions.

Chinese stimulus: Policymakers in China have responded to softening

growth dynamics and renminbi depreciation by pulling several policy levers.
This stimulus hasn’t been sufficient to turn these dynamics around, but more
can and will be done, in our view, if and when needed.

UBS CIO GWM September 2018  11

Currencies
Shaky conditions, long list of risks
Tilmann Kolb
Amid an adverse backdrop marked by trade tensions and tighter global Analyst
liquidity, emerging market currencies were hit by spillover sentiment from
the Turkish currency crisis. We expect challenging conditions to persist in
the near term, with further setbacks likely. Given the potential for more
weakness, but also for periods of relief, we abstain from taking directional
exposure against the US dollar or euro for now.

The Turkish lira’s free fall spilled over to other emerging markets and pressured
their currencies in the past month. Those vulnerable to ebbing liquidity – i.e. Fig.1: EM currency preferences
currencies of countries that have current account deficits, are reliant on port- Positioning over tactical investment horizon
folio inflows, and have large shares of foreign-denominated public and private underweight neutral overweight
debt – are likely to face bouts of stress whenever sentiment toward emerg-

LatAm
BRL
ing countries deteriorates. Apart from the lira, they include the South African MXN
rand, Indian rupee, the Indonesian rupiah. CZK
HUF
For investors to view emerging markets in a positive light again, they would

EMEA
PLN
need to see more stable global conditions, greater domestic economic activ- RUB

ity, and reduced political risks. That said, emerging market asset valuations TRY
ZAR
have improved and should offer attractive opportunities again in the medi-
CNY
um to long term.
IDR
INR
Turkey is not the only source of concern. The Chinese yuan’s sustained de- KRW
preciation against the US dollar has raised questions about whether the
Asia

MYR
authorities in Beijing are actively pushing down the currency’s value amid PHP
escalating trade tensions with Washington. Recent measures by the People’s SGD
Bank of China (PBoC) suggest it is willing to counteract and slow the broad THB
CNY downtrend, but not necessarily to force a reversal. TWD
USD
EUR
Also, in the wake of weaker recent economic data, Chinese policymakers
are opening the spigots again, at least to some extent. They have cut the new old
required reserve ratios for banks, widened the range of assets that can be
Source: UBS, as of 23 August 2018. This chart shows our tactical positioning in
used as collateral, provided stimulus for infrastructure investments, and di- EM currencies, usually over a six-month investment horizon. These are relative
aled back on deleveraging efforts. A positive turn in the Chinese economy value positions meant for those seeking investment opportunities in EM cur-
rencies. The views take into acount returns from interest rate differences. The
can carry over to other emerging markets and, by assuaging investor worries length of the bars reflect risk-return considerations.
around systemic risks like mounting defaults in China, lend support to their
currencies. How fast and effective new policy measures transmit to the real Fig. 2: Rapid CNY depreciation raised eyebrows,
economy, as well as the way Chinese policymakers balance their deleverag- we expect some more weakness
ing goal and economic growth aspirations, will remain important over the USDCNY exchange rate and CIO forecasts
coming months.
7.2

A potential Sino-US trade war and its effect on Chinese growth prospects,
on the other hand, would likely crush sentiment and infect other emerging 7.0

markets. These risks come on top of the USD’s strengthening momentum

and tighter global monetary conditions spurred by US Federal Reserve’s in- 6.8

terest rate hikes. So we continue to expect setbacks in the near term.

6.6

In our FX strategy, we keep an overweight on the Singapore dollar (SGD) against

6.4
the Taiwan dollar (TWD). Further US tariffs against China would likely affect Tai-
wan’s growth prospects, while Singapore should be relatively insulated. We stay
6.2
on the sidelines in Latin American and EMEA currencies for now, as domestic
2015 2016 2017 2018 2019
and geopolitical risks overshadow fundamental drivers and leave no trades with
attractive risk-reward profiles, in our view. USDCNY
CIO Forecast

Source: Bloomberg, UBS, as of 23 August 2018

UBS CIO GWM September 2018  12

 What’s at stake? Economic & policy backdrop Candidates & key trends Scenarios & implications
7 October – Nationwide federal vote to elect a new 0.9 1.8 2.5 Luiz Inacio Lula da Silva (PT): Born in 1945. - Given recent shifts in political alliances, we
president; 54 of the 81 seats in the senate; all 513 seats Leftist. Brazil’s president from 2002–2009. now assign a 35% probability to a scenario in
in the lower house; governors for all 27 states. GDP Unlikely to be able to run, having been convicted which the next president will be a reformist
(y/y in %) -3.5 of corruption and money laundering. He's in (Alckmin), and another 40% probability to a
28 October – Second round of nationwide federal detention as of now. scenario in which the election is won by a
6.3
presidential election if no candidate reaches 50% of the 2.9 3.8 4.2 quasi-reformist (Bolsonario, Silva), that is,
Inflation
vote in the first round. (year end in %) Jair Bolsonaro (PSL): Born in 1955. Rightist. someone who does not have a strong
Federal deputy. A captain from the army, he conviction on the reforms that must
became known for his nationalist and implemented to fix the economy. The
Current account conservative views. chances of an anti-reformist candidate
Congress's current composition: (% of GDP) -0.5 -0.8 (Haddad, among others) winning are around
-1.3 -1.5 Geraldo Alckmin (PSDB): Born in 1952. Center. 25%, in our view.
The governor of São Paulo state, he emerged as
a strong potential candidate after not being - A true reformist (Alckmin) could have a
Budget balance
linked to the Lava Jato probe. better chance of being elected if the runoff is
(% of GDP)
-5.5 -5.0 between a reformist and a quasi-reformist. If
-9.0 -7.8
Senate Marina Silva (REDE): Born in 1960. Center-left. the second round boils down to a
'16 '17 '18E '19E Former senator and minister of the environment. competition between a quasi and an anti-
reformist, we believe the quasi-reformist will
Ciro Gomes (PDT): Born in 1957. Far-left. prevail.
Brazil's economy is in the midst of a long recovery that Former member of the Lower House.
started after former President Dilma Rousseff's - We maintain our view that the next
impeachment in 2016. The recession was deep and Henrique Meirelles (PSD): Born in 1945. president will advocated for the passage of
prolonged, and the recovery has been slower than Center. Current minister of finance and president the pension reform bill before the end of the
expected, with several bumps along the way. In May 2017, of the central bank. first half of 2019.
President Michel Temer's bribery tape crisis put an end to
Emerging market electoral monitor

Brazil discussions about social security reform; in May 2018, the
Lower
truckers' strike paralyzed the country for 11 days, and
Chamber
triggered a shock to confidence that froze investment
projects, slashing the economy's growth prospects.
Consequently, the GDP gap may some take years to be
bridged.
Fernando Haddad (PT): Born in 1963. Leftist. - We believe that market and economic
Former Mayor of São Paulo. Will become PT's uncertainty will stay high in Brazil in the
presidential nominee in case Lula's candidacy is coming months. The best investment strategy
denied by the Supreme Electoral Court. for now is to keep portfolios well diversified,
avoiding a strong concentration in any asset
Polling/Social media trends (below): class, and to stay patient until a clearer
According to the latest Datafolha survey, opportunity shows up.
Bolsonaro (22%) is leading the polls when Lula is
not considered. Marina Silva (16%) is a close
second, followed by Ciro (10%). Geraldo Alckmin
is next with 9%, followed by Haddad (4%).
Importantly, the number of undecided voters is
high, so the race is open.

Google search trends (with Lula) Google search trends (without Lula) Social media following

Facebook Likes Twitter Followers

Alckmin 0.9m 1m

Bolsonaro 5.6m 1.3m

Haddad 0.4m 0.6m

Marina Silva 2.3m 1.9m

Lula 3.7m 0.4m

Gomes 0.3m 0.2m

Source: Brazil – Brazilian Senate and Chamber of Deputies, Google, UBS. As of August 2018. Pictures: Wikipedia, Creative Commons. See Appendix for details.

UBS CIO GWM September 2018  13

Emerging Markets
publications

A monthly guide to investing in emerging market financial assets

Investing in emerging markets Monthly flagship White Papers

Investing in emerging markets Dissecting long-term trends in emerging
September 2018
Chief Investment Office GWM

Africa – Cradle
Investment Research

Including investment views across asset of Diversity market regions & countries
classes and regions UBS Chief Investment Office
Wealth Management white paper
Africa
5 September 2017

Cradle of Diversity
Russia
When the global meets the local Back at Global Center Stage
Equities: Credit: Currencies: Focus: Economy:
Latin America
Beyond peak trade
Mind the valuation Fork in the road, Shaky conditions, Turkey not out of Policy rate hikes
gap opportunities on long list of risks the woods yet; in crisis scenarios
the wayside contagion limited - How much is
nonetheless enough?

Middle East
Prosperity beyond oil
This report has been prepared by UBS AG, UBS Financial Services Inc. (UBS FS), and UBS Switzerland AG.
Please see important disclaimers and disclosures that begin on page 17.

Asset class publications Regional investment themes

Equities Long term investments (LTIs)
• EM Equity Monthly describing county preferences Thematic investments with a 5yr+ investment horizon

Currencies
• EM FX Monthly including currency preferences
• FX one-pagers (BRL, MXN, RUB, ZAR, TRY, CEE3, APAC)

UBS CIO GWM September 2018  14

Appendix
Photo Attribution

Page 1:
“Portrait of Luiz Inácio Lula da Silva” by Agência Brasil (Secretaria de Imprensa e Divulgação). is licensed
Luiz Inácio Lula da Silva:
under CC BY 3.0 br

“Federal Deputy Jair Bolsonaro in a public hearing at the Ethics Council of the Brazilian Chamber of Depu-
Jair Bolsonaro:
ties.” by Agência Brasil Fotografias is licensed under CC BY 2.0

“O governador de São Paulo Geraldo Alckmin em dezembro de 2016.” by Alexandre Carvalho is licensed
Geraldo Alckmin:
under CC BY 2.0

“Marina Silva na caminhada pela Praça da Estação, em Juiz de Fora (MG)” by msilvaonline is licensed under
Marina Silva:
CC BY 2.0

“O ministro, ex-governador do Ceará e deputado federal eleito Ciro Gomes.” by Roosewelt Pinheiro/ABr -
Ciro Gomes:
Agência Brasil is licensed under CC BY 3.0 br

“RIO DE JANEIRO/BRAZIL, 28APR11 - Henrique Meirelles, Adviser, Olympic Public Authority, Brazil” by World
Henrique Meirelles:
Economic Forum from Cologny, Switzerland is licensed under CC BY-SA 2.0

“Brasília- DF 27-10-2016 Fernando Haddad (PT/SP)” by Lula Marques/ Agência PT is licensed under CC BY-
Fernando Haddad
SA 2.0

UBS CIO GWM September 2018  15

Appendix
Non-Traditional Assets

Non-traditional asset classes are alternative investments that include hedge funds, private equity, real estate, and
managed futures (collectively, alternative investments). Interests of alternative investment funds are sold only to qualified
investors, and only by means of offering documents that include information about the risks, performance and expenses of alter-
native investment funds, and which clients are urged to read carefully before subscribing and retain. An investment in an alterna-
tive investment fund is speculative and involves significant risks. Specifically, these investments (1) are not mutual funds and are
not subject to the same regulatory requirements as mutual funds; (2) may have performance that is volatile, and investors may
lose all or a substantial amount of their investment; (3) may engage in leverage and other speculative investment practices that
may increase the risk of investment loss; (4) are long-term, illiquid investments, there is generally no secondary market for the
interests of a fund, and none is expected to develop; (5) interests of alternative investment funds typically will be illiquid and sub-
ject to restrictions on transfer; (6) may not be required to provide periodic pricing or valuation information to investors; (7) gener-
ally involve complex tax strategies and there may be delays in distributing tax information to investors; (8) are subject to high fees,
including management fees and other fees and expenses, all of which will reduce profits.

Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured
depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any
other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept
them for an extended period of time before making an investment in an alternative investment fund and should consider an alternative
investment fund as a supplement to an overall investment program.

In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these
strategies:

• Hedge Fund Risk: There are risks specifically associated with investing in hedge funds, which may include risks associated with
investing in short sales, options, small-cap stocks, “junk bonds,” derivatives, distressed securities, non-U.S. securities and illiquid
investments.
• Managed Futures: There are risks specifically associated with investing in managed futures programs. For example, not all managers
focus on all strategies at all times, and managed futures strategies may have material directional elements.
• Real Estate: There are risks specifically associated with investing in real estate products and real estate investment trusts. They involve
risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax, real
estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks associated with
the ability to qualify for favorable treatment under the federal tax laws.
• Private Equity: There are risks specifically associated with investing in private equity. Capital calls can be made on short notice, and
the failure to meet capital calls can result in significant adverse consequences including, but not limited to, a total loss of investment.
• Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of the United States should be aware that even for
securities denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer’s “home” currency can
have unexpected effects on the market value and liquidity of those securities. Those securities may also be affected by other risks
(such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.

UBS CIO GWM September 2018  16

Appendix
Research publications from Chief Investment Office Global Wealth Management, formerly known as CIO Wealth Management Research,
are published by UBS Global Wealth Management, a Business Division of UBS AG or an affiliate thereof (collectively, UBS). In certain
countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation
of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recom-
mendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific
recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that
you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the prod-
ucts mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unre-
stricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained
from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy
or completeness (other than disclosures relating to UBS). All information and opinions as well as any prices indicated are current only
as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those
expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment
decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opin-
ions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid
and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on infor-
mation barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affil-
iates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future perfor-
mance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you
invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an invest-
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Version as per April 2018.

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UBS CIO GWM  September 2018   17