Outlook 2012: European economic crisis will continue to affect trading for EM assets

By Christine Van Dusen

Atlanta, Dec. 30 - Secondary market activity for 2011 can, perhaps, be summed up in one phrase, uttered by a London-based trader: "It's been a year in which hope has triumphed over reality." For 2012, investors are expected to a take a much more realistic stance, closely watching the European economic situation and scrutinizing positions.

"EM equity investors will be happy to forget 2011, with typical losses in the BRICS of 20%, versus just 2% to 10% losses in United States and United Kingdom equity markets," the trader said. "But EM debt, while far from enjoying a stellar year, has at least outperformed many other credit indices by 15% to 20%."

The year began on a positive note, with inflows into dedicated EM bond funds, but faltered after the start of the Arab Spring and the earthquake in Japan.

"The 30 bps to 50bps of widening that followed would only serve as a precursor of what was to come," he said. "The optimism of the first quarter was to be undone by Greece and the resulting euro contagion."

In the thick of the European financial crisis, emerging markets assets - which for a long time had been viewed as something of a safe haven - took a hit, he said.

"For EM it meant that no matter how strong the fundamentals, there is a limit to how much you can outperform when all around you is falling apart," the trader said.

Returns for emerging markets fixed income, overall, are expected to reach 5% to 8% in 2012, according to a report from JPMorgan.

Asia's high-grade corporates should see excess return of 450 basis points to 500 bps, according to Barclays Capital Markets. Asia's high-yield corporates should see 13% to 15% total return, and Latin America and emerging Europe, Middle East and Asia should see returns of 6% to 8%.

"As in 2011, the greatest threat to emerging markets is external," Barclays Capital said in a report. "Our primary concern today is that the European crisis intensifies. Worryingly, credit concerns have now infected the European core and the IMF is under-resourced to provide a liquidity backstop on its own."

Overall, the JPMorgan Corporate Emerging Markets Bond Index spread is expected to widen during the first three months of 2012.

"A rally ... is entirely possible, in our view, but requires a workable solution for Europe, which can hopefully be found within the first quarter of 2012," JPMorgan said in another report.

Corporates in focus

For the corporate side, returns are expected to be front-loaded into the first quarter of 2012.

"Performance during this period should be driven by spreads recoupling with fundamentals, investors deploying excess cash, U.S. economic data staying resilient despite the global slowdown and progress being made toward a liquidity backstop for peripheral sovereigns," Barclays said.

"Performance could deteriorate thereafter if the European slowdown spreads further into EM and the U.S., credit availability continues to contract, fundamentals begin to deteriorate and investors' excess cash is depleted."

Emerging markets are better poised than developed markets to weather the continuing storm.

"However, most of this strength is already priced in, and the secular improvement that has underpinned EM so far has slowed," the report said. "Moreover, the outlook is fraught with tail risk, and emerging market assets fare poorly when tail risks crystallize."

Sovereign debt eyed

For 2011, emerging markets sovereign debt was a top performer, JPMorgan said.

And Middle Eastern and North African sovereigns were particular standouts, a trader said.

"They've shrugged off the Japanese earthquake and are trying to shrug off the chaos unfolding in Europe," he said. "Ultimately, ratings-wide, debt matrices-wise, location-wise and with local banks still pretty much flush with cash and proving a solid backstop bid for paper, the market for the most part is closing the year in fair shape."

Still, the year did see some casualties from the region, including Dar al-Arkan and Kuwait's Kipco, he said.

Corporate spreads widened

Meanwhile, corporate spreads widened by almost 250 bps, from 300 bps at the start of January to 540 bps in December, Barclays said.

"A quarter of this widening took place in the first half of the year, a period in which U.S. markets were stable but EM corporates underperformed both U.S. markets and EM sovereigns," the report said. "The bulk of the widening took place during the global selloff that began in August, after the U.S. downgrade, the Japanese earthquake's disruption to global supply chains filtered into the economic data, and further deterioration in Europe."

During that time, EM corporates performed in line with sovereigns and underperformed modestly against U.S. corporates, Barclays said. "We believe much of this was due to the lower liquidity and higher beta of the EM asset class."

Russian oil, gas bonds favored

Sector-wise, Russia's oil and gas names ended 2011 with good liquidity and low leverage. Going forward in 2012, those bonds will be in focus.

"High prices should keep cash flows large enough to cover planned capital expenditures," Barclays said. "Our favored names are Gazprom and Lukoil, which have the strongest liquidity in the sector. In this sector, we also like Qatar corporates and Dolphin Energy paper as fundamentally strong, defensive credits."

Other corporate bonds that are favored for 2012 include Indonesia's coal mining companies, Korea's policy banks, Russia's telecommunications companies and Brazil's largest banks, Barclays Capital said.

Banks could underperform

JPMorgan is recommending a neutral position on Russian banks and underweight on most Kazakhstan banks for 2012.

The future is cloudier for Turkey's banks, Barclays Capital said, due to expected price volatility. Brazilian pulp companies are also facing adversity, with significant selling that is not expected to subside in 2012. And Dubai, which is in better shape than in 2009, could be vulnerable.

"Given the high level of global uncertainty and the region's still-significant financing needs and dependence on commodity prices, we do not think that the Emirate is immune to global risks and we prefer higher-quality credits, as well as specific short-dated high-yield names," Barclays said.

Volatility will continue

The market should expect to see increased scrutiny of positions, tighter holding positions, more regulations, more political involvement and fewer traders taking positions, a trader said.

"Of course not everything will sell," he said. "Not every name or credit can say, 'I will issue a sukuk and it will fly off the shelves. There are no more free lunches and lay-ups in this market anymore.

"It's going to remain thin and whippy and fickle. It's going to be quite volatile. A bit more of the bid-offer spread will be back," he said. "Of course, huge opportunities and times of very good value will appear."

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