EMEA Monthly:Diverging trends

Investor’s focus on bad EM vs good EM is particularly evident in EMEA: higher global commodity prices and G2 rates are supportive Russian assets and damaging for Turkey. CEE reflation story is emerging, but it is unwise to trade them as one country. Politics in the region will remain as important as macro.

    Data over the last few months support our better growth outlook for EMEA, as Russia exits recession and economic activity picks up in South Africa with commodities cycle. In CEE output gaps have largely closed and inflation is returning. Turkey faces headwinds from wavering monetary policy, higher energy prices, increasing cost of external financing, strained relations with the EU, and domestic politics.

    Divergent monetary policy as inflation decelerates in Russia and South Africa and picks up in Turkey and CEE due to rising energy costs, wage-cost pressures, and FX pass-through. Turkey is attempting to stall lira depreciation via ad-chock liquidity tightening, while avoiding significant policy rate hikes. In Russia a large rate-cutting cycle (250bps) is coming. In South Africa, we see shifts in SARB’s forecasts that make our call for rate cuts by mid-2017 more likely. Expect stable rates in CEE, but further unorthodox easing in Hungary and the Czech National Bank to exit the FX floor (in 3Q2017).

    Politics will dominate headlines, in Russia, we are hopeful for a partial lifting of US sanctions: “if Putin likes Trump, it is an asset” to quote president-elect Trump. Obama extended US sanctions beyond March 2017. European sanctions were extended to March and July 2017. EU-Turkey relationship will remain challenging, but US may pivot closer to Turkey. A referendum on executive presidency in Turkey is likely in 1H2017. In South Africa, ANC may consider extending presidential term as debate on President Zuma continues.

    We remain constructive on local rates. We expect high yielders to once again be the focus, supported by falling inflation and supportive CBs. In Russia, we take profit on 3Y XCCY receivers (close to target) but keep strong overweight on local bonds. We also expect South African bonds to rally- both with steepener bias. However, we remain on the sideline in Turkey for now. In Czech position into short-end payers, keep the steepener bias, but expect an outperformance in local bonds vs Bunds ahead of the FX floor removal. In Poland we see further room for the belly of the curve to rally while in Hungary the risk-premia remains too aggressive price which implies positioning for a flatter curve.

    In FX RUB is one of our top longs, ZAR is a fledgling positive story. We like buying the rand against the EUR and TRY. In the low yielders, we like selling 9m EURCZK forwards, as evidence of reflation in Czech Republic is building - we expect a removal of the FX floor by Q3 at the latest. We also favour HUF over PLN, as political concerns linger in Poland.

    In Sovereign credit our key overweights are Russia and South Africa, which is priced for a downgrade to high-yield we expect it to avoid. Medium-term, we also think there is an underappreciated path for Russia to return to IG in 2017 via an S&P upgrade. We are underweight CEE on tight valuation vs growing European risks.