Capital Markets Monitor

Capital Markets Monitor FEBRUARY 2015 CONSEQUENCES OF CENTRAL BANKS’ “EASING WARS” ■ ■ ■ The ECB announcement of a comprehensive QE program has br...
4 downloads 0 Views 2MB Size
Capital Markets Monitor FEBRUARY 2015

CONSEQUENCES OF CENTRAL BANKS’ “EASING WARS” ■





The ECB announcement of a comprehensive QE program has brought to the fore the challenges posed by the ECB and BoJ easing moves. Other countries will either need to match these easing measures, or see their currencies strengthen against the euro and yen. On the heels of QE (v. 1.0) driven by the Fed and BoE, this fresh wave of QE (v. 2.0) will prolong a world of plentiful liquidity and zero/negative interest rates —more than six years after the financial crisis. Such a sustained period of extraordinarily accommodative monetary conditions—which can be justified as necessary to support the economic recovery—will also have important consequences which are now becoming evident. Specifically, divergence in G4 monetary policies has already heightened uncertainty and market volatility. Such uncertainty and volatility is likely to persist, if not increase, given that political tensions (Russia/Ukraine, Greece etc...) are also on the rise.

The Capital Markets Monitor and other IIF publications are available on the Institute’s website: http://www.iif.com Questions or comments regarding this publication may be addressed to:

Hung Tran Executive Managing Director 1-202-682-7449 [email protected]

Sonja Gibbs Director, CEM 1-202-857-3325 [email protected]

Paul Ticu Deputy Director, CEM 1-202-857-3301 [email protected]

Zeynep Elif Aksoy Senior Financial Economist 1-202-857-3647 [email protected]

Key issues of the month ............................................................................... 2 Special Feature I: Secondary bond market liquidity—warnings signals........ 6 Special Feature II: Asian frontier capital market development ..................... 8 Special Feature III: Tracking the U.S. dollar-funded carry trade ................... 9 Special Feature IV: Financing for SMEs in Europe remains constrained ..... 10 Asset performance in perspective .............................................................. 11

Emre Tiftik Financial Economist 1-202-857-3321 [email protected]

Fiona Nguyen Senior Research Analyst 1-202-682-7443 [email protected]

Asset management corner ......................................................................... 12 Sovereign debt markets ............................................................................. 13 Bank health monitor ................................................................................... 14 Credit markets ........................................................................................... 16 Issuance ..................................................................................................... 17 Emerging markets ...................................................................................... 18 Equity markets ........................................................................................... 19 Currencies .................................................................................................. 20 Commodities ............................................................................................. 21 Mutual fund flows ...................................................................................... 22

Data cutoff date: February 2, 2015 iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

page 2

CAPITAL MARKETS MONITOR | February 2015

The ECB announcement of a comprehensive QE program has brought to the fore the challenges posed by the ECB and BoJ easing moves. Other countries will either need to match these easing measures, or see their currencies strengthen against the euro and yen. On the heels of QE (v. 1.0) driven by the Fed and BoE, this fresh wave of QE (v. 2.0) will prolong a world of plentiful liquidity and zero/negative interest rates —more than six years after the financial crisis. Such a sustained period of extraordinarily accommodative monetary conditions—which can be justified as necessary to support the economic recovery—will also have important consequences which are now becoming evident. Specifically, divergence in G4 monetary policies (Chart 1) has already heightened uncertainty and market volatility (Chart 2). Such uncertainty and volatility is likely to persist, if not increase, given that political tensions (Russia/Ukraine, Greece etc...) are also on the rise. NEGATIVE NOMINAL INTEREST RATES As expected, the key instrument and channel of transmission of extraordinary monetary accommodation has been interest rates—-all along the yield curve. Indeed, government bond yields in major countries have fallen irregularly over the past six years to record lows in many cases (Chart 3). Even in the U.S.—where the Fed had ended QE3 last October and is contemplating hiking the Fed funds rate target later this year, —10yr Treasury yields have declined to within 30bp of the alltime record lows seen in July 2012. Indeed, G3 government bond yields have been negative in real terms for sustained periods over the past few years, and remain near -2% in Japan (Chart 4, next page). What is unprecedented is the growing number of countries where nominal interest rates have become negative as well. At present, the ECB, SNB and Danish central banks have adopted negative deposit rates of -20 to -50 basis points, usually above certain thresholds. More significantly, government bonds in a number of countries, with maturities above 1 year, have traded at negative nominal yields (Chart 5, next page). As of last week, an estimated $3.6 trillion of government bonds (or 16% of the JP Morgan Global Bond Index) traded at negative yields. These include government bonds of a number of Euro Area governments ($1.7 trillion), where weighted average yields are negative out to 6yr maturities, Japan ($1.8 trillion—these yields have fluctuated around zero) and smaller amounts from Switzerland, Denmark and Sweden. A sustained period of ultra-low and even negative interest rates would lead to distortions in the financial system—many of which may be hidden today, but could accumulate and pose a significant financial stability risk the longer low rates iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

1

Total Assets of G4 Central Banks percent of GDP 65 BoJ 60 Fed 55 BoE 50 ECB 45 40 35 30 25 20 15 10 5 0 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: Fed, BoJ, BoE, ECB, IIF.

2

Asset Price Volatility index, rebased 1/1/2009=100 160

Interest rates

140

FX

120

Commodities

Equity

100 80

60 40 20 0 2009

2010

2011

2012

2013

2014

2015

Source: Bloomberg, IIF.

3

G3: 10-Year Government Bond Yields percent 9 8 7 6

5

G

4

U.S.

3 2

Germany Japan

1 0 1990

1995

Source: Bloomberg, IIF.

2000

2005

2010

2015

page 3

CAPITAL MARKETS MONITOR | February 2015

persist. Firstly, the "risk free" rates serve as the foundation and benchmark for calculating and assessing risks in financial and investment transactions. Zero or negative "risk free" rates undermine this foundation and could lead to miscalculation and mispricing of risk (discussed further below). Secondly, low rates significantly reduce income on pension savings, boosting the present cost of pension liabilities, thus widening the already-substantial funding gaps at almost all defined benefit pension funds (Chart 6). As baby boomers increasingly join the ranks of the retired, and given the context of strained public finances and under-saving by the household sector, this situation will soon pose a serious public policy challenge. In the meantime, it may lead consumers to attempt to save more for their old age, adding another headwind to sustained consumption growth. Another factor driving interest rates lower has been investor fear of deflation. Leaving aside the effect of collapsing oil prices, or hikes in sales tax in the case of Japan, inflation rates have remained well below policy targets in the U.S., Europe and Japan. In fact, Euro Area (and U.S./UK) inflation expectations as measured by 5 year-5 year forward rates are lower today than when ECB President Draghi mentioned this rate to lay the groundwork for QE (Chart 7, next page). And in the U.S., the Fed's preferred measure, the Personal Consumer Expenditures Index, increased by just 0.7% yoy in December, the smallest increase since 2009 when the Fed started the first of the QE programs. Against the background of low inflation and low interest rates, some green shoots may begin to emerge. In December, bank lending to the private sector in the Euro Area is finally back in positive territory (though just +0.1% adjusted for sales and securitization), after falling for nearly three years. In addition, corporate bond issuance has reached records, averaging over €1 trillion a year in the past three years, offsetting to some extent the decline in bank lending. Hopefully, the ECB QE program can nurture those green shoots going forward so that growth and inflation will be revived. CURRENCY GYRATIONS Another key transmission channel for central bank easing is through exchange rates. Indeed, since the BoJ and more recently the ECB began to discuss QE in earnest (in late 2012 and November 2014 respectively), the yen and Euro have weakened by 40% and 10% respectively versus the USD. Thus far, exchange rate movements against the USD have been deemed orderly and within the remit of monetary policy aiming to address domestic concerns (fighting deflation risk and reviving growth). However if the U.S. begins to experience a negative impact from adverse currency movements in its net trade position, damaging U.S. growth (as was the case in Q4 iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

4

G3: Real 10yr Government Bond Yields percent 6 5 Germany 4 3 2 1 0 -1 Japan -2 -3 -4 1995 2000 2005

U.S.

2010

2015

Source: Bloomberg, IIF

5

Selected Countries: 2year Government Bond Yields percent 2.0 Switzerland France

1.5

Germany

1.0

Japan

0.5

0.0 -0.5 -1.0 2010

2011

2012

2013

2014

2015

2006

2009

2012

Source: Bloomberg

6

Gap in U.S. State Pension Funds $ trillions 3.2 3.0 2.8 Liabilities 2.6 Assets 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 1997 2000 2003

Source: The Pew Charitable Trusts

page 4

CAPITAL MARKETS MONITOR | February 2015

2014, when net trade siphoned off a full percentage point from GDP growth), there would be more pushback against the exchange rate implications of monetary policy measures. So far, this pushback has taken the form of asking the governments concerned to use other policy tools (fiscal and structural) to alleviate reliance on monetary policy to promote growth, but criticism could become more pointed in the future. If this were to materialize, it would further elevate uncertainty. Besides the U.S., many other countries have experienced upward pressure on their currencies from the weakening euro and yen. Last month, the SNB decided not to maintain the cap of CHF1.20 against the Euro, fearing inappropriately loose monetary conditions domestically as well as potential valuation losses on its almost half a trillion euro reserves. The Swiss franc shot up by 40% within hours before settling down to be more than 20% stronger than before—causing significant financial losses and a strong headwind against the Swiss economy. Denmark also felt the pressure on its krone peg against the euro. This has led its central bank to ease further, including reducing its already-negative deposit rate to -50 basis points to defend the peg—but pressure appears to continue. Currency pressure has also been building up in Asia. Over the past 3 years, the South Korean won has strengthened by about 60% against the yen (Chart 8), with other EM Asian currencies also under upward pressure. With GDP slowing to 0.4% qoq in Q4 2014 from 0.9% in Q3 2014, and core inflation falling well below 2%, it is likely that Korea will have to ease monetary policy more aggressively than the moderate pace seen in 2014. (See our recent research note for further analysis). China has experienced a similarly strong appreciation of the RMB vs the yen during the same period. As the Chinese economy slows—with the official PMI posting 49.8 in February—a further strengthening of the RMB against the yen would add pressure for more monetary easing in China in the foreseeable future. The case for easing would be stronger if the PBOC continues to abstain from accumulating FX reserves—as evidenced by the decline of China's reserves by $150 billion in the past two quarters. Much of the decline could have been the valuation effect of USD strengthening against the Euro and yen—but it's clear that the PBOC had not accumulated FX reserves in the face of large current account surplus in the same period. In addition to the overall economic impact, gyrations in major exchange rates could have implications for financial stability. Volatility in FX markets has increased significantly from very low levels just six months ago (Chart 9). More specifically, a strengthening and volatile USD could trigger an unwinding of the huge amount of USD-based carry trades that have been accumulated in recent years. We've estimated the volume of such carry trades to be some $9 trillion (Chart 10) — iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

7

G4: 5y-5y Forward Rates percent 5.0 USD GBP 4.5 EUR JPY 4.0 3.5

3.0 2.5 2.0 1.5

1.0 0.5 Jan 12

Jul 12

Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

Source: .Bloomberg

8

Asian Currencies: Exchange Rates vs. the Japanese Yen index, 1/1/2012 = 100; up = appreciation 160 150

Chinese yuan Korean won Malaysian ringgit Thai baht

140 130 120 110 100 2012

2013

2014

2015

Source: Bloomberg

9

Currency Market Volatility: G7 and Emerging Markets percent 12 Emerging markets G7 11 10 9 8 7 6 5 Jan 13

Source: Bloomberg.

Jul 13

Jan 14

Jul 14

Jan 15

page 5

CAPITAL MARKETS MONITOR | February 2015

and the possible unwinding of carry trades could lead to disorderly market conditions, given the fact that secondary market liquidity has deteriorated noticeably in recent years (see Special Features I and III).

10

ASSET VALUATION Perhaps the most important channel of transmission of extraordinary monetary policy has been via lifting asset values, both through the liquidity effect and by lowering the rates used to discount future streams of earnings. Indeed, since the Fed began to embark on the first round of QE, the U.S. equity market as measured by the S&P500 has gained over 200%. European equities, which lagged the U.S. during the Fed’s QE programs, have surged nearly 10% just since early November when the ECB began to seriously prepare for QE (Chart 11). The run-up in asset values—not only in equities—has contributed to economic activity through the wealth effect. However, it is questionable whether such wealth effects can be relied on to underpin sustained and broadly-based growth in consumption, as assets have been distributed unevenly and concentrated in a small percentage of households. Continued monetary accommodation is thus needed to support buoyant asset markets, which in turn can promote growth. However, this chain of logic cannot be sustainable—the longer monetary accommodation is deployed, the more asset prices can become overvalued and vulnerable to correction. For the S&P500, for example, the Shiller cyclically adjusted price-earnings ratio, or CAPE, has reached a multi-year high of 26.8—quite lofty compared with the historical average of 16.5 (Chart 12). While less than the record high P/E ratio of 44.2 just before the bursting of the dotcom stock bubble in 2000, the current P/E ratio is higher than many previous interim peaks which preceded substantial market corrections. In addition, the asset gap between asset valuation and underlying growth continues to widen, implying that the need for "reconciliation" is becoming more pressing. TIME FOR “RECONCILIATION”? To sum up, extraordinary monetary accommodation is still needed to revive persistently low growth and low/negative inflation. However, the longer this goes on, the more asset prices become over-valued, vulnerable to correction. In contrast to “QE v.1.0” when market volatility had been kept at record low levels, under “QE v.2.0,” volatility has broken out...first in FX markets then spreading to other financial markets. This reflects investor concern about rising market risk, as shown by our U.S. Market Risk Index for some time now. This means the time for "reconciliation" of the asset gap is getting shorter. We had better see the green shoots of recovery and inflation soon! iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Carry Trade: USD Credit to Non-banks Outside the U.S. $ trillion, outstanding stock 10 9 Bonds issued by non-banks 8 Bank loans to non-banks 7 6 5 4 3 2 1 0 2002 2004 2006 2008 2010 2012 2014

Source: BIS, IIF estimates.

11

U.S. and Euro Area Equity Market Performance index, rebased 11/1/2008 = 100, local currency terms 205 U.S.

185

Euro Area

165 145 125 105 85 65 2009

2010

2011

2012

2013

2014

2015

Source: Bloomberg.

12

U.S. Cyclically-Adjusted PE Ratio (CAPE) ratio of real equity prices to real earnings, dotted line= LT avg 45 40 35 30

25 20 15 10 1990

1994

1998

2002

2006

2010

2014

Source: http://www.econ.yale.edu/~shiller/data.htm Long-term average taken from Shiller’s calculations for the life of the index (1880-present).

Paul Ticu 1-202-857-3301 [email protected]

CAPITAL MARKETS MONITOR | February 2015

page 6

A number of metrics suggest further deterioration in secondary bond market liquidity As part of our ongoing assessment of secondary bond market liquidity (see the July-August and November 2014 Capital Markets Monitors) we pointed out that secondary bond market liquidity conditions in both mature and emerging markets have been showing signs of impairment. This note takes a fresh look at the evolution of liquidity metrics in light of recent central bank actions and market developments.

1

However, the co-movement of the bid-ask spread with the CBOE Volatility Index (VIX) suggests that both indicators are driven by risk aversion—and both could be equally jumpy in the face of market turbulence. If volatility were to spike, the bid -ask spread could widen to problematic levels. Another liquidity metric—the average number of trades per month (Chart 2) has declined over the past year, by approximately 5% from about 900,000 to 850,000. Over the past two years, average daily trading volume decreased from over $900 billion/day to under $700 billion per day—a decline of some 20% in trading activity.

The decline in net primary dealer positions has taken place broadly over the same period as a marked drop in the Citigroup market liquidity index, which takes several fixed income market segments into consideration (including credit default swaps, Treasury bond futures, interest rate swaps and swaptions). This index has been on a downtrend since 2012—a clear reflection of deteriorating liquidity conditions. Another illustration of the connection between the activities of primary dealers and prevailing levels of risk aversion can be seen in Chart 4 (next page): during the recent turbulence in equity markets, with the VIX rising by some 50% between early October 2014 and mid-January, primary dealer inventories of riskier high-yield corporate bonds dropped by 60%, while iniif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

7.5

21 19

7.0

17 15

6.5

13

11

6.0

9 7 Jan 14

Apr 14

Jul 14

Oct 14

Jan 15

5.5

Source: MarketAxess, Bloomberg, IIF.

2

Total FINRA TRACE Bond Trades vs. Avg. Daily Volume trades per month, 000s avg daily trading volume, $ billion 1020 1000 Total trades Avg. daily vol. (rhs) 980 950

940

900

900

850

860

800

820

750

780

700

740 Jan 13

REDUCED DEALER POSITIONS Net primary dealer positions in U.S. government securities have fallen from about $125 billion as of January 2013 to under $15 billion at present (Chart 3). While a reduction in net positions dealer inventories can be explained in part by the expectation of rising interest rates, it is also indicative of increased dealer risk aversion during market downturns.

MarketAxess BASI (rhs)

23

WIDER BID-ASK SPREADS, LOWER TRADING VOLUMES Taken together, recent movements in a number of liquidity metrics reveal a degree of deterioration: since mid-2014 the average bid-ask spread for corporate bonds (Chart 1) has been rising in tandem with the turnaround in volatility (about 20% above summer 2014 levels). Under normal market conditions, a wider bid-ask spread could be in fact a positive factor, as it increases dealer profitability and could lead to improved liquidity conditions.

U.S. Corporate Bid-Ask Spread (BASI) vs. Market Volatility VIX, percent BASI bid-ask-spread , bps 27 8.0 VIX 25

Jul 13

Jan 14

Jul 14

650 Jan 15

Source: FINRA, IIF.

3

Net Primary Dealer Positions in U.S. Gov't Securities vs. Citi U.S. Market Liquidity Index net positions, $ billion index Net positions 175 0.9 Liquidity index (rhs) 150 0.7 125 0.5 100 75 0.3 50 0.1 25 0 -0.1 -25 -0.3 -50 -75 -0.5 2010 2011 2012 2013 2014 2015

Source: Bloomberg, IIF.

Paul Ticu 1-202-857-3301 [email protected]

CAPITAL MARKETS MONITOR | February 2015

page 7

Greater use of electronic trading platforms could help, but would require changes in market structure ventories of less-risky investment grade corporate bonds fell much less.

4

The problem does not appear to be limited to the U.S.—Chart 5 shows that the average bid-ask spread on mature market 10yr government bond futures—arguably some of the most liquid instruments in the world—has increased by one full basis point in recent months. In emerging markets (excluding Russia/ Ukraine as outliers), average bid-ask spreads have been at elevated levels since 2012. More striking still is the increase in spread volatility over the past year—this jumped by almost 70%

20 15 15 10 10 5

GREATER USE OF ELECTRONIC TRADING COULD HELP LIQUIDITY To the extent that deterioration in secondary bond market liquidity is attributable to dealer retrenchment, this could potentially be mitigated by greater use of electronic trading platforms. These are an alternative to the traditional voice-based dealer transaction model, but are still in very early stages of development. Electronic equity trading is order-driven, whereby a central limit order book facilitates matching of buy and sell orders. However, electronic trading in bonds is not orderdriven; instead, it relies on the “request for quote” model, whereby an interested trader signals willingness to buy or sell and asks for a price.

Primary Dealer Inventories of Corporate Bonds vs. VIX $ billion CBOE VIX High Yield 25 30 Investment Grade VIX (rhs) 25 20

0 May 13

5 Sep 13

Jan 14

May 14

Sep 14

0

Jan 15

Source: New York Fed, Bloomberg, IIF. Inventories are of bonds with maturities greater than one year.

5

Average Mature Market Bond Futures Bid-Ask Spread bps, 30-day rolling average 3.0 Mature market bid-ask spread 2.5 Average since 2000 Average since 2010

2.0 1.5 1.0

While this type of trading works well for standardized products, such as Treasuries, the diversity and variability of corporate bonds creates a barrier to electronic trading and precludes a more efficient order-driven environment. According to research from McKinsey and Greenwich Associates, MarketAxess and Bloomberg dominate electronic trading in bonds. Single-dealer platforms such as Aladdin (Blackrock), GSessions (Goldman), BondPool and others have only approximately 1% of market share and transactions larger than $250,000 remain dominated by traditional voice brokering. Blackrock recently published a paper calling for standardization in corporate bond markets—a much needed step if electronic trading is to gain market share. Greenwich analysts point out that asset managers expect the status quo to continue, with the majority expecting multidealer platforms such as Bloomberg and MarketAxess to continue growing. In sum, there are notable indications that secondary bond market liquidity has been experiencing stress across various metrics, not just in the U.S. but globally. While the strain on overall market liquidity as U.S. interest rates normalize may be offset to some degree by easier monetary policy from the ECB and BoJ, it remains to be seen whether secondary bond market liquidity will be sufficient to handle potential market corrections, particularly after years of largely one-way flows into bond markets. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

0.5 0.0 -0.5 2011

2012

2013

2014

2015

Source: Bloomberg, IIF. Avg of 10-Year futures for U.S., Canada, Germany, France, Sweden, U.K., Switzerland, Japan, Australia, Korea.

6

Bid-Ask Spreads for EM Local Currency Gov't Bond Yields 30 day moving avg. bid-ask, bps spread volatility, % 10 25 9

Bid-ask spread

8 7

20 Spread volatility (rhs)

6

15

5 4

10

3 2

5

1 0 2005

2007

2009

2011

2013

2015

Source: Bloomberg, IIF. Countries: Brazil, Bulgaria, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Israel, Korea, Lithuania, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Romania, South Africa, Taiwan Province of China, Thailand, Turkey.

0

Zeynep Elif Aksoy 1-202-857-3647 [email protected]

CAPITAL MARKETS MONITOR | February 2015

page 8

Rapid growth—but Asian frontier markets are still very underdeveloped relative to regional peers Frontier capital markets in Asia—which we define as Pakistan, Sri Lanka, Vietnam, Bangladesh, Mongolia, and Myanmar)— have been developing very fast albeit from low bases. EQUITY MARKETS GROWING FAST BUT LIQUIDITY STILL A CONCERN Taking a long view, equity trading in frontier Asia dates back to 1890 when the first stock exchange was established in Sri Lanka, followed by Bangladesh and Pakistan in the 1950s. Myanmar is expected to open its first stock exchange this October. Over the past decade, Asian frontier equity markets have seen rapid growth in market capitalization with the exception of Mongolia. While average equity market capitalization increased from 15% of GDP in 2005 to more than 22% in 2014, frontier equity markets still have a long way to catch up with their regional emerging and developed counterparts, where average equity market capitalization is almost 100% of GDP (Chart 1). While liquidity remains a concern, many Asian frontier governments have been undertaking reforms to their financial regulatory frameworks to attract foreign investors and increase liquidity.

1

Asian Equity Market Capitalization percent of GDP 200 180 160 140 120 100 80 60 40 20 0

2014

SG MY TH JP PH KO IN ID CN SL PK VN BD MO

Source: ADB, Bloomberg, IMF, WB, national stock exchanges, IIF.

2

Asian Domestic Local Currency Bond Market Size percent of GDP 180

LOCAL CURRENCY CORPORATE BOND MARKETS—STILL IN THEIR INFANCY

160

Asian frontier domestic local currency bond markets remain very underdeveloped (except in Sri Lanka where the market is about 35% of GDP—on a par with China and the Philippines). This is particularly true relative to the growth of their economies: for example, the Sri Lankan domestic bond market has grown almost 50% since 2005, but GDP has grown at an average annual pace of more than 15%. Other Asian frontier bond markets have grown on average from about 6% to around 16% of GDP since 2005 (Chart 2). However, domestic corporate bond markets remain virtually non-existent, less than 5% of GDP for these countries, with Sri Lanka again being the leader. Moreover, even for sovereign bonds, secondary market trading remains non-existent.

120

Excepting Bangladesh and Myanmar, Asian frontier governments have been able to access international markets—though infrequently. Sri Lanka has been the most active issuer, with $1 -2bn per year since 2009. Several Asian Frontier corporates have also issued a few Eurobonds in recent years.

2005

140

2005 2014

100 80

60 40 20

0

JP KO MA HK TH SG CN SL PH PK VN ID BD MO

Source: ADB, IMF, WB, Thomson One, Dealogic, national central banks, Bloomberg, IIF.

Asian Bank Assets percent of GDP

3 300

2005

250

2014

200

SOME HAVE SIZABLE BANKING SYSTEMS Some Asian frontier countries have sizable banking systems relative to the size of their economies (around or over 100% of GDP in Vietnam and Mongolia—Chart 3). Bank loan growth has been generally been slowing in recent years after a period of very strong loan growth (except in Mongolia where bank loans are still growing at double-digit rates due to a policydriven loan boom). In the wake of this rapid credit growth, some banking systems, including in Bangladesh, Mongolia, and Pakistan have high NPL ratios (8-15%). iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

150 100 50 0

JP KO MO TH CN VN MO PH IN SL BD ID PK MY

Source: IMF, national central banks, IIF.

Emre Tiftik 1-202-857-3321 [email protected]

CAPITAL MARKETS MONITOR | February 2015

page 9

PERSISTENT RISE IN USD-FUNDED CARRY TRADES, BUT... Fueled by the Fed’s accommodative policies, low exchange rate volatility and persistent interest rate differentials between the U.S. and many other countries, USD-funded carry trade activity have seen a sharp rise over the past 7 years. While tracking of carry trade positions at a high frequency presents a significant challenge, as it requires detailed and timely data on investors’ positions, the BIS measure of carry trade based on BIS banking and debt securities statistics suggests that the size of the USD-funded carry trade market has more than doubled since 2008, standing at over $9 trillion as of September 2014 (Chart 1). Notably, much of this surge has been due to robust bond issuance in U.S. dollars outside the U.S., particularly in emerging markets. ...THE ATTRACTIVENESS OF USD AS A FUNDING CURRENCY IS WANING Carry trade positions are typically highly leveraged strategies which involve borrowing in low-interest rate currencies and investing in higher-yielding assets in other currencies. Given that the profitability of these positions is quite sensitive to exchange rate movements and returns from the interest rate differential, sharp changes in monetary policy expectations could lead to a disorderly unwinding of carry trade positions, particularly during periods of financial stress. Although this has not been the case thus far, the increasing divergence in the monetary policies of the Fed and the ECB (and to a lesser extent the BoJ) has significantly reduced the attractiveness of USD-funded carry trades since late August (Chart 2). The decline in carry-to-risk ratios—an ex-ante measure of the profitability of carry trades—has been particularly significant against the major mature market currencies (Chart 3). Data on net positions of non-commercial traders in FX futures also suggest that the dollar is becoming a target currency— after having been perceived as a funding currency for many years. Indeed, large speculators are now heavily net long in the U.S. dollar against almost all major currencies. (Chart 5 page 20). The marked shift in ETF investors’ allocations towards U.S. equities and bonds over the past few months is another metric pointing to the rising role of the U.S. dollar as a target currency (see our new report on Trends in Investment Fund Portfolio Allocation for further discussion). Going forward, the demand for USD-funded carry trade is set to continue to diminish, as the strength of the dollar is likely reduce many emerging market companies’ appetite for borrowing in USD. A faster pace of Fed rate hikes than currently reflected in market pricing could indeed lead to a disorderly reversal of the USD carry trade, with significant implications for global financial markets. On the other hand, euro carry trades are likely to become more attractive as the ECB is set to provide more liquidity to the markets via its sovereign-debt based QE program. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

1

U.S. Dollar Credit to Non-banks Outside the U.S. $ trillion, outstanding stock percent Bonds issued by non-banks 10 35 Bank loans to non-banks 9 30 %Chg oya (rhs) 8 25 7 20 6 5 15 4 10 3 5 2 0 1 0 -5 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Source: BIS, IIF estimates.

2

Returns on USD-Funded Carry Trade index, end-2000=100 (both scale)

reversed scale

210

70 75

190

80

170

85

150

90

Stronger USD

95

130

100

90

105

USD-funded carry trade returns

110

110

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

115

So urce: Bloomberg carry return indices, IIF calculations..

3

Carry-to-Risk Ratio ratio, USD financed carry trade 0.5 August 2014

0.4

February 2015 0.3 0.2 0.1

0.0

NZD

AUD

Source: Bloomberg, IIF estimates..

NOK

CAD

GBP

Thousands

By some estimates, U.S. dollar denominated carry trade positioning stands at over $9 trillion

Jessica Stallings 1-202-857-3333 [email protected]

CAPITAL MARKETS MONITOR | February 2015

page 10

New lending continues to decline from pre-crisis peaks, and equity financing is limited As the ECB launches sovereign debt-based QE in an effort to alleviate disinflationary pressure and support growth, lending to SMEs in Europe continues to decline from pre-crisis peaks, albeit at a slower pace and with differentiation among countries. Looking at the periphery countries in 2014, there were signs of improvement in Spain, where economic recovery is taking hold, and a slight uptick in Italy, based on 12-month cumulative flows (Chart 1). In Greece and Cyprus, where liquidity pressures remain acute and credit quality has significantly deteriorated, new lending to SMEs continues to decline sharply. Data from national central banks on outstanding loans to SMEs indicate a decline in stock of 25% in both Ireland and Portugal since the start of 2010, while in France, loans increased by over 5% from 2012Q1.1 Outside the Euro Area, new loans to SMEs in the UK increased by 25% in 2014 compared with 2013, although in net terms, the stock of loans fell slightly as repayments remained larger than new lending. 2 Interest rates on new loans to businesses up to €1 million have generally declined since the start of 2014, and spreads between core and periphery countries have narrowed (Chart 2). However, it remains likely that interest rates on new loans are higher than those reported by the central banks, which may be due to differences between offered rates versus those taken up, short-term versus long-term maturities, the percentage of loans covered by guarantees, and a compression in credit spreads between stronger and weaker quality credits (see the IIF-Bain report on SME financing). In some countries, there is high competition for lending to healthy, growing SMEs, particularly exporters, and banks report receiving little margin on these loans. Ireland’s increasing rates, by contrast, may suggest a strengthening market, as the rise in rates may partially reflect a normalization of risk pricing. Improving access to finance for Europe’s SMEs—which are traditionally quite dependent on banks as their main source of financing—requires broadening sources of funding, especially to include equity finance. Many high growth SMEs, which have the potential to create jobs and fuel economic growth, are too small to access public markets or attract private equity investment. Already-low levels of venture capital and private equity investments fell even further during the crisis (Chart 3), and while some promising public sector initiatives have been launched, a significant gap remains. Banks would be better positioned to offer credit to those SMEs who were able to raise new equity through alternative financing. More broadly, adequate access to both debt and equity financing would help enable Europe’s SMEs to grow to their potential or to restructure as necessary. 1. Based on the European Commission definition of SMEs as having less than 250 employees and either up to €50 million turnover or a balance sheet total of up to €43 million. 2. The Bank of England defines SMEs as firms with an annual turnover of up to £25 million. Outstanding loans have been adjusted by flows. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

1

New Loans to SMEs* 12-month cumulative flows; end-2004=100 250 Ireland 200 150

Euro Area

Cyprus* Italy

100

Portugal

50

Spain 0 2005

2007

2009

Greece

2011

2013

Source: ECB, Bank of Greece, IIF. *Uses proxy data on new loans to non-financial corporations up to €1 million. Although many loans to SMEs may be no more than €0.25 million, data on loans up to €1 million is more widely available, particularly prior to 2010. Data on loans to SMEs in Cyprus is based to end-2009.

2

Interest Rates on New Loans to Non-Financial Corporations loans ≤€1 mn; percent Portugal Ireland 9 Spain Italy 8 Germany Austria

7 6 5 4 3 2 2006

2008

2010

2012

2014

Source: ECB

3

Venture Capital and Private Equity Investment in EU* € billion index, 2007=100 20 120 Replacement capital Rescue/turnaround Growth 100 Buyout* Later stage venture 15 Start-up 80 Seed 10

60

40 5 20 0

2007

2008

2009

2010

2011

2012

2013

Source: EVCA, IIF. Data includes investment in EU-28 countries except for Croatia, Malta, Slovakia, and Slovenia. **Buyout funds were equal to €55 billion in 2007.

0

page 11

CAPITAL MARKETS MONITOR | February 2015

A relatively risk-averse start to 2015, as safe haven investments dominate asset class performance. Annual Returns for Selected Asset Classes

Annual Returns for Commodity Classes

2015ytd returns 1 percent,Precious metals

2 percent, 2015ytd returns

Gold U.S. dollar (DXY) U.S house prices¹ EM equities** Global equities** MM equities** EM currency Energy commodities Industrial metals Commodities* Agricul. Commodities* Copper*

Precious metals Energy commodities Commodities Industrial metals Agricul. Commodities*

-10

-5

0

5

Gold has been the best performing asset year to date, with copper lagging on broad-based concerns about growth

3

-5

10

0

5

10

Gold, silver and platinum have posted gains in 2015, while weak fundamentals have undermined industrial metals and agricultural commodities.

A Annual Bond Returns* percent, 2015ytd

Emerging Market Equity and Sovereign Bond Returns

4 percent, 2015ytd Philippines Egypt South Africa China Russia Turkey Indonesia Malaysia Chile Poland Peru Mexico Hungary Brazil Colombia

10yr U.S. Treasury IG EM sovereign EM sovereign AAA corporate IG EM corporate 2yr U.S. Treasury A corporate

Bonds* Equities** Red and blue, vertical lines are EM sov. bond and equity benchmarks respectively.

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 * EMBIG index total returns. ** MSCI index total returns in USD-terms.

HY EM sovereign

Investor differentiation continues, reflected in very divergent performance across EM countries. However, EM bond and equities have both posted modest gains ytd in aggregate.

Global IG corporate

EM corporate BBB corporate

in Value of U.S. Dollar 5 Change percent, 2015ytd

AA corporate B corporate BB corporate Global HY corporate HY EM corporate CCC & lower corporates -3 -2 -1

0

1

2

3

4

5

* Ranked by 2014 total returns; global corporate and U.S. Treasuries: Bank of America/Merrill Lynch indices; Bloomberg

A defensive mood has sent investors into bonds, with U.S. Treasuries being the best performing sector. Yields in some mature markets are now negative up to 5 years out. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Russian ruble Euro Turkish lira Chilean peso British pound Brazilian real Chinese renminbi Mexican peso Korean won South African rand Yen Indian rupee -3 USD depreciation

0

3

6

9

12

15

18

USD appreciation

Excluding Russia—where there are other factors at work, the dollar has appreciated most against the euro this year as ECB launches its ambitious QE program.

page 12

CAPITAL MARKETS MONITOR | February 2015

2015: More of 2014?

Relative Asset Class Performance

Absolute Asset Class Performance

1 percent, cumulative return since Jan 2014

2 percent, cumulative return since Jan 2014

20

6

15

4

10

2

5

0

0

-2

-5

-4

-10 -15 -20 -25 Jan 14

MXWD Index MXEM Index JGAGGUSD DJUBS Index Apr 14 Jul 14

MXWO Index MXEF Index JPEIGLBL Index DXY Index Oct 14 Jan 15

The U.S. dollar continues to outperform, while at the other extreme, commodities have continued to underperform. EM equities have recovered some of the losses.

3

Correlations of Major Asset Classes percent, 30-day average of 30-day correlations

-6

60/40 Balanced WE/WB EME/WE EME/EMD

-8 -10

-12 Jan14

Apr14

Jul14

Oct14

Jan15

WE = world equities, WB = world bonds, EME = emerging markets equities, EMD = emerging markets debt.

$AUM Volatility of Asset Class Funds since July 2014

4 percent

DM Equities

75 55

EM Equities

35

Balanced 15 EM Bonds

-5

-25 -45 -65 Mar 14

Alternatives WE & WB DME & EME

May 14

Jul 14

DM Bonds

EME & EMD WB & EMD

Sep 14

Nov 14

0

Jan 15

The correlation between global bonds and emerging markets debt has dropped drastically as investors have pushed mature market yields into negative territory. Evolution of Fund AUM since Jan 2014 DM Bonds DM Equities EM Bonds EM Equities 40 Balanced Alternatives 35 30 25 20 15 10 5 0 -5 -10 Jan 14 Apr 14 Jul 14 Oct 14 Jan 15

5 percent

Source: EPFR, IIF

Assets under management in EM equities have increased since the beginning of the year, while EM bonds have not yet recovered. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

2

4

6

8

10

12

14

The volatility of assets in the alternatives space has been on the low side, as AUM has been relatively constant in 2H2014. Select HFR Hedge Fund Performance Since Jan 2014

6 percent 4 2 0

-2 -4 -6 -8 Jan 14

Global Hedge Fund Equity Hedge Event Driven Absolute Return Fixed Income

Apr 14

Jul 14

Oct 14

Jan 15

Although hedge funds have shown improved performance year-to-date, these will have to continue to make up for the poor investment performance of recent years

page 13

CAPITAL MARKETS MONITOR | February 2015

With markets expecting the first Fed rate hike in late 2015, demand for long-term bonds continue to be robust globally amid growth concerns. Expected Timing of First Fed Rate Hike

1 expected timing of first rate hike, based on Fed funds futures Jan 16

U.S. Treasury Yield Curve

10-2 year

2 basis points 300

10-5 year

250

Nov 15

200

Sep 15 Jul 15

150

May 15

100

Mar 15

50

Jan 15

0

Nov 14

-50

Sep 14 Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

-100 2005

2007

2009

2011

2013

2015

Markets currently price in the first rate hike for around December 2015.

The U.S. yield curve continues to flatten as concerns about global growth prospects support demand for long-term bonds.

10yr Bond Yields and Short Rate Futures 3 U.S. basis points (both scale)

4 basis points, cumulative change since May 22, 2013

3.3 3.1

10-year Government Bond Yields

U.S. 10-year Treasury 3-month Eurodollar futures, Mar. 16 (rhs)

2.9 2.7 2.5

2.3 2.1

1.9 1.7 1.5 Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

2.5 2.3 2.1 1.9 1.7 1.5 1.3 1.1 0.9 0.7 0.5

Yields on 10-year U.S. Treasuries are at their lowest level since May 2013.

percent, 90-days volatility 16 Yields Volatility of yields (rhs) 14

7.5 7.0

12 6.5

10

6.0

8

6 5.5 5.0 2010

4 2 2011

2012

60 0 -60 -120

U.S.

-180

Germany Spain

-240 -300 May 13

Sep 13

Jan 14

May 14

Sep 14

Jan 15

The yield premium offered by 10-year U.S. Treasuries over German Bunds has been an important factor supporting demand for U.S. bonds. Foreign Investor Share in Local Government Debt Market

Local EM Government Bonds

5 percent

120

2013

2014

2015

EM local currency government bond yields continue to decline, in line with downward trend in mature market rates. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

6 percent

Peru Poland Indonesia Mexico South Africa Hungary Malaysia Russia Turkey Romania Brazil Thailand Czech Colombia Korea India

Dec-14 Jun-13

0

20

40

60

The share of foreign investors in local currency government markets has increased significantly in Poland, Indonesia, Brazil and Colombia since mid-2013.

page 14

CAPITAL MARKETS MONITOR | February 2015

Mature market loan growth (ex-Euro Area) picked up modestly in 2014, while emerging market loan growth decelerated slightly. Global Banks: Equity Market Returns

1 MSCI indices (USD returns), end-2012= 100

2

U.S. Euro area Emerging markets Japan U.K.

150 140 130

Cross-border Claims on Developing & Developed Countries year-on-year percent change 50

40 30 20 10

120

0

110

-10

100

Developed countries Developing countries -30 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 -20

90 80 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15

U.S., EM and Japanese bank equities have lost 3-9% year to date while Euro Area bank equities, supported by the launch of ECB QE, have gained 3-8% year to date. U.S. UK Japan Euro area Emerging markets

Global Banks: Loan Growth

3 year-on-year percent growth 30 25

Source: BIS; IIF calculations. *** Cross-border claims by sector, immediate borrower basis (consolidated claims).

BIS cross-border claims on developed countries declined by 1% year over year in Q3 2014 while claims on developing countries increased by 18%. U.S. Large-Cap Banks Net Income

4 USD billion 30 20

20 10

15

0

10 5

-10

0

-10

Net income Annual average (rhs)

-20

-5

-30 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14

U.S. bank lending picked up in 2014 whereas EA bank lending continued to contract. EM bank lending remained solid, albeit with some deceleration.

Net income of the largest 15 U.S. banks was $23 billion3.5% lower year over year.

U.S Banks: Loan Growth

Total C&I Real Estate Loans Consumer Loans

5 percent, yoy 25 20 15

U.S. Banks: Real Estate Loans

6 percent, yoy

15

5

10

CRE

5

-5

-10

0

-15

-5

-20

Revolving home equity loans Closed-end residential

20

10 0

Total

25

'07

'08

'09

'10

'11

'12

'13

'14

'15

U.S. bank lending increased year over year across different categories in January up 14% for real estate loans, 5% for consumer loans, and 3% for real estate loans. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

-10

'07

'08

'09

'10

'11

'12

'13

'14

U.S. commercial real estate loans increased almost 7% year over year in January.

'15

page 15

CAPITAL MARKETS MONITOR | February 2015

Loans to the private sector increased for the first time since July 2012, led by the household loans. Loans to non-financial corporates continue to decline. ECB: Excess Liquidity in Euro Area Banking System percent Excess liquidity 900

Bank Profitability

1 MSCI, return on equity ratio

2 EUR billion, 20-day moving average

18

1.2

Eonia (rhs) 13

1.0 600

8

0.8 0.6

3

-2

Emerging markets Japan U.S. Euro Area

-7 -12 2005

2007

2009

2011

2013

2015

Return on equity for Euro Area banks remains well below that of many mature market peers.

Euro Area: Loan to the Private Sector

3 percent oya, sa 14

1.4

0.2

0.0 0 2011

2014

2015

Euro Area Bank Interest Rates on Corporate Loans 7.0

10

Loans to private sector

6.0

Periphery

6.5

8

5.5

6

5.0

4

4.5

2

4.0

0

3.5

-2

3.0

-4 2007 2008 2009 2010 2011 2012 2013 2014

2.5 2003

Greece: Outstanding Deposits

2013

4 percent, loans over one year

Loans to private sector, adjusted for sales and securitization

5 EUR billion

-0.2 2012

Excess liquidity resumed its downward trend in January, with the short-term interest rates remaining in negative territory.

12

With banks continuing to ease credit standards, EA private sector loans (adjusted for sales and syndication) increased in December for the first time since July 2012.

0.4

300

Core

2005

2007

2009

2011

2013

Negative credit growth in the EA periphery, partly reflects the discrepancy in loan interest rates between core and periphery. Bond Holdings of Euro Area MFIs

6 percent of total assets

380 360 340 €142 bn 320 300 280 260 240 Estimated €11 billion 220 outflow in Jan 2015 200 180 2007 2008 2009 2010 2011 2012 2013 2014 2015

12 EA government bonds 11 10 EA corporate bonds 9 8 7 6 5 4 3 2 1998 2000 2002 2004 2006 2008 2010 2012 2014

The election of a Syriza-led coalition government resulted in turmoil in Greece’s financial markets. Deposit outflows are estimated to be around €11 billion in January.

As the ECB prepares to purchase sovereign bonds under its QE program, bank holdings of government bonds now stand near 6% of total assets.

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

page 16

CAPITAL MARKETS MONITOR | February 2015

Although the prospect of ECB QE has been supportive for Euro Area credit markets, U.S. high-yield spreads continued to widen in January; a recent investor poll puts high-yield debt as the "favorite asset class to short." Global Investor Poll: Favorite Assets to Short/Long

High Yield Corporate Bond Spreads

1 bps, option-adjusted spreads

2 percent or respondents

1,050

EM bonds HY corp bonds HG corp. bonds G7 sov. bonds Gold EM currencies G7 currencies Real Estate Commodities EM equity DM equity

Europe

950

U.S.

850 750 650 550 450 350 250 2010

2011

2012

2013

2014

2015

High yield corporate bond spreads have widened by some 20 basis points year to date in the U.S.—but not in Europe.

U.S. Corporate Bond Spreads

3 bps, option adjusted spreads 700

500

400

Short

0 2 4 6 8 10 12 14 16 18 20 22 24

A recent Bloomberg poll suggests that 18% of respondents chose HY debt as the preferred asset class to short— more than the 13% that would bet against DM bonds. European Private Funding Market Volume number of deals Private placements Corporate Schuldschein 40 250 USPP cross-border Europe 35 Number of deals (rhs) 200 30

4 USD billion Energy Health care Industrial Telecom IT

600

Long

25

150

20

100

15

300

10

200

50

5

100

0

0 2007 2008 2009 2010 2011 2012 2013 2014 2015

Impacted by record-low oil prices, bond spreads have widened more in the energy sector than other industries.

U.S. Private-Label Term Securitization Issuance by Type

5 $ billion

2010

CDO

1500

RMBS

ABCP

1250

CMBS

ABS

1000

2000 750

1000

500

500

250 2000 2002 2004 2006 2008 2010 2012 2014

Source: John Kiff, IMF, Inside Mortgage Financing, JPM, CMA, FRB.

U.S. securitization issuance amounted to $672 billion in 2014—80% below the 2006 peak.

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

2014

0

European Private-Label Term Securitization Issuance by Type

CDO2

0

2013

6 $ billion

3000

1500

2012

Private funding (private placements and direct lending) for companies in Europe grew in recent years.

3500

2500

2011

Source: S&P, Private Placement Monitor, CMS Bureau Francis Lefebvre, I'Agefi, various bank research

0

68% 5%

Percent placed with investors

6%

CDO2 CDO RMBS ABCP CMBS ABS

23% 24% 34% 34% 42%

2000 2002 2004 2006 2008 2010 2012 2014

Source: John Kiff, IMF, Inside Mortgage Financing, JPM, CMA, FRB.

European securitization issuance amounted to a little over $300 billion in 2014—only 34% of which was placed with investors.

page 17

CAPITAL MARKETS MONITOR | February 2015

G4 bond issuance started the new year on a much stronger footing than last year while EM bond issuance has been weak. Global loan issuance has been weak year to date.

1

G4 Corporate Bond Issuance $ billions, 2015 ytd

2700 2400

Japan UK Euro area U.S.

2100 1800 1500

EM-30 Corporate Bond Issuance

2 $ billion, 2015 ytd 800

700 600

High-yield

500

High-grade

400

1200 900

300

600

200

300

100

0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

G4 corporates issued $215 billion of bonds in January—on par with last year’s average pace.

0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

EM corporates issued $28 billion of bonds in January— almost 50% lower than last year’s average pace.

EM-30 Loan Issuance

G4 Loan Issuance

3 $ billions, 2015 ytd

4 $ billions, 2015 ytd

3200

600

2800

Leveraged loan

2400

Other loan

500 Leveraged loan

2000

400

1600

300

1200

Other loan

200

800

100

400

0

0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

January G4 loan issuance amounted to $78 billion—more than 70% below last year’s average pace.

US

1400

UK

1200

Japan

1000

Similarly, January emerging market loan issuance amounted to only $7 billion.

EM-30 Bank Bond Issuance

G4 Bank Bond Issuance

5 $ billions, 2015 ytd

Euro area

6 $ billions, 2015 ytd 300 250

MENA

200

Latin America

150

EM Europe

800 600

100

400

EM Asia

50

200 0

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

G4 banks issued $104 billion of bonds in January—50% above last year’s average pace.

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

EM corporates issued $12 billion of bonds in January— more than 40% lower than last year’s average pace.

page 18

CAPITAL MARKETS MONITOR | February 2015

Emerging market bond spreads stabilized in January following a sharp runup in Q4 2014. EM asset price volatility has subsided in recent weeks.

1

Emerging Market Equity Indices by Region MSCI indices (USD returns), end-2011=100 130

2

EMUSD-denominated Sovereign Debt Spreads (EMBIG) percent bps 8 500 EMBIG yield Treasury yield Spread (rhs)

7

120

450

6

110

400

5 100

350 4

90 80

Latin American and EM European equities have lost 2-5% year to date whereas EM Asian equities have gained around 2%.

Frontier Markets FM Asia FM Latin America

1 2012

2013

2014

2015

200

After rising over 100bps in H2 2014, the EMBIG spread has widened only around 25 bps year to date—due entirely to declining Treasury yields. Emerging Markets USD-denominated Corporate Debt

Frontier Markets USD-denominated Sovereign Spreads

3 (NEXGEM), bps 800

250

2

70 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15

900

300

3

EM Asia EM Europe Latin America

4 Spreads (CEMBI), bps 1000

FM Africa FM Europe FM Middle East

Emerging markets Latin America EM Asia Africa EM Europe

900 800

700

700

600

600

500

500

400 400

300

300 Jan 12

Jul 12

Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

NEXGEM spreads have widened some 40- 50 bps year to date with spreads for FM Middle East and FM Europe widening 100-150 bps.

14

EMBIG (rhs)

18

12

10 9

Emerging Markets EM Asia Latin America

12

8

9

6

6

4

3

2

5

0

4 Jan 12 Jul 12

13

14

15

Jan 14

Jul 14

Jan 15

Emerging markets asset price volatility has subsided in recent weeks after a spike earlier in January.

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Africa EM Europe

8

10

12

Jul 13

CEMBI spreads have widened more than 40 bps on average. Impacted by Russian tensions and oil prices EM European CEMBI spreads have widened more than 80 bps ytd.

15

0

Jan 13

6 Yields (GBI-EM), percent 16

Equities

21

Jul 12

Emerging Markets Domestic Local Currency Sovereign

Emerging Market Equity and Debt Volatility

5 30-day historical volatility of MSCI-EM index (USD returns) and EMBIG returns, percent 24

200 Jan 12

7 6

Jan 13 Jul 13

Jan 14 Jul 14

Jan 15

Emerging market domestic local currency sovereign yields have declined around 35 bps year to date, almost 90bps for Africa and EM Europe.

page 19

CAPITAL MARKETS MONITOR | February 2015

Following the ECB’s announcement of QE, Euro Area equities approached 7-year highs. Data on fund allocations suggest rotation from U.S. stocks to Euro Area equities. Selected Equity Sectors

Global Equity Market Performance

1 MSCI indices, end-2013=100 115 110

2 index, rebased 1/1/2013 = 100 160

U.S. Japan Euro area Emerging markets

150 140

105

130

100

120

U.S. consumer discretionary Euro area consumer discretionary EM consumer discretionary Global energy

110

95

100

90

90

85 Jan 14 Mar 14 May 14 Jul 14 Sep 14 Nov 14 Jan 15

80 Jan 13

In the wake of the announcement of ECB’s sovereignbond based QE program, Euro Area equities have recorded large gains since mid-January, reaching 7-year highs. Fund Asset Allocations in U.S. and Euro Area Equities

U.S.

Jul 14

Jan 15

Returns in Euro Area consumer discretionary stocks has particularly robust, while U.S. consumer discretionary stocks have been broadly stable.

4 index, end-2004=100 11

Euro Area (rhs)

275 250

59 58

10

57 56

9

225

S&P 500 Buyback

200

S&P 500

175 150

55 54

8

125 100

53 52 2010

Jan 14

S&P 500 Buyback

3 % of global fund equity holdings; dashed-line10-14 avg. 60

Jul 13

2011

2012

2013

2014

2015

7

Source: EPFR, IIF.

Weekly data on fund investors asset allocations also indicates a shift towards Euro Area equites from U.S. stocks starting in late January. Forward P/E Ratios

50 2005

2007

2009

2011

2013

2015

Corporate buybacks continue to lend support to the U.S. stock market more broadly.

Correlation of EM and FM Equities with World MSCI

5 MSCI indices, price to 12M forward earning estimates, dotted lines=2014-14 average 16 15 14 13 12 11 10 9 8 7 6 2005 2007 2009

75

6 30-day rolling correlations in returns; dashed lines: 05-14 avg. 0.7 EM

0.6

FM

0.5 0.4 0.3 0.2 0.1

Developed markets Emerging markets

2011

2013

2015

The prospect of ECB QE has boosted mature market valuations slightly, while valuations remained roughly flat in emerging markets iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

0.0 -0.1 2005

2007

2009

2011

2013

2015

Due to the their relatively low correlations with other asset classes, frontier markets remain appealing for many investors who are looking for portfolio diversification.

page 20

CAPITAL MARKETS MONITOR | February 2015

The U.S. dollar continues to rally. With global volatility picking up amid divergent monetary policies of major central banks, the appeal of USD-funded carry trades is waning. FX Volatility

Global Currencies

12

1 index

2 index, rebased 1/1/2014 = 100

Emerging markets

35

G7

30

116 8

112 108

25

4 Jan 13

104 Jan 14

Jan 15

20

100

96

15

USD (trade-weighted) JPY Emerging markets EUR

92 88

10

84

5 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Divergence across G3 monetary policies continues to contribute to a rise in FX volatility.

Renminbi 2.5 Trading band 2.0 30d impl. vol (rhs) 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Weak -2.0 Renminbi -2.5 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15

0.7

3.5

0.6

3.0

CAD, AUD,NZD EUR, JPY and CHF GBP (rhs)

2.0 1.5

1.0

0.0

80 60 40 20 0

-100

-20

-200

-40

-300

-60 2015

0.4 0.3 Pre-2008 Crisis Average

0.2 0.1 2008

2009

2010

2011

2012

2013

2014

2015

The decline in correlation levels across EM exchange rates suggest that the theme of EM differentiation persist.

Daily FX Trading Volumes

100

2014

0.5

6 $ trillion, CLS data based on 17 currencies 100

0

Post-2008 Crisis Average

0.5

200

2013

Jan 15

2.5

Large Speculators Net FX Positions vis-a-vis US dollar

-400 2012

Oct 14

In late January, the greenback reached its highest levels in over a decade.

4.0

5 thousands, below zero means net short positioning 300

Jul 14

4 ratio

The RMB fell to the bottom of its official trading band in early February; volatility has returned to levels prevailing in mid 2013.

400

Apr 14

Correlation Across EM Exchange Rates

Onshore Renminbi

3 % difference from reference rate

500

80 Jan 14

-80

Large speculators’ net long positions in the U.S. dollar suggest that the attractiveness of the dollar as funding carry trade currency is waning. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

6.0 5.8 5.6 5.4 5.2 5.0 4.8 4.6 4.4 4.2 4.0 Jan 12 Jun 12 Nov 12 Apr 13 Sep 13 Feb 14 Jul 14 Dec 14

Average daily FX trading volume was $5.14 trillion in 2014, up by 3% from $4.99 trillion in 2013.

page 21

CAPITAL MARKETS MONITOR | February 2015

While commodities have been broadly out of favor, weak fundamentals may now be largely priced in. Early February has brought a modest rise in oil prices.

1

Bloomberg Commodity Index and U.S. Dollar Index index index, inverse scale 140 79 135

81

130

83

125

89

80

Bloomberg Commodity Index

91

70

U.S. dollar index (rhs)

93

60

95

50 Jan 14

95 Jan 14

May 14

Sep 14

Jan 15

Commodities have decoupled from the dollar in recent weeks: while the dollar continued to strengthen, commodity prices are showing the first signs of finding a footing. Oil Prices

3 $ per barrel 110

100 90 80 70

WTI

60

Brent

50 Apr 14

Jul 14

Oct 14

Jan 15

Benchmark crude oil prices have risen in early February, from their lowest levels since 2009--temporary reprieve, or are negative fundamentals fully priced in?

1390

Gold U.S. 10yr breakeven inflation (rhs)

1340

2.4 2.2 2.1

1290

2.0 1.9

1240

1.8 1.7

1190

1.6 Jul 14

Oct 14

Jul 14

Oct 14

Jan 15

Comex Copper Prices $ per pound 340 330 320 310 300 290 280 270 260 250 240 Jan 14

Apr 14

Jul 14

Oct 14

Jan 15

Copper prices have been hurt by poor fundamentals, concerns about Chinese growth. However, speculation about potential Chinese stimulus has provided support of late.

6 index, rebased, 1/1/2013 = 100

percent 2.3

Apr 14

Apr 14

Soy, Corn and Wheat Prices

Gold Prices vs. 10yr Breakeven Inflation

5 $ per ton ounces

Energy Industrial metals Agriculture

With the lowest prices in several years, the energy sector may be starting to attract investors; prices in other commodity sectors have not declined to the same extent.

4

120

1140 Jan 14

100

90

110

40 Jan 14

110

87

115

100

120

85

120

105

Energy, Industrial Metals and Agriculture Indices

2 index, rebased, 1/1/2014 = 100

Jan 15

1.5

Gold prices have decoupled from inflation expectations this year, reflecting risk aversion during January and suggesting some hope that disinflationary pressures will ease. iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

125 115 105 95

85

Soy Corn

75 65 Jan 14

Wheat Apr 14

Jul 14

Oct 14

Jan 15

The latest WASDE report, which predicts ample acreage for grains, record soybean production and higher wheat supplies, helps explain lower agricultural prices of late.

page 22

CAPITAL MARKETS MONITOR | February 2015

Early 2015 saw a decline in emerging market mutual fund flows, a preference for high-grade over high yield bonds, and inflows to commodity equity funds. Flows to Mature Market Bond and Equity Mutual Funds

1 $ billion 80 60 40

20 0 -20 -40

Bonds

-60

Equities

-80 -100 Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

Flows to Emerging Market Bond and Equity Mutual Funds

2 $ billion

30 25 20 15 10 5 0 -5 -10 -15 -20 -25 Jan 13

Bonds Equities

Jul 13

Jan 14

Jul 14

Jan 15

Source: EPFR.

Source: EPFR.

In the first weeks of 2015, mature market bonds saw inflows, while mature market equities experienced outflows.

Global Equity, High-Grade and High-Yield Bond Fund Flows

3 $ billion

Equity

80

High-yield

60

High-grade

40

Net flows to EM funds, while still negative, started to recover in January.

Flows to High-Yield and High-Grade ETF Funds

4 $ billion 40 30 20 10

20

0

0

-10

-20 -40 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 Source: EPFR.

Cumulative Flows to European Mutual Funds

5 $ billion, Euro Area domicile

50

-30

High-yield

-40 Jan 13

Jul 13

Jan 14

Jul 14

Jan 15

In another reflection of risk aversion, high-grade ETF funds were favored over high-yield ETF funds.

Commodity and Energy Equity Fund Flows

6 $ billion 6

80

60

High-grade

Source: EPFR.

In contrast to mature market equities, investors sent flows to both high yield and high grade funds.

70

-20

4 Bond Equity

2 0

40

-2

30

-4

20

-6

10

-8

0

-10

-10 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15

-12 Jan 13

Source: EPFR.

Source: EPFR.

Investors continue to prefer Euro Area bond mutual funds over equities.

iif.com © Copyright 2015. The Institute of International Finance, Inc. All rights reserved.

Energy Commodity

Jul 13

Jan 14

Jul 14

Jan 15

With record low commodity prices, both energy and commodity equity funds saw inflows, suggesting some degree of bargain-hunting.