1

Greed and Fear: Reassessing Emerging Markets’ Fair Value

Friday, December 2nd 2005

Marco Annunziata

Managing DirectorHead of Research and Strategy

Unicredit Banca Mobiliare

2

Global Outlook

3

Overview: Key issues

Eurozone’s growth outlook slightly stronger (or rather less weak…)…but slowing in 2007 on tighter fiscal policies and slowing world growthExpect ECB to hike a cumulative 50bp through March, on hold thereafter

US growth on track, decelerating to potential (3 ½ %)Housing market could deflate consumptionFed to keep hiking: 4.25% by end-05, level off at 4.75% in mid-06Bond yields to follow…but how soon?

FX markets: USD to rise before it falls again vs EUR

4

UBM Outlook

2003 2004 2005 2006 2007WORLD 2.6 4.1 3.4 3.5 3.5 USA 2.7 4.2 3.7 3.5 3.3 JAPAN 1.4 2.7 2.3 2.1 2.0 CHINA 9.4 9.5 9.3 8.9 8.7 EUROZONE 0.7 1.8 1.4 1.8 1.6 GERMANY -0.2 1.1 1.1 1.6 1.1 ITALY 0.4 1.0 0.2 1.2 1.2 FRANCE 0.9 2.1 1.6 1.9 2.1

WORLD* 2.0 2.1 2.4 2.1 1.8 USA 2.3 2.7 3.5 2.7 2.0 JAPAN -0.3 0.0 -0.1 0.6 0.7CHINA 1.2 3.9 2.0 2.4 3.2EUROZONE 2.1 2.1 2.2 1.9 2.0GERMANY 1.0 1.7 2.0 1.6 2.0ITALY 2.6 2.1 2.0 2.0 1.7FRANCE 2.1 2.1 1.8 1.5 1.4* OECD (ex high-inf lation countries)

Eurozone&Germany numbers assume a 3% VAT hike in 2007

Eurozone CPI numbers assume "the Dutch effect" in Jan 2006

GROSS DOMESTIC PRODUCTACTUAL UBM FORECASTS

CONSUMER PRICE INDEX

5

FX and Brent Forecasts

FX Forecast Spot FWD Mar-06 FWD Jun-06 FWD Dec-06

Euro/Usd 1.17 1.18 1.13 1.18 1.15 1.19 1.23Usd/Yen 120 118 123 117 119 114 110Usd/Chf 1.32 1.31 1.35 1.30 1.33 1.28 1.25

Cable 1.72 1.71 1.67 1.71 1.69 1.71 1.78Euro/Yen 140 139 139 138 137 135 135Euro/Gbp 0.68 0.69 0.68 0.69 0.68 0.69 0.69Euro/Chf 1.55 1.54 1.53 1.54 1.53 1.53 1.54

Brent Forecasts ($pb)

Q4-05 Q1-06 Q2-06 Q3-06 Q4-062005

average2006

average

57 58 54 60 57 55 57

6

Interest Rates Forecasts

Bond Forecasts Actual Dec-05 Change Mar-06 Change Sep-06 ChangeUS Fed Funds 4.00 4.25 25 4.50 50 4.75 75UST 2-year 4.36 4.50 14 4.52 16 4.72 36UST 10-year 4.47 4.60 13 4.75 28 4.65 18

ECB Refi Rate 2.00 2.25 25 2.50 50 2.50 50Bund 2-year 2.75 2.80 5 2.85 10 2.80 5Bund 10-year 3.44 3.60 16 3.65 21 3.75 31

Update 28-Nov-05

We forecast only a mild increase in benchmark yields The market is already pricing fully Fed Funds at 4.75% and ECB rate at 2.50%

for Sep-06

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Emerging Markets Outlook

8

Current Spreads have bottomed out

237133

318

143273

179

617566

382

550

704

514

0

200

400

600

800

1000

1200

1400

1600

1800

2000

EMBI+ Africa Asia Europe LatinAmerica

Non Latin

Last Min Max Average

EMBI+ Current Values (with Min, Max and Average since 01/01/2000)

Source: Bloomberg/JPMorgan

9

Almost all EM Spreads have tightened over the past year

0

100

200

300

400

500

600

700

800

900

1000

Ecu

ador

Nig

eria

Arg

entin

a

Bra

zil

Phi

lippi

nes

Ven

ezue

la

Pan

ama

Col

ombi

a

EM

BI +

Tur

key

Ukr

aine

Per

u

Mex

ico

Rus

sia

Mor

occo

Bul

gari

a

Sou

th A

fric

a

Pol

and

Mal

aysi

a

Egy

pt

Source: Bloomberg/JPMorgan

USD Bonds

050

100150200250300350400450500

Arg

entin

a

Ven

ezue

la

Bra

zil

Phi

lippi

nes

Per

u

Tur

key

Mex

ico

Com

posi

te

Sou

th A

fric

a

Rom

ania

Mal

aysi

a

Bul

gari

a

Cro

atia

Col

ombi

a

Pol

and

Hun

gary

Cze

ch R

epub

lic

Lith

uani

a

Slo

vaki

a

Source: Bloomberg/JPMorgan

EUR Bonds

USD denominated bonds have outperformed EUR bonds

Europe has underperformed

Tightening potential for NE Eurobonds is very limited

(thin bars indicate the spread tightening)

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EM Total Returns YoY11% in USD and 7% in EUR

0.0% 5.0% 10.0% 15.0%

Africa EURAfrica USD

Europe EUR

Non Latin EURMiddle East USD

Composite EURAsia EUR

Latin America EURNon Latin USD

Asia USD

Composite USDEurope USD

Latin USDMiddle East EUR

source: Bloomberg/JPMorgan

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EM have outperformed other credits in 2005

-100

-80

-60

-40

-20

0

20

40

60

01/05 02/05 03/05 04/05 05/05 06/05 07/05 08/05 09/05 10/05 11/05

bp

ch

an

ge

sin

ce

re

fere

nc

e d

ate

USA10 EU10 EMBI+ Spread BBB swap spread

All variables are normalised to zero on 01/01/05

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EM Total Returns YoYfor the largest components of the EMBI+

Brazil23%

Mexico19%

Philippines8%

Russia17%

Turkey9%

Venezuela7%

others17% The EMBI+ is highly

concentrated on a few issuers: 6 countries represent over 85% of the index

2005 total returns both in USD and EUR are high

0% 5% 10% 15% 20%

Mexico

Turkey

Brazil

Russia

Venezuela

Philippines

USD EUR Source: Bloomberg/JPMorgan

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Are current levels justifiedSupportive factors vs risks

EM benefit from several supporting factors: Low volatility making funding cheaper Improved fundamentals (Fiscal, debt, CA, rating upgrades) Reduced borrowing needs (2006 pre-financing has started early) Still high risk appetite Currency appreciation Strong commodity prices and robust world growth Widened investor base

But also faces important risks: Historically low spreads Increasing benchmark yields and tighter Fed/ECB monetary policy Upcoming elections and reduced margin for policy mistake Bond bubble might still burst instead of deflating Oil price might switch from support to threat Pipeline of inflows remains positive but low

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Supportive FactorsLow Volatility

8

13

18

23

28

33

38

01/03 04/03 07/03 10/03 01/04 04/04 07/04 10/04 01/05 04/05 07/05 10/05

200

250

300

350

400

450

500

550

600

650

700

750

Vix Index (LHS) EMBI+ (RHS) Source: Bloomberg, JPMorgan, CBOE

VIX and EMBI+

Volatility is down, EMBI+ is tighter

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Supportive FactorsCredit quality has generally improved

LTFC Rating Upgraded from On (date) Outlook DateBulgaria S&P BBB BBB- 27-ott-05 Positive 27-ott-05

Fitch BBB BBB- 17-ago-05 Stable 17-ago-05Czech Republic Fitch A A- 26-ago-05

Hungary Fitch A- A- 16-gen-04 Negative 12-gen-05Poland S&P BBB+ BBB 10-giu-99 Positive 22-mar-05

Fitch BBB+ BBB 19-nov-99 Positive 12-ott-05Romania Moody's Ba1 Ba3 02-mar-05 Positive 02-mar-05

S&P BBB- BB+ 06-set-05 Stable 06-set-05Russia Moody's Baa2 Baa3 25-ott-05 Stable 25-ott-05

S&P BBB- BB+ 31-gen-05 Stable 31-gen-05Fitch BBB BBB- 03-ago-05 Stable 31-gen-05

Slovakia Moody's A2 A3 12-gen-05 Positive 12-gen-05Fitch A A- 11-ott-05 Stable 11-ott-05

Turkey Moody's B1 Ba3 03-gen-97 Positive 11-feb-05Fitch BB- B+ 13-gen-05 Stable 13-gen-05

Ukraine S&P BB- B+ 11-mag-05 Stable 11-mag-05Fitch BB- B+ 21-gen-05 Positive 08-giu-05

Brazil Moody's Ba3 B1 12-ott-05 Positive 12-ott-05S&P BB- B+ 17-set-04 Positive 08-nov-05Fitch BB- B+ 28-set-04 Positive 11-ott-05

Mexico Moody's Baa1 Baa2 06-gen-05 Stable 06-gen-05S&P BBB BBB- 31-gen-05 Stable 31-gen-05

Venezuela Moody's B2 Caa1 07-set-04 Stable 07-set-04S&P B+ B 12-ago-05 Stable 12-ago-05Fitch BB- B+ 14-nov-05 Stable 14-nov-05

Philippines Moody's B1 Ba2 16-feb-05 Negative 13-lug-05S&P BB- BB 17-gen-05 Negative 11-lug-05Fitch BB BB+ 12-giu-03 Negative 11-lug-05

downup Source: Bloomberg

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Supportive FactorsThe external vulnerability is lower

External indebtedness has decreased in the last couple of years

Current account balances have improved in most of the countries

Only exceptions: Turkey (due to oil and strong import) and Russia (Dutch disease and strong rise in import).

Russia CA surplus is still high.

CA % of GDP

-10

-5

0

5

10

15

20

TURKEY BRAZIL MEXICO VENEZUELA PHILIPPINES RUSSIA

2003 2005 2006

External Debt % of GDP

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

TURKEY BRAZIL MEXICO VENEZUELA PHILIPPINES RUSSIA

2003 2005 2006

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Supportive FactorsExternal debt issuance

Net issuance of external debt is generally supportive for most of the countries considered:

•Brazil, Mexico, Venezuela, and Philippines show no strong need to access primary market.

•Russian sovereign issuance is virtually disappearing, while the government is thinking about capping corporate access to external debt.

•Turkey plans to increase net issuance.

External Debt Net I ssuance (mn $)

-20000

-10000

0

10000

20000

30000

40000

TU

RK

EY

BR

AZ

IL

ME

XIC

O

VE

NE

ZU

ELA

PH

ILIP

PIN

ES

RU

SS

IA

200420052006

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Supportive FactorsHigh risk appetite for EM bonds

Appetite for risk has increased despite rising UST yields

The EMBI+ has reached a new all time low on Nov. 28th at 236bp

230

250

270

290

310

330

350

370

3.50 3.75 4.00 4.25 4.50 4.75 5.00

Begining of Q1-05Begining of Q2-05Begining of Q3-05Begining of Q4-05In Q1 05In Q2 05In Q3 05In Q4 05Last

Source: Bloomberg/JPMorgan

UST 10Y

EM

BI+

10-year US Treasury up, EMBI+ down

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Supportive FactorsInflows should remain high

0

50

100

150

200

250

300

350

400

Private flows LatinAmerica

Europe Africa/MiddleEast

Asia/Pacific

2003 20042005f 2006f

Net Financial Flows to EM Economies by Region(in USD bn)

Source: IIF, Capital Flows to Emerging Market Economies Sep-24 05

20

Supporting FactorsReal and nominal exchange rates

Differential between nominal and real effective exchange rate highlights pressures Central banks have to face to maintain the chosen currency regime.

Since 1995, we’ve seen a contraction of this differential, meaning that the likelihood of a currency risk has been generally reducing.

The graph highlights the latest Turkish crisis in 2001, the Russian one in 1998-99 and the recovery from the general Peso crisis in the mid-90’s.

Going forward, the only currency that might come under stress is the Venezuelan Bolivar, but this would not entangle a generic contagion effect.

Differential between REER yoy and NEER yoy

-100

-80

-60

-40

-20

0

20

1995 1997 1999 2001 2003 2005

TURKEYMEXICO BRAZILVENEZUELAPHILIPPINESRUSSIAN FEDERATION

Venezuela under pressure?

21

- 20%

- 15%

- 10%

- 5%

0%

5%

10%

15%

Bra

zil

Mexic

o

Russ

ia

Turk

ey

Philip

pin

es

Venezu

ela

- 200

- 150

- 100

- 50

-

50

100

150

FX appreciation (avg.2005 vs. avg. 2004)energy balance in 2004 (bn $ - RHS)

These big-6 are either neutral or even favoured by high oil prices: the fuel and energy items shows a nil or positive contribution to the total balance of goods, the only exceptions being Turkey and Philippines.

The few negative balance of goods (Turkey, Philippines and Mexico) in turn, are further compensated by the balance of services, so that the only country seriously affected by the “oil bill” remains Turkey…

…nevertheless, the appreciation that the currencies under consideration underwent in the last year helps lowering the burden of the negative “oil bills” in Turkey and Philippines.

From supportive to risk?High Commodity Prices

- 15%

- 10%

- 5%

0%

5%

10%

15%

20%

25%

30%

BrazilMexicoRussiaTurkeyPhilippinesVenezuela

fuel and energy balance / GDPgoods balance / GDPCA / GDP

22

Potential threatDecoupling of EM Spreads and BMK yields

The relation between UST yields and EMBI+ has inverted in Q3-05

Correlation between 10-year UST and EMBI+ was roughly 60% in 2004 versus –40% in 2005

Sep-05 is the turning point, with the market radically changing its expectations on Fed monetary Policy and UST yields

2

3

4

5

6

7

8

9

10

01/02 07/02 01/03 07/03 01/04 07/04 01/05 07/05

200

300

400

500

600

700

800

900

1000

Bund 10-year (LHS)

US Treasury 10-year (LHS)

EMBI+ Rebalanced (RHS)

Source: Bloomberg, JPMorgan

EMBI+ and BMK

Sep-05

Correlation 10-year UST and EMBI+

In Q1-05 14.6%

In Q2-05 43.5%

In Q3-05 -45.8%

In Q4-05 -29.1%

Change US Treasury 10-year EMBI+ Bund 10-year EUR EMBI+

in 2005 +26 -121 -19 -9

In Q1-05 +27 +26 -2 -2

In Q2-05 -53 -82 -48 -8

In Q3-05 +27 -54 -1 -12

In Q4-05 +9 -5 +26 +3

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Upcoming Elections:Risks of slippage ahead of the vote

Improvement in fundamentals is also partly due to the substantial capital inflows in EM since 2004 and to the global environment that has contributed to these inflows

Borrowers should remain cautious, as the prices of their bonds reflect not only the intrinsic quality of the borrower but also that of the improved global environment…

… therefore, they should not become complacent about their macro or monetary policies and the implementation of structural reforms, especially ahead of elections (Mexico: Jul-06, Presidential + Parliamentary ; Brazil: Nov-06, Presidential + Parliamentary ; Venezuela: 2006, Parliamentary ; Russia: Q2/Q3-08 Presidential, Q4-07/Q1-08 Parliamentary)

If anything,

EBV + TMP(Fed, ECB) + RBY => less margin for mistake

with

EBV: Expensive Bond ValuationsTMP(Fed, ECB): tighter monetary policies from both the Fed and the ECBRBMK: Rising Benchmark Yields

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In the end it is all about money

Between Greed and Fear, the Sharks of Finance have made up their mind:

EM total returns are among the highest EM fundamentals have improved EM borrowing needs are lower Global risk appetite is still high Investor base has widened Fed Fund Rate at 4.75% is fully priced and the new Fed Chairman should have little

incentive to surprise the market We forecast only moderately higher benchmark yields

H1-06 appears safe for EM, with some volatility building in Q2 due to market expectations regarding the end of the monetary policy tightening cycle in the US and EU

H2-06 could be more volatile depending on global liquidity and more importantly: local politics.

Market conditions remain favourable but more fragile