How Em Fx Outperforms Em Equities

8/6/2019 How Em Fx Outperforms Em Equities

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Nomura International plc

How EM FX outperforms EM equities

Overcoming inflation and underdeveloped capital markets

10 May 2011

Anthony Morris+44 (0)20 7102 [email protected]

ANY AUTHORS NAMED ON THIS

REPORT ARE RESEARCH

ANALYSTS UNLESS OTHERWISEINDICATED

SEE DISCLOSURE APPENDIX A1FOR ANALYST(S)

CERTIFICATION(S) ANDIMPORTANT DISCLOSURES

Swati Aggarwal+44 (0)20 7102 [email protected]


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2

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

BRIC GDP weighted Portfolio MSCI weighted portfolioSharperatio,annualized

(199

9-2010)

Equity ER ($) Equity ER (LC) FX ER

EM equity returns have gained most from FX component

Source: Bloomberg, Nomura Research. Researc h (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the includedcountries local policy rate. Long EM FX is Nomura FX return indexes. Countries included are: Brazil, Russia, India, China, Mexico, Indonesia, Malaysia, South Korea, Taiwan, South Africa, Turkey, Poland and Israel. Allreturns have been volatility-adjusted to have a constant vola tility of 10% over this time period. The BRIC portfolio has Brazil, Russia, Indian and China and is also GDP weighted.

EM equity

(USD)

EM FXEM equity(Local Currency)

value-add of equities value-add of FX

EM FX outperforms equities in local currency


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Key Messages

3

Some EM countries have higher growth (e.g. BRIC)

but also high inflation and underdeveloped capital markets

In such contexts, EM FX has outperformed EM equities

EM FX has beta like EM equities, but higher alpha

Given its higher liquidity, EM FX enables higher allocations to high-

growth economies

EM FX outperformance is especially clear in 2011


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EM problems: underdeveloped equities, inflation


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Hence, equity portfolio allocation unrelated to economic size

Source: IMF World Economic Outlook (October 2010), Nomura Research. GDP weights are 2010 IMF forecasts. . MSCI weights refers to the weights in MSCI ACWI and are correct as of February 2011

EM weighting: equity smaller than GDP China + India = Korea + Taiwan?

63%

87%

37%

13%

0%

20%

40%

60%

80%

100%

GDP MSCI weights

Advanced countries Rest

12%

3%

2%

3%

0%

2%

4%

6%

8%

10%

12%

14%

16%

GDP MSCI weights

China +India South Korea+Taiwan


7/307

Many economically important firms are not listed

Source: Schneider et. al Shadow Economies All over the World (July 2010) Policy Research Working Paper 5356 , World Bank. Top 100 companies for Brazil are from the Exame survey of the biggest and bestcompanies in Brazil

Non-listed companiesSome of the best performing companies may not be public

- Efficiently-managed private enterprises

- Better-performing state-owned enterprises

- Similar to Mittelstand companies in Germany

Foreign companiesMany foreign companies have significant revenues from EM,but are not listed locally

- e.g. Swedish/Swiss company ABB derives 55% of its

revenue from EM

Significant shadow economiesMany EM countries have substantial parallel economies,

not reflected in equity markets

- Business activities which are not reported to authoritiesto avoid taxes and regulations

Top 100 companies in Brazil by sales

Listed, 35

Foreign , 44

Private, 21

Unlisted, 65

Shadow economy can be substantial in EM

0%

10%

20%

30%

40%

50%

G7 Developing

countries

China India Brazil RussiaSizeofthesha

doweconomy

(asa%

ofGDP)


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Small markets are easily flooded by global hot money

Source: Bloomberg, Nomura International (April 2011).

Indian stock markets: growth trade or global liquidity trade?

-1500

-1000

-500

0

500

1000

1500

2000

2500

3000

0

5000

10000

15000

20000

25000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

mnUSD

Index

BSE SENSEX (lhs) Net monthly FII inflows into Indian equity markets (12m moving average, rhs)


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9

0

50

100

150

200

250

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Index(volatility-a

djusted)

Periods of sustained deviation in the performance of the two indexes Shanghai SE Composite S&P 500

Regulatory policies impact EM equity performance...

Source: Bloomberg, Nomura International (April 2011). The Shanghai Composite index has been volatility-adjusted to have the same volatility as the S&P 500 over this sample period

... and illiquid

Are US equity markets and regulation the two drivers of Chinese equity returns?

Chinese governmentintroduces NTS reforms,making hitherto untradeableshares tradable

Government boostsmarket liquidity byallowing more institutionalinvestors to buy A-sharesand lifting the ban onbanks which prohibited

financing of stockinvestment

CSRC announcesQFII schemeallowing FII todeal in A-sharesalbeit with severalrestrictions

Governmentannounces aRMB4trn economicstimulus program


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... while questions remain about governance

Source: Transparency International

... and illiquid

Regulatory institutions in EM are perceived to be weaker

Corruption Perceptions Index 2010 Results


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11

Inflation is bad for equities and pervasive in EM

Source: Bloomberg, Nomura Research (March 2011) . S&P 500 deflated by inflation is the SPX/CPURNSA. US inflation in the 1970s refers to average CPI y-o-y between January 1970 and December 1979 . Current CPIrefers to latest available CPI data (April or March 2011)

Inflation is pervasive in EMHigh inflation is bearish for equities

0% 2% 4% 6% 8% 10%

US in1970s

Taiwan

Malaysia

Mexico

S. Africa

S. Korea

Turkey

Poland

Israel

China

Indonesia

Brazil

India

Russia

Current CPI y-o-y

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

0

1

2

3

4

5

6

7

8

9

10

1960 1970 1980 1990 2000 2010

Inflation y-o-y, rhs S&P 500 (deflated by inflation), lhs


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12

Equity returns have failed to deliver noticeable alpha

Source: Bloomberg, Nomura Research (April 2011) . Bovespa futures index returns have been volatility-adjusted to have the same volatility as the S&P 500 futures index over this time period.

Brazilian equities have reflected movements in the S&P 500 more than the countrys growth

0

50

100

150

200

250

1996 1998 2000 2002 2004 2006 2008 2010

Cumulativeexcessreturns(volatility-adjusted)

Bovespa futures index

S&P 500 futures index


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EM FX is also EM beta


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14

EM FX tracks EM equities

Source: Bloomberg, Nomura Research (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the included countrieslocal policy rate. Long EM FX is Nomura FX return indexes. Countries included are: Brazil, Russia, India, China , Mexico, Indonesia, Malaysia, South Korea, Taiwan, South Africa, Turkey, Poland and Israel. All returns havebeen volatility-adjusted to have a constant volatility of 10% over this time period.

GDP-weighted portfolio MSCI- weighted portfolio

Correlation with equity returns in USD: 79%

Correlation with equity returns in LC: 69%

Correlation with equity returns in USD: 79%

Correlation with equity returns in LC: 66%

0

50

100

150

200

250

300

1999 2001 2003 2005 2007 2009 2011

Cumula

tiveexcessreturns

(volatility-adjusted)

Long EM FX

Equity (in USD)

Equity (in local currency)

0

50

100

150

200

250

300

1999 2001 2003 2005 2007 2009 2011

Cumula

tiveexcessreturns

(volatility-adjusted)

Long EM FXEquity (in USD)


Pure equity component has worse risk-adjusted returns than the FX component


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Individual countries also show high correlation

Source: Bloomberg, Nomura Research (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the included countrieslocal policy rate. FX returns is Nomura FX return indexes.

Country

Correl. of FX returns with equity returns

Country

Correl. of FX returns with equity returns

USD Local currency USD Local currency

Brazil 80% 31% Poland 70% 41%

China -5% -5% Russia 35% 29%

India 61% 48% S Africa 71% 14%

Indonesia 77% 50% South Korea 62% 33%

Israel 45% 19% Taiwan 56% 43%

Malaysia 43% 27% Turkey 58% 34%

Mexico 63% 36%


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Both EM FX and EM equities are linked to economic growth

Source: Bloomberg, Nomura Research (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the included countrieslocal policy rate. Long FX is Nomura FX return indexes. 1Lustig, Hanno and Adrien Verdelhan, The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth," 2007, American Economic Review, 97(1),89-117. All returns have been volatility-adjusted to have a constant volatilit y of 10% during this time period.

EM FX and EM equities carry sovereign risk

- During crisis, EM FX plunges at the same time as local equities

Many EM equity investors are de-facto currency investors

- Substantial investment from G10 investors benchmarked to EM equities denominated in G10 currency

EM currencies usually have high carry, like high beta G10 currencies

- Lustig and Verdelhan (2007)1 have argued that higher interest rate currencies earn risk premium

- G10 FX has higher rates than USD sometimes but not othersEM FX almost always has, especially for BRIC

- For G10 currencies with higher interest rates, strong correlation is seen

Australia Sweden

0

100

200

300

400

500

600

1985 1990 1995 2000 2005 2010

Cumulativeexcessreturns

(volatility

-adjusted)

Periods when interest diff is negative

Long FX

Equity (in USD)


0

50

100

150

200

250

300

1999 2003 2007 2011


(volatility

-adjusted)

Periods when interest diff is negative

Long FX

Equity (in USD)



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China-linked FX baskets can work for CNY

Source: Bloomberg, Nomura International(December 2010). All returns are excess returns i.e. Returns above cash rate. US equities and Chinese equities refer to the respective MSCI total return indices in dollars. Chinesegovt bonds have been calculated from the S&P CITIC China bond indices . Yuan carry refers to the Nomura FX CNY return index and US bonds refer to the Bloomberg EFFAS US govt bond index(> 1Yr). All returns havebeen adjusted to have same volatility as C10

Correlation to global markets are lower

Nomura C10 is a better reflection of Chinese growth

C10 Yuan carryChina

equitiesUS bonds US equities

C10 100% 5% 47% 3% 46%

Yuan carry 5% 100% -9% 7% -8%

China equities 47% -9% 100% -19% 63%

US bonds 3% 7% -19% 100% -33%

US equities 46% -8% 63% -33% 100%

Yuan-carry is different

Yuan FX carry suffers due to very tightly-controlled currency markets

When investors are bullish on China, being long is a negative carry trade

Negative carry is reduced when investors are more bearish on China

The C10 Index

Carry-weighted long positions in 10 currencies from a set of 24 which:

- have highest export exposure to China

- are liquid

Rationale

Yuan-dollar rate is not investable; often large negative roll cost in NDFs

C10 currencies should benefit most from China growth due to stronglinkages

C10 is less correlated with global equities Outperforms other Chinese assets

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


(volatility-scaled)

Nomura C10 Yuan-dollar carry

Chinese equities China real GDP index

0.0

0.4

0.8

1.2

1.6

Nomura C10 Yuan-dollar carry Chinese Equities

Sharpe ratio Calmar Ratio


18/30

EM FX outperforms EM equities


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EM FX portfolios have better risk-adjusted returns

Source: Bloomberg, Nomura Research (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the included countrieslocal policy rate. FX is Nomura FX return indexes.

Comparison of Sharpe ratios (2001-10) Comparison of Calmar ratios (2001-10)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

GDP weights MSCI weights

FX with C10 FX Equities($) Equities(LC)

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

GDP weights MSCI weights

FX with C10 FX Equities($) Equities(LC)


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Outperformance from good returns and low correlations

Source: Bloomberg, Nomura Research (January 2011). Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TR indexes in LC for the included countrieslocal policy rate. Long EM FX is Nomura FX return indexes. All returns have been volatility adjusted to a volatility of 10%

Performance in individual countries (2001-10)

Average correlations

0%

10%

20%30%

40%

50%

60%

Intra-FX Intra-FX

(without CNY)

Intra-FX

(with C10)

Intra-Equities

(LC)

Intra-Equities

($)

-4%-2%

0%

2%

4%

6%

8%

10%

12%

China Turkey Brazil Indonesia Russia India Poland Malaysia South

Africa

Mexico Israel South

Korea

Taiwan

Vo

latility-adjustedannual

excessreturns

C10 Long EM FX Equity returns ($) Equity returns (LC)


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21

60

600

1996 1998 2000 2002 2004 2006 2008 2010

Cumulativeexcessre

turns

(log-scaledandvolatility-adjusted)

Long BRL

S&P 500 futures

index

Bovespa futures

index

FX returns succeed in delivering noticeable alpha

Source: Bloomberg, Nomura Research (April 2011). Bovespa futures index returns and BRL returns have been volatility-adjusted to have the same volatility as the S&P 500 futures index over this time period . Long BRL isthe returns on the Nomura FX BRL returns index.

BRL reflects Brazils unique growth, not the S&P 500

100


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FX does better in countries where...

Source: S&P World by numbers September 2009 , Bloomberg, Nomura Research (January 2011) . Equity (USD) refers to MSCI TR indexes in USD for the included countries Fed funds rate. Equity (LC) refers to MSCI TRindexes in LC for the included countries local policy rate. FX is Nomura FX return indexes. Stock market cap as a % of GDP refers to the freely floating market capitalization as of September 2009. GDP figures are 2009.Average inflation differential refers to difference with US values. China has been excluded from scatter plot due to unusual behaviour of carry.

... equity is underdeveloped ... inflation is high ... rates are high

R = 0.30

0%

20%

40%

60%

80%

100%

120%

140%

-0.5 0.0 0.5 1.0

Stockmar

ketcap(%ofGDP)

FX Sharpe ratio - Equity (LC) Sharpe ratio

R = 0.42

-4%

0%

4%

8%

12%

16%

20%

-0.5 0.0 0.5 1.0

Averageinfla

tiondiff.(2001-2010)


R = 0.61

-5%

0%

5%

10%

15%

20%

25%

-0.5 0.0 0.5 1.0

Averagenomina

lratediff.(2001-2010)



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FX avoids many of the drawbacks of other EM assets

Source: Nomura International, BIS Triennial Central Bank Survey, World Federation of Exchanges. Equity daily turnover consists of turnover in equities and exchange traded derivatives in 2009 as reported by WorldFederation of Exchanges. OTC derivatives have not been included however by most accounts they are negligible. FX turnover is turnover in OTC derivatives as reported by BIS and exchange traded derivatives as reportedby WFE for 2009.

Greater scalability and liquidity

More professional market, less prone to retail trends

Less influenced by regulation

Corporate governance is not an issue

Only some firms use equities, but everyone uses FX

- State-owned vs. private

- Listed vs. non-listed

- Domestic vs. foreign

- Unofficial vs. official

EM FX is more scalable than EM equities

0 20 40 60 80

Indonesia

Mexico

Malaysia

Poland

Turkey

S. Africa

Israel

Russia

Brazil

Taiwan

India

Korea

China

Average daily turnover (bn $)

Equities FX


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EM FX versus EM equities in 2011


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-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

Equity total returns

($)

Equity total

returns(LC)

Equity excess

returns (LC)

Equity futures-

based index (LC)*

LC cash accrual

(based on policy

rates)

Spot FX

appreciation

FX returns

Yeartodatereturn

s

GDP-weightedportfolio

EM FX has outperformed EM equities in 2011

*Stock futures based index includes only those countries for which local currency denominated futures contracts are available. Excluded countries are Indonesia, Israel and Russia.Source: Bloomberg, Nomura Research (6 May 2011). Equity TR ($) is the MSCI US TRindex for the 13 countries weighted by the 2010 GDP in US dol lars. Equity TR (LC) is the MSCI LC TR index for the 13 countriesweightedby the 2010 GDP inUS dol lars.Equi ty ERin LCis LC TRover pol icy rates (For China 1 year deposit rate has been used. EMFX returns are the returns on a GDP weightedportfol io of NMFX return indexes. AndLC cashaccrual is the policyrate thatwould be accrued YTD. Iequity-futures based index represents the returns from holdingand rolling the active stock futures contract

High inflation and rate hikes have contributed to the outperformance of the EM portfolio


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FX has outperformed equities in the BRIC countries (1/2)

Source: Bloomberg, Nomura Research (6 May 2011). Equity TR ($) is the MSCI US TR index for the country. Equity TR (LC) is the MSCI LC TR index for the country. Equity ER in LC is LC TR over policy rate (For China 1year deposit rate has been used). Stock futures based index represents the returns from holding and rolling the active stock futures contract. EM FX returns are the returns on a GDP weighted portfolio of NM FX returnindexes. And LC cash accrual is the policy rate that would be accrued YTD. C10 is the NMC10U index on Bloomberg

China India

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

Equity

TR ($)

Equity

TR (LC)

Equity

ER (LC)

Futures-

based

index

LC cash

accrual

Spot FX FX returns

Y

TDreturns

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

Equity

TR ($)

Equity

TR (LC)

Equity

ER (LC)

Futures-

based

index

LC cash

accrual

Spot FX FX

returns

C10

YTDreturns


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FX has outperformed equities in the BRIC countries (2/2)

Source: Bloomberg, Nomura Research (6 May 2011). Equity TR ($) is the MSCI US TR index for the country. Equity TR (LC) is the MSCI LC TR index for the country. Equity ER in LC is LC TR over policy rate (For China 1year deposit rate has been used). Stock futures based index represents the returns from holding and rolling the active stock futures contract. The stock futures index has not been shown for Russia due to the lack of a localcurrency denominated stock futures contract EM FX returns are the returns on a GDP weighted portfolio of NM FX return indexes. And LC cash accrual is the policy rate that would be accrued YTD.

Brazil Russia

-12%

-8%

-4%

0%

4%

8%

Equity

TR ($)

Equity

TR (LC)

Equity

ER (LC)

Futures-

based

index

LC cash

accrual

Spot FX FX

returns

Y

TDreturns

-2%

0%

2%

4%

6%

8%

10%

12%

Equity TR

($)

Equity TR

(LC)

Equity ER

(LC)

LC cash

accrual

Spot FX FX returns

YTDreturns


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Key Messages

28

Some EM countries have higher growth (e.g. BRIC)

but also high inflation and underdeveloped capital markets

In such contexts, EM FX has outperformed EM equities

EM FX has similar beta as EM equities, but higher alpha

Given its higher liquidity, EM FX enables higher allocations to highgrowth economies

EMFX outperformance is especially clear in 2011


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Analyst certification:We, Anthony Morris and Swati Aggarwal, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred to in thisreport, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or v iews expressed in this report and (3) no part of my compensation is tied to anyspecific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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How Em Fx Outperforms Em Equities

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