any further rebalancing to be unhedged, strengthening USDJPY. We believe the Republican sweep of Congress makes it very likely that HIA 2.0 will be passed (Homeland Investment redux?}. Following the 2005 HIA, USD/JPY rose from 102 to 117 (Chart 20). Given US corporate exposure is heavily concentrated in European and Asian countries (including Japan), flows out of these currencies into USD would
be the most pronounced.
Trade: We recommend buying a 6m USD/JPY digital call for 10% spot ref: 108.95). The strike aligns with our end-2017 USD/JPY forecasts of 120, and with a 10% entry level provides a 10 to 1 return. The risks to the trade are a decline in risk sentiment, a retreat from the US Treasury’s “strong dollar” policy by the new administration, and/or a failure of the US to meet already high expectations for
significant fiscal easing.
EM sovereign credit has more downside
Our bullish dollar + bearish US rate view leaves us bearish on EM. In our view, Mexico, Brazil and Colombia (longer duration low spread foreign currency bonds) are especially vulnerable, while the higher yield and lower duration of lower quality and shorter EM bonds will be more defensive. A review of the taper tantrum (May 2013) shows that: 1) EM underperformed UST at the start; 2) BBB sovereigns underperformed the most, and had not yet recovered in a year; and 3) BB and B-rated bonds recovered to beat USTs 8- 10 months later. This time, we expect a sharp selloff with an eventual recovery.
Our bearish view on LatAm credits in particular is driven by 1) positioning in LatAm is heavier than in EMEA or Asia — watch outflows from IG crossover investors who will rethink their EM IG investments; 2) their exposure to commodities and 3) vulnerability to a potential decline in US trade. Our choice of the basket is fairly obvious - Mexico is clearly the most vulnerable to NAFTA and a decline in remittances, uncertainty on the pace of the economic recovery and debt dynamics are extremely challenging in Brazil while tax reform delays could mean a credit rating downgrade in Columbia.
Taking account of both oil and US rates as independent variables, a regression analysis shows that a 100bp Tsy backup would be related to 30-45bp wider spread (Chart 22).
Note that residuals show spreads are currently about 35bp too tight.
The trade: Sell equally weighted basket of Mex 47s, Brazil 45s and Colom 44s Current average yield: 5.74%, annual carry & roll 30bp; target: 6.35%; stop: 5.25%
On a portfolio basis for benchmark real money investors, we recommend moving out of long higher quality LatAm, leaving higher yielding shorter bonds. A commodity price
rebound or a reversal of US rates is a risk to the trade.
Chart 21: Total return of EM sovereigns during taper tantrum May 2013
Total return index value 104
100 |
96
92
88 fice May-13 Jul-13)-- Sep-13.-Nov-13. Jan-14.—- Mar-14.— May-14
BBB rated Source: BofA Merrill Lynch Global Research, Bloomberg
——US try master BB rated B rated
Chart 22: EM sovereign spreads widen with declining oil prices Jun 2014
Commodity collapse 475
100 425 375 vhs) 325 90 Taper tant 275 25 225 May-13 May-14 May-15 May-16
Brent IGOV Index (rhs) Source: BofA Merrill Lynch Global Research, Bloomberg
10 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016
BankofAmerica <2” Merrill Lynch
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