Emerging Markets Strategist HSBC

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Text of Emerging Markets Strategist HSBC

25 May 2011

Emerging Markets Cross-Asset Strategy

Global Research

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Emerging Markets StrategistBetter than it seems A not-too-hot not-too-cold global economy supports investments in EM Concerns shift from inflation to growth in EM We recommend staying long hard-currency bonds and extending duration in local markets, and favoring EM Asian FX and secular growth stories in equity

We remain positive on EM, despite global headwinds. Investors show concern about the impact on EM of a deteriorating global environment. We disagree: a not-too-hot nottoo-cold global economic backdrop supports investments in EM. Low US Treasury yields should remain supportive to carry trades due to a softer US economy and in spite of the second round of quantitative easing (QE2) coming to an end on 30 June. We see concerns shifting from inflation to growth in EM, which has important implications in terms of asset allocation. Weaker growth is not good for equities, while an easing of inflation pressures provides a solid base for fixed income. EM currencies might be trapped in the middle of USD gyrations. Thus, we maintain a preference for emerging markets hard-currency debt, and we call for a more cautious approach in FX and equities. Inflation concerns are easing because of a retracement in commodity prices, moreaggressive interest-rate tightening, a reweighting toward more-conventional monetary policy, and weaker economic data. We extend our quantitative analysis offering in EM. We introduce a new rich/cheap external debt model to value positioning across the different country curves. Also, our EM Central Bank Monitor now is available on Bloomberg at HSER. Local markets: Depricing of interest rate hikes is almost done; we recommend long duration in Mexico, South Africa, and Indonesia. External debt: We remain fully invested, as we see room for 15-25bps spread tightening; we are overweight high-yielders Argentina, Venezuela, and Ukraine. FX: We favour IDR, MYR, CNH, and SGD in Asia; BRL, MXN, and COP in Latam; and RON in EMEA. Equities: These are experiencing a drag from lower growth expectations, but benefiting from easing inflations fears; we recommend good secular growth stories: Brazil, China, Indonesia, Malaysia, and Turkey, over Korea, Mexico, Poland, and Thailand.

EM Fixed Income, Equity, and FX Strategy TeamsPablo Goldberg Global Head of EM Research HSBC Securities (USA) Inc. +1 212 525 8729 pablo.a.goldberg@us.hsbc.com View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report:

HSBC Securities (USA) Inc.

Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Emerging Markets Strategist Cross-Asset Strategy 25 May 2011

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ContentsBetter than it seems Local markets External debt FX Equity EM Flows WatcherMacroeconomic forecasts EM FX forecasts EM Central Bank Watcher Surprise Indices Trade ideas

3 14 16 18 20 2728 29 30 31 32

Tables and chartsLocal markets EM Inflation linkers and break-evens External debt Rich/Cheap Model External debt External yield curves External debt bonds, CDS, and basis FX: Spot, HSBC forecasts, and forward curves Equities

3333 36 38 40 42 43 45 47

Disclosure appendix Disclaimer

49 51

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Better than it seems A not-too-hot not-too-cold global economy supports investments

in EM Concerns shift from inflation to growth in EM We recommend staying long hard-currency bonds and extending

duration in local markets, and favoring EM Asian FX and secular growth stories in equity

Staying positiveDespite decreasing volatility of EM assets, investors worldwide appear to be uneasy, keeping cash on the sidelines. Markets are doing too well, given the number of shocks out there; we must be due for a correction is a typical phrase that we hear a lot lately. Going over the laundry list of headwinds facing the market, one can understand why some investors feel a sense of impending crisis: deteriorating growth expectations in the developed world, large fiscal deficits in the US and Japan, weakening debt dynamics in the Eurozone periphery, and inflation pressures in emerging markets.Chart A1: Decreasing volatility of EM fixed income and equity30% 25% 20% 15% 10% 5% 0% Jun-07Source: HSBC

We disagree. We believe those factors provide underlying support for EM in the short term. Indeed, we see a sort of repetition of the lowgrade Goldilocks scenario for EM presented during a good part of 2010. This scenario is formed by three elements: Ample global liquidity. The belief that such liquidity will remain in spite of the end of QE2. Strong fundamentals in EM. Putting it more simply, a lot of money is floating around and it has to go somewhere; for now, this place continues to be the emerging markets. Strong balance sheets in EM continue to attract interest, and while risks from abroad lead to some volatility, they do not derail the appetite for the asset class. True, this time around, EM might not see the benefit of falling yields in the US. Nonetheless, we believe growth in the US is not strong enough to push rates significantly higher either, and we consider a double-dip unlikely. Europe is a concern, but we do not see an involuntary and disruptive default as a likely outcome.

Pablo Goldberg Global Head, EM Research HSBC Securities (USA) Inc. +1 212 525 8729 pablo.a.goldberg@us.hsbc.com

150% EM EXD EM Equities 125% 100% 75% 50% 25% 0% Mar-08 Dec-08 Sep-09 Jun-10 Mar-11

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In our inaugural edition of Emerging Markets Strategist: Turning more positive on EM risk (1 April 2011), we forecast an end of the reflow of funds out of EM and into the developed markets. Since then, we have seen a strong recovery of inflows into EM-dedicated funds, both equity and fixed income (see page 27). This reflow was the result of better growth prospects for the US and Germany, and increasing inflation concerns in EM. As the growth outlook in developed markets softened and EM central banks increased their focus on inflation, we foresaw the flow of funds favoring EM one more time. We believe that these dynamics are likely to remain in place. Different from the situation in 2010, we are witnessing a rotation of themes that dominated investors perception of EM year-to-date: the inflation theme is being deflated, and concerns are shifting toward weakening economic activity. This rotation has important consequences in terms of asset allocation. Softer growth expectations are not good for equities, while an easing of inflation pressures provide a solid base for fixed income. EM currencies might be trapped in the middle of USD gyrations; thus, we maintain a preference for emerging markets hard-currency debt, and we call for selectiveness in FX. Valuations have corrected in many of these asset classes, and while our long-term view of EM remains bullish, we maintain that a more selective approach is warranted in the short term. In most places, value has been squeezed; thus, long EM positions should be seen more as a carry play than a capital appreciation story. This is what our low-grade Goldilocks scenario is about.

touching 3.75% in January, 10yr US Treasury yields dropped to about 3.13% at the time of this writing. We disagree with those who believe there is a bubble in EM valuations; rather, we see a very generous pricing of risk worldwide brought about by very low funding rates in the developed markets. HSBC Economics believes the level of US Treasury yields depends on economic data, and that the end of QE2 should not, per se, lead to higher yields in the US. Chart A2 shows that the announcement of QE2 marked the lows of US Treasury rates, which moved higher in anticipation of higher economic growth. Because we expect that economic activity will stay subdued and core inflation will be relatively tame, we anticipate that yields will stay range-bound and that the US Federal Reserve will stick with an accommodative policy into 2012. So far, economic data support our assessment, which in turn is positive for EM fixed income and FX.Chart A2: UST10y yields driven by expectations on growth (%)4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 2.2 2.0 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 UST10yr Bloomberg median 2011 GDP Fcst 2.6 2.4 2.2 2.0 QE2 announcement 3.4 3.2 3.0 2.8

Source: Bloomberg

Its the economy, stupid!We expect global interest rates to remain low and to continue to support crossover flows into EM. What brings money into EM is not only strong fundamentals but also the low level of yields in the developed world. After almost

The most challenging headwind to inflows into EM is a potential correction in risk-free rates, in our view. We got a clear glimpse of that during 4Q 2010. Therefore, we expect that things will likely change when developed-market yield curves and policy rates begin a consistent process of normalization, but we are not there yet. Furthermore,

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we do not see the end of QE2, scheduled for 30 June 2011, as the day of reckoning.

Deflating inflation fearsThe structural case in favor of EM remains intact, we believe. Ultimately, the value of the emerging markets comes from an absolute structural improvement in their fundamentals, and also its relative performance against developed markets. These movements are so profound that they are shaping geopolitics in a significant way. Who would have thought that EM was going to be in such position as to claim its right to chair the International Monet