Mid-Quarter Update: Bond and Equity ‘Connect’

- Staying the Course — "Our Q3 trading range thesis is intact; the sharp pullback in GEMs in recent days should not turn into a rout. After some consolidation at or just below current levels – the seasonals are not good for August and September – we expect a breakout to new highs and strong gains for emerging markets in Q4."
- Good Quarter — "Emerging markets are having a good quarter. At one stage in early-August, MSCI GEMs were up by over 10%. EMEA and Latin America (both now up 9.8% in Q3) have led the way, while Asia (+4.8%) has lagged; GEMs (+6.8%) have outperformed AC World (+6.1%). Both emerging market currencies (+1.9%) and bonds (+6.6%) have delivered positive returns."
- Worrying about Bonds — "The latest symbol of the ‘wall of worry’ is the collapse of US bond yields to 2.6% (10-years). Since March 2010, nominal yields are down by 120bp but real yields have barely moved (-10bp) as inflation has fallen sharply."
- Bond/Equity ‘Disconnect’ — "At US yields below 6%, equities tend to fall when yields fall (correlation between US bonds and equities of +0.84 since the start of 2007). However, since early-July, US equities have rebounded as bond yields have fallen – a ‘disconnect’."
- Emerging Markets’ ‘Connect’ — "The bond/equity link in GEMs is the exact opposite. The correlation between equities and bond yields is -0.84, given that debt yields are typically the main driver of equity prices; equities like low yields, so there is no ‘disconnect’ in GEMs. This relationship should only break down if ‘double-dip’ fears cause a new bout of risk aversion, so pulling equities lower."
- Resolution — "Our global strategy team sees the bond/equity disconnect being resolved via lower bonds not lower equities. This outcome should not threaten emerging markets as long as yields do not rise too far."
- Regions/Countries — "We remain cautious near-term and look to add beta around end-Q3. We stay Overweight in the more defensive Asia and continue to prefer EMEA (Neutral) to Latin America (Underweight). We raise to Overweight Peru, Czech Republic and Egypt (from Underweight) and Poland (from Neutral). We cut Thailand and Turkey to Neutral and Malaysia and Mexico to Underweight."
- Sectors — "We upgrade Utilities to overweight, based mainly on attractive valuations, underperformance in the third quarter and the sector’s low beta status. We reduce slightly our Overweights in IT, Industrials and Materials. We make several changes to our Model Portfolio of stocks".
Citigroup Global Emerging Markets Strategy 20100816

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