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Monthly Commentary

Risk sentiment was belatedly bolstered with a realization that the ECB’s longer?term liquidity injections (the LTRO) was as close as we would come to a bazooka and by a change in the calendar (hoping 2012 wouldn’t be like 2011). Moreover, there was gradual realization that hard landing concerns in China were largely misplaced, while the US showed increasing signs of stable, while largely unexciting, economic growth. Hence, with the main risks related to the Eurozone sovereign debt crises, which is hardly new, the market felt comfortable to put on risk, hedged with EUR shorts early in the year. Concerns about a sharp downturn in Eurozone economic growth were also reduced by a second strong PMI reading that puts into question some of our more bearish than consensus growth views. While there was still event risk galore, such as the pending S&P ratings downgrades of potentially the entire Eurozone followed by Fitch later in the month, the market overcame these events as they failed to surprise already negative expectations.

In terms of EM specific developments, Chinese equity markets rallied significantly, bolstered by a belief of additional imminent RRR cuts and fading hard landing concerns. The negative sentiment regarding Hungary remained early in the year, but on the back of a PR offensive, bearish Hungary trades were very crowded and quickly unraveled against a backdrop of better global risk sentiment.

While recognizing early the impact of the ECB LTRO, and being somewhat punished for it late December, we remained light for the first half of the month in light of the potential for a negative ratings surprise. Moreover, we felt that it was good news that the market had moved back to focus on Greek developments rather than those of Spain or Italy (or even France). However, it
was still not clear to us that the market had fully digested what the first sovereign debt restructuring in the Eurozone would mean and the possible knock?on effects of a flawed deal could have on the rest of the periphery, such as Portugal. Nevertheless, we remained constructive during most of the month, but we were too quick to cut/hedge any P&L in light of the event risk.

As the month progressed, we slowly added bullish EM risk, especially in EMFX (MXN, RUB, ZAR, MYR, KRW, and PLN) offset in part by long EURHUF (something we cut after its strong performance, despite no real change on the ground). We tactically added high beta EM credits and reentered a received Itraxx Senior Financials hedge, as we thought this asset would be the greatest
benefit from the bullish ECB LTRO view. Finally, some more uncorrelated rates receivers in Brazil and South Africa also paid off modestly during the month. In retrospect, we were too cautious and we missed a massively trending month with very shallow pullbacks and after the S&P decision came closely in line with our best case scenario, we should have added more risk.

Against a better global backdrop and an increasing realization that tail risks in the Eurozone post LTRO are more contained, risky assets started strongly in the New Year. In the absence of any new negative macro surprises and with a largely under invested market that saw strong inflows as a new year dawned, emerging market equity markets delivered their best performance since October and closed 11.2% higher in a month marked by only the shallowest of pullbacks. The S&P500 rallied 4.4%, once again starting to approach levels last seen early summer 2011 (and close to post?Lehman highs). Emerging market currency and local fixed income, as proxied by the GBI?EM, posted its strongest month since April 2009 with a 7.4% return. Clearly, EMFX led the rally contributing more than 5% to the overall total return with Mexico, Hungary, and Turkey leading the way – the least liked EMFX assets in late 2011. Local fixed income also benefitted from the stronger environment and rallied 2.3% during the month with Indonesian fixed income delivering a particularly stellar performance. Otherwise, the strongest EMFX performers also saw the strongest rate rallies, suggesting that these countries benefitted from foreign fixed income inflows (or short covering in the case of Hungary and to a lesser extent the unwinding of paid position in Turkey). However, overall we saw limited inflows into the EM fixed income funds during the month, while EM equity did see a significant increase in fund inflows during the month.

Outlook

The better tone in risk, a better global growth outlook, and a belief of reduced tail risk will be subject to how the negotiations in Greece pan out. Ultimately, we believe that despite the Greek story having been hanging over the market for well over two years, the market would be unable to decouple from a disorderly default March 20th. However, we remain constructive that ultimately the Greek government and the Troika will take a decision that will significantly reduce the risk of an imminent Greek related tail?risk. Nobody is arguing that the deal on the table, reaching a debt to GDP ratio of 120% by 2020, is in anyway sustainable, but rather the international community is again kicking the can down the road. After a successful PSI deal it will be much harder for Greece to default on private sector debt principal payments as most will be replaced by a 30?year bullet payment. That said, the precedent set in Greece with regards to other potential sovereign debt restructuring, such as Portugal, will be important as well as what role official sector involvement (the ECB holdings in particular) will play in any debt restructuring scenario. We note that the market in February and early March will still have to navigate some key events such as the debt exchange itself, retroactive inclusion of collective action clauses in local Greek debt, and the triggering of CDS. While we remain constructive on these events and that EM can remain decoupled from them, we remain somewhat cautious despite lagging behind in January. Ultimately, from an EM point of view, with Euro? zone tail risks hopefully sufficiently mitigated by end? March, we are back to watching and trading global growth and there the news looks a bit too good to be true in the case of
Europe. Let’s see, but if recent PMI readings are correct the Eurozone recession is more likely now to be a shallow one as the core delivers better?than?expected growth. Hence, with global growth possibly on a better path come Q2, we remain constructive laggard EM growth stories, such as Mexico and we note that with S&P500 near post?Lehman highs, many EM asset are still far short of such lofty levels.