Emerging Markets Bond Update Oct 9, 2013 Jane Lesslie, CFA, MSc, Senior Portfolio Manager David Nava, MBA, Associate Portfolio Manager

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1 Oct 9, 2013 Jane Lesslie, CFA, MSc, Senior Portfolio Manager David Nava, MBA, Associate Portfolio Manager Total Return (%) Spread (bps) Total Return (%) Spread (bps) Wk MTD YTD Last Wk YTD Wk MTD YTD Last EMBI Global Div (6.29) 334 (0) 76 Colombia (BBB) (8.59) 180 (4) 68 China (AA-) (0.23) (0.01) (3.76) Philippines(BBB-) (7.89) 165 (7) 44 Chile (AA-) (6.96) 164 (4) 48 Indonesia (BB+) (12.11) 308 (9) 129 Malaysia (A-) (4.08) Turkey (BB+u) (9.65) 271 (4) 94 Kazakhstan(BBB+) (5.06) 285 (5) 78 Hungary (BB) (18) Russia (BBB) (4.55) 219 (5) 62 Vietnam (BB-) (0.14) 310 (36) 6 Peru (BBB+) (11.06) 177 (2) 63 Venezuela (B) (2.01) (1.24) (9.14) Mexico (BBB) (0.35) 0.01 (8.20) Ukraine (B) (8.25) 955 (15) 323 Brazil (BBB) (10.88) 238 (1) 98 Dom. Rep. (B+) (3.25) 408 (19) 65 Panama (BBB) (10.74) 203 (3) 74 Argentina (CCC+) (19) 14 Wk YTD US Treasurys (0.13) (0.14) (2.59) EMD Local(USD) (6.26) US Invest Grade (0.10) (0.01) (2.46) Br Real(vsUSD) (7.24) Canada Bond Mrkt (0.14) (0.26) (1.82) Mx Peso(vsUSD) (1.77) US HY (BB & B) (5) (52) Ru Ruble(vsUSD) (5.14) EM Corp Debt (3.33) 339 (2) 38 Turk Lira(vsUSD) (10.24) EM Equities(USD) (4.48) Ch Yuan(vsUSD) (0.09) (0.05) 1.74 Commodities(USD) (0.09) 0.47 (4.11) Cad Dollar(vsUSD) (3.62) Source: JPMorgan, Merrill Lynch, MSCI, TSX, Bloomberg. Emerging market bonds continued in recovery mode over the course of September and early into October with returns month to date of 0.41%. Spreads were unchanged over the last week, finishing at 334 basis points. With angst about the US Gov t shut down/debt ceiling/potential US default dominating the airwaves along with the slower growth this is expected to spawn, expectations for an early Fed taper, ( i.e. reduction in purchases of US Treasuries by the Federal Reserve) have been tabled. Offsetting this support from the US Treasury market are continuing concerns about mixed economic data out of emerging markets. However, Purchasing Manager Index data in emerging economies (as well as developed ones) on balance turned positive as October opened. We see spreads in a trading range from resistance at 313 basis points to support at 374 basis points, the recent high. Yields on the index having peaked at 6.20% a month ago, today stand at 5.80%. Credit curves have flattened ie where risk premiums on longer terms bonds have fallen more than those on shorter term bonds. Having increased the average maturity of our portfolio throughout July and August, we have now begun to take profit on these positions. One reason for our caution is the technical outlook. Having seen one week of positive inflows, after 17 successive weeks of outflows, flows to dedicated EM funds once again turned negative last week- albeit at $229M this represented a mere 0.09% of assets under management. Outflows from the sector since June have amounted to $34Billion. Balancing this, surveys show that dedicated investors have below index allocation to sovereign bonds and the remaining issuance to the end of the year is roughly $7.5B. In fact a number of countries including Croatia, Kenya and Hungary have now decided to postpone issuance.

2 Page 2 To put this remaining expected issuance in context, EM bond markets saw more than $53B in issuance in September with a ratio of EM corporates to sovereigns about 2:1. JP Morgan estimates that total EM external debt issuance for the year, notwithstanding a very tough backdrop, will still amount to a record $411B. While the near term issuance picture is generally supportive, we are concerned about a deterioration in EM fundamentals as exhibited by the ratio of countries upgraded to those downgraded as the latter are now outstripping the former. The ratio of those countries put on positive outlook relative to those on negative outlook has similarly deteriorated. (see charts below) Brazil last week was downgraded from positive outlook to stable by Moody s which fired a shot across the country s bow given the growth of sovereign debt, particularly lending to state owned banks which now amounts to some 10% of GDP, and a lack of progress on economic reform to buttress growth which Moody s now expects will be only 2% this year and next. Brazil s most recent industrial production numbers were down 1.2% y/y. The state controlled energy company, Petrobras, was downgraded a notch. This does not indicate a wholesale deterioration across all EM. In fact the Philippines last week was finally upgraded to Baa3, investment grade, last week and was left on positive outlook. With foreign exchange reserves of $84 Billion and total external debt of $54 billion this is one of the more bullet proof countries in our index. These two rating agency decisions reinforces two key themes for us:

3 Page 3 First: that investors in EM going forward will have to be more discriminating in their choice of countries in which to invest - in the absence of the rising tide that previously carried all boats- and Second: that the approaching election cycles in countries such as Brazil, India, Indonesia, South Africa and Turkey next year - against a less supportive liquidity backdrop will cause populist rhetoric to be ratcheted up likely prompting more volatility at a time when investors are less inclined to turn a blind eye. As the IMF reminded this week, reform momentum has slowed across EM even as these countries competitiveness and productivity has stalled as the following charts from the Bank Credit Analyst illustrate: As we write this, the EM bond team is winging its way to Washington DC for the Annual Meetings of the International Monetary Fund. We suspect a number of countries may face a public shellacking at the hands of investors disappointed by the poor policy response to spring/summer market upheavals. - Turkey is a key example where the industrial production in this heretofore economic star fell 4% month over month in August. (Although PMI data from Turkey released on October 1 st exhibited a strong bounce, as did Poland at 53 and Hungary at 54.4 all soundly in expansionary territory). We are finally seeing some more positive data from gaff-prone Indonesia where headline CPI unexpectedly fell to 8.4 from 8.8 and the country reported a trade surplus in August, contrary to market expectations. We expect the country s current account deficit in 2014 to narrow to $20B from an estimated $27B this year. FX reserves at the end of September stood at $95.7B. Preelection spending remains a key risk for the moment. Bellwether South Korea reported an increase in industrial production in August of 2.8% y/y, up 1% m/m.

4 Page 4 Now What IMF meetings aside, this is a fairly heavy week for data. The central bank in India eased liquidity curbs while Indonesia, perhaps as a consequence of better CPI and trade data, unexpectedly stayed on hold instead of tightening at its monetary policy meeting. Korea and Peru are expected to keep rates on hold while Brazil is expected to hike another 50 bps. We are also looking for industrial production data out of Mexico (looking for signs of recovery) Slovakia, Kazakhstan, India, Philippines and Malaysia. With markets following current accounts more intensely, Turkey s large and chronic current account deficit will be watched closely; less so Poland s and Romania s. We are also expecting September lending data from China, forecast to be below August levels Looming somewhat farther out is China s third plenary session of the party central committee in November. Market expectations of announcements regarding a serious economic reform package have been steadily intensifying, as is the awareness of how much of China s recent growth has been sparked by a lending boom. During the Asia crisis of 1997 China played an important stabilizing role. In private meetings with the US Treasury in 2005 (notwithstanding the continuous Capitol Hill harping about currency manipulation ) US officials emphasized to us how grateful they remained 8 years later that China had restrained itself from launching a competitive devaluation of its currency against EM peers, notably those in Asia.

5 Page 5 China seems to be playing a similar stabilizing role now and given its economy is a multiple of what it was in 1997 with proportionately greater impact. Consider the following chart (source: Bloomberg) which illustrates what has happened to China s currency in the face of recent devaluations by its BRIC peers. We presume for a country that exemplified an export driven growth model that now faces a structural slowdown in its sustainable growth rate, such a material loss of competitiveness comes at a particularly challenging time. Add to this an inability to sustain the intense level of credit expansion which has buttressed growth since the financial crisis and one can see the country faces significant challenges. Investment and economic outlook information contained on this report has been compiled by RBC Global Asset Management Inc. from various sources. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC Global Asset Management Inc., its affiliates or any other person as to its accuracy, completeness or correctness. This report may contain forwardlooking statements which are not guarantees of future performance. Forward-looking statements, which use predictive words like may, could, should, would, suspect, outlook, believe, expect, intend, forecast and similar expressions, involve inherent risks and uncertainties and it is possible that actual results, actions or events could differ materially from those expressed or implied in the forward-looking statements. RBC Global Asset Management Inc. and its affiliates assume no responsibility for any errors or omissions. This information has been provided on a voluntary basis by RBC Global Asset Management Inc. and is for informational purposes only. RBC Global Asset Management takes reasonable steps to provide up-to-date, accurate and reliable information, and believes the information to be so when issued. All opinions and estimates contained on this site constitute our judgment as of the indicated date of the information, are subject to change without notice and are provided in good faith but without legal responsibility. To the full extent permitted by law, neither RBC Global Asset Management Inc. nor any of its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the outlook information contained herein. Interest rates and market conditions are subject to change. / Trademark(s) of Royal Bank of Canada. Used under licence. RBC Global Asset Management Inc. 2013