PORTFOLIO DISCUSSION INVESTMENT EMERGING MARKET …€¦ · A tale of two taperings The second tapering In terms of the EM growth story, one cannot escape focusing on what is happening

INVESTMENTINSIGHTS

August 2013

PORTFOLIO DISCUSSIONEMERGING MARKET STRATEGY

A tale of two taperingsINVESTMENTINSIGHTS

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AUTHOR

George IwanickiManaging Director Macro StrategistEmerging Market Equities [email protected]

IN BRIEF• In his recent webcast from London, Emerging Markets strategist George Iwanicki

described the emerging markets at the end of the second quarter as being influenced by two “taperings”—first, the announcement by the US Federal Reserve that it will start to wind down its monthly asset purchases, and second, the move by Chinese policymakers to clamp down on a segment of non-bank lending.

• Chinese tapering will delay the rebound in emerging market growth, placing further downward cyclical pressure on corporate profit by weighing on profit margins. US tapering has put pressure on debt and currencies in countries with current account or capital account exposures.

• Amid the gloomy news flow, emerging market valuations have fallen to levels that historically have almost always provided a positive return. At the same time, concerns over credit growth in emerging markets appear overblown, as credit cycles in most countries do not appear to be stretched to levels that suggest an impending bust.

• Within emerging markets, we continue to favour China and Russia in our macro-informed portfolios, while leaning against defensive markets in the ASEAN region and Latin America, given richer valuations. In view of neutral global business cycle signals we hold a slight tilt towards cyclical sectors but continue to have a negative view on materials. Instead, we favour technology.

Most investors will now be familiar with the word “tapering,” which the US Federal Reserve (the Fed) has used to signal a timeline for winding down its quantitative easing (QE) programme and ultimately terminating its monthly bond purchases. However, for emerging market (EM) investors it is a tale of two taperings. The “second tapering” is the move by Chinese policymakers against a segment of non-bank lending, which will have the effect of delaying both the Chinese and, arguably in the context of the broader asset class, the EM growth rebound that we have been hoping for.

As discussed in the last emerging market strategy paper, “Navigating the Headwinds” (May 2013), earnings and estimate weakness have prevented EM equities from performing over much of the past two-and-a-half years. EMs have effectively stimulated their own business cycle amid the sluggish growth backdrop in the developed world. EMs experienced relatively strong growth in 2009, 2010, and into 2011, which gave rise to inflation pressures. However, since then we have seen a material economic slowdown that has weighed on profits and profit margins. Our view has been, and remains, that this is largely a cyclical pressure on profits. We do not find evidence of a broad-based acceleration in wage inflation that would threaten to permanently impair profit margins.

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2 | J.P. Morgan emerging market strategies: A tale of two taperings

A tale of two taperings

The second tapering

In terms of the EM growth story, one cannot escape focusing on what is happening in China. First, it is clear that the Chinese government is committed to a longer term rotation of the Chinese economy away from its heavy reliance on investment and towards a more balanced, more consumer-led growth path. In fact, we would argue that the Chinese have been successful so far in beginning to moderate the investment “kicker” to growth. Exhibit 1A illustrates the beginnings of this rotation over the past couple of years away from the overreliance on investment.

At the same time, Chinese policymakers have also been managing a business cycle against a backdrop of worries about credit growth, housing and inflation. Consequently, policymakers were already pursuing a dual mandate when much more recently they added a third objective to focus on non-bank lending (Exhibit 1B).

The Chinese recognise that financial intermediation is a long-term positive, but they are clearly concerned about a segment of non-bank lending that is known as “wealth management product” (WMP). Part of WMP looks like it is being recycled back from large bank-sponsored products to smaller banks, and it appears to be wholesale funding disguised as deposits. Policymaker concerns about WMP lending led the People’s Bank of China to limit liquidity to the Shibor market and thus prompted the gyrations witnessed in June (Shibor is China’s equivalent of Libor). In our view, the focus on non-bank lending in China does not mean that we should be anticipating a crash. However, despite our earlier confidence of an upturn in the China cycle, we have to acknowledge that policymakers are at greater risk of making a policy error, given the multiple objectives they are now pursuing.

Having said that, the risk of a policy error does not necessarily increase the risk of a capital markets-induced or externally-imposed breakdown in growth. Investors need to remember three things: first, this is a relatively closed capital account economy; second, the ongoing current account surpluses, while not what they were a few years ago, are still positive to the tune of 2% of GDP; and finally, the country has ample international reserves—nearly USD 3.5 trillion at last reading. As such, while there is a higher risk of a policy error being made, we do not think that the risks of a capital markets-imposed problem in China have risen.

EM growth disappointment not limited to China

We know from the recent data in China that the economy has slowed somewhat in the wake of the government’s attempts to rein in the wealth management product segment of non-bank lending. However, what is interesting is that the ‘growth disappointments’ are not unique to China.

In China the shift away from investment-led growth is continuing, while recent monetary actions suggest policymakers are tackling non-bank credit growth EXHIBIT 1A: CHINA CONTRIBUTIONS TO ECONOMIC GROWTH

Source: J.P. Morgan, NBS, PBoC, as of June 30, 2013.

0.9% -3.5%

0.4% -0.4% -0.2%

4.2% 4.6%

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4.5% 8.1% 5.5% 4.5%

3.9%

-4%

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16%

2008 2009 2010 2011 2012

Investment Consumption Net Exports

EXHIBIT 1B: CHINESE CREDIT GROWTH BY PROVIDER

Source: J.P. Morgan, NBS, PBoC, as of June 30, 2013.

RMB bn

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INVESTMENTINSIGHTS

J.P. Morgan Asset Management | 3

Economic data suggests that economic momentum is sluggish across emerging markets

EXHIBIT 2: PURCHASING MANAGERS’ INDICES BY COUNTRY

Source: J.P. Morgan, Markit, as of June 30, 2013. Readings above 50 indicate an expansion in manufacturing activity, while a reading below 50 indicates a contraction.

Jul'1

1

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11

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Global U.S. U.K.

Germany France

Italy Spain

Greece Ireland

Australia Japan China

Indonesia

Korea Taiwan

India Brazil

Mexico Russia

50.651.952.548.648.449.150.045.450.349.652.348.251.049.449.550.350.451.351.7

51.254.649.049.044.044.544.242.148.644.450.451.651.352.051.252.051.852.250.8

49.652.849.046.844.545.145.341.852.444.346.550.551.548.247.453.752.255.652.2

50.054.050.946.044.646.744.641.451.444.345.051.550.750.150.654.751.157.150.0

51.555.850.949.842.947.846.141.750.340.247.752.349.749.951.553.253.255.052.0

50.954.348.250.343.945.846.843.051.545.648.550.450.550.950.254.252.553.452.0

50.452.150.248.144.445.544.745.048.036.751.150.451.752.650.751.050.851.750.6

51.352.650.352.050.550.145.645.248.243.452.149.350.951.346.153.647.854.749.8

51.253.949.750.949.147.045.343.349.743.351.949.950.849.745.252.646.051.749.9

50.553.751.350.348.248.343.743.247.342.349.349.949.747.544.550.445.553.050.0

50.753.648.949.148.543.343.940.550.147.450.651.051.648.043.752.046.554.750.4

49.653.447.947.947.344.043.840.948.547.849.147.750.147.143.951.048.753.752.6

50.353.949.248.448.944.343.742.048.650.250.248.748.846.447.154.249.153.151.6

51.054.350.751.048.546.845.141.048.351.650.748.848.549.248.957.550.652.250.8

51.253.651.150.250.047.845.037.749.751.350.549.650.650.752.756.651.453.750.7

51.656.051.848.446.747.944.541.351.549.551.148.350.852.054.154.751.153.850.8

51.356.049.946.246.943.843.540.750.143.950.749.350.551.951.254.949.356.352.9

50.254.046.145.244.744.842.043.151.242.450.748.448.151.050.554.849.355.253.2

49.752.548.345.045.244.641.140.153.147.249.948.250.249.449.255.048.555.951.0

48.851.445.643.043.444.342.341.953.940.347.949.351.447.247.552.948.755.252.0

48.751.549.744.746.043.644.042.150.945.347.747.651.647.546.152.849.355.151.0

48.751.148.947.442.745.744.542.251.843.048.047.950.545.745.652.849.854.452.4

48.851.047.746.043.745.543.541.052.142.846.949.551.947.447.852.950.255.552.9

50.652.351.549.446.447.348.145.349.743.851.549.251.651.147.150.150.451.750.4

Exhibit 2 shows the purchasing managers’ indices (PMIs) by country. The bottom half of the table, which shows PMIs in the emerging world, shows a broader loss of momentum. The fading of the green in the heat map that we were seeing late last year is not confined to China, but has spread to some of the other markets. The U-shaped recovery that we had anticipated a quarter ago, and expected to be seeing by now, has remained elusive. We still think a recovery will unfold in the second half of the year, but we have to acknowledge that there has been a delay.

The effect of this delayed recovery is that we have still yet to see a breakout of earnings or earnings estimates. We are stuck in an environment where both earnings momentum and earnings estimate momentum are negative as a result of the absence of a rebound in emerging economies.

Unfolding Federal Reserve tapering is pressuring EM debt

Returning to the more commonly recognised “tapering,” we need to examine where EMs are most vulnerable to the Fed’s advertised ending of QE. To do this, it is important to establish the policy background of de-leveraging and zero interest rates in the developed world that have accompanied QE. The effect on EMs of this policy mix in developed markets was twofold.

The first effect was that EM policymakers needed to stimulate domestic demand growth to offset the weakness in their export markets. The second effect was that even though EM central banks did cut rates, nominal rates (policy rates as well as local bond rates) remained at levels that began to look quite attractive relative to the near-zero rates in the developed world. As a result EMs pushed rapid growth in domestic consumption to offset an export slowdown and also attracted a fair amount of what we call the ‘reach for yield’ trade within fixed income markets.

Netting those two factors out—stronger domestic demand growth and higher interest rates—we begin to see some current account surpluses move to lower levels and some current account deficits open up. There are three countries that particularly stand out in the larger investable emerging markets, namely South Africa, Turkey, and India. In each case, current account deficits moved out to approximately 5% of GDP, which is a level where, even for EMs, there are concerns about the need for external financing.

In addition, the second effect, the carry trade or the ‘reach for yield’, began to become quite evident in some of the local EM debt markets. In fact, although it is difficult to get comprehensive data on local EM inflows and ownership share by foreign investors across all markets, broadly speaking there were fairly heavy inflows into select markets.

INVESTMENTINSIGHTS



In some markets foreign ownership of EM local debt rose as high as 30%. However, as the end of QE began to be signalled, concerns rose that some of the carry trade would be unwound and that current account deficits would look more vulnerable in an environment where liquidity is going to be reduced by the Fed.

Assessing the vulnerability of EM currencies to Fed tapering

To identify the vulnerability of EMs to Fed tapering, we therefore need to assess not just EM current accounts but also the dependency of EMs on capital inflows from the developed world. Exhibit 4 aims to do this by juxtaposing the financing need (horizontal axis) with the level of reserves a country holds (vertical axis) to show which countries would have sufficient reserves to cover the removal of those portfolio inflows and which countries are at more risk of having insufficient reserves. The fan pattern rotates from the lower left, which is high risk (in red), to the upper right, which is low risk (green).

The good news is the bulk of countries are in the upper half of the fan. Notably, a number of Asian countries are in the upper right. Taiwan, in fact, is in a net financing surplus situation, so doesn’t even appear on the chart. On the far left there are a handful of countries, generally speaking countries in the Europe, Middle East and Africa region (and Turkey in particular) that appear more vulnerable from a flows perspective, given the relatively low level of reserves versus their net funding needs. As a result, they may see further pressure on their currencies.

Beyond ‘flow risk’ is there any lingering ‘valuation risk’ for EM currencies? Our standard currency chart (see Exhibit 5 on next page) shows valuations relative to our estimates of fair value on the horizontal axis and the degree of carry on the vertical axis. The arrows indicate recent movements in the currencies featured. The clear message is that recent reversals have diminished much of fundamental currency overvaluation in EMs.

Emerging market currencies became more vulnerable to a Fed policy shift amid stronger domestic demand growth and higher interest ratesEXHIBIT 3A: CURRENT ACCOUNT POSITIONS, 2012

Source: J.P. Morgan, IMF, UBS, as of June 30, 2013.

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% of GDP

EXHIBIT 3B: CUMULATIVE DEBT INFLOWS, USD BILLIONS

Source: J.P. Morgan, IMF, UBS, as of June 30, 2013.

HUF TWD INR

PHP CZK CLP THB IDR

0 20 40 60 80 100 120

CNY PLN BRL TRY

KRW MXN 3Q 2009 to 1Q 2013

Most EMs are well reserved against an external funding slowdown when the Fed tapers QE EXHIBIT 4: EM FINANCING NEEDS AND CURRENCY RESERVES

Funding Gap

Source: J.P. Morgan, IIF, as of June 30, 2013.

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TW (80%,+3.9)

INVESTMENTINSIGHTS


While there has been a broad migration of EM currencies towards the left hand side of the chart, there are still a few currencies that look rich relative to fair value. The Russian rouble, Brazilian real and, to a lesser degree, the Colombian peso all fall into this camp and are notably all currencies of commodity exporter countries. Egyptian pound official rates still appear a bit expensive, although we recognise that a black market has developed for the currency in the wake of the ongoing political pressures in the country. For years we were concerned that the supercycle in industrial materials and in commodities more generally had generated an echo of over-valuation in commodity currencies. At this point, as the super-cycle in industrial commodities begins to reverse, somewhere between one-half and two-thirds of the overvaluation in some of the commodity exporter currencies has been wiped away.

The other important point is that when you look at some of the currencies that we noted as being relatively vulnerable to an external funding slowdown, they don’t appear to have valuation risk as well as flow risk. The Indian rupee is now

definably cheap; the South African rand, which was hit hard early in the second quarter, is now on the cheap side of neutral; and Turkey, which appears vulnerable to a slowdown in portfolio flows, is trading around fair value. In fact, across emerging markets we have trouble finding examples where there is a combination of valuation risk as well as flow risk. Broadly speaking, we find either one or the other for selected countries or currencies in the universe. Additionally, the rotation in currencies has overall resulted in less of an overvaluation problem and the currencies that are still on the right hand side of the chart are no longer as overvalued as they were previously.

Our standard valuation metric now looks unambiguously attractive

We’ve spent a lot of time on bad news and worries about the EM asset class so you may be wondering if there is anything positive to say. As regular readers will know, we focus on our standard valuation metric, looking at the price-to-book (P/B) ratio for the asset class (see Exhibit 6A on next page), which has been a very useful tool in identifying when to own the asset classes and when to fade the asset class in portfolios. The historical rule argues that investors should aggressively buy the asset class at 1.5x P/B or below, and to fade the asset class at 2.5x P/B or above (as that is generally the valuation level whereby the price is effectively “ahead of the story”). At 1.44x P/B, we have moved below the 1.5x level, into the range of valuations that historically have been consistent with positive forward returns (see Exhibit 6B on next page).

As bad as the news flow is in EM, we would highlight that it is not the grounds for a crisis. However, valuations are at crisis levels and historically you have been paid to buy the asset class at this point. It is very rare to see these valuations when the news flow is very good, so we need to recognise that these opportunities usually arise when the environment feels uncomfortable, which is where we are today.

Recent reversals have wiped out a lot of the overvaluation of EM currenciesEXHIBIT 5: CURRENCY VALUATION AND SUPPORT

Source: J.P. Morgan estimates, as of June 30, 2013.•REER (real effective exchange rate) relative to fair value (export-adjusted

ten-year average REER) on the x axis and policy rate on the y axis.•CARRY (a currency with a high IR).•Countries over the line of best fit provide good carry for their currency valuation.

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REER vs CARRY – arrows show move since January 2013

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INVESTMENTINSIGHTS



EM domestic credit cycles—advanced but not destined for bust

The other ‘good news’ relates to EM credit growth. Amid all the concerns about EMs, one of the worries that investors have been thinking about is whether the domestic demand stimulus we’ve seen has motivated credit cycles that have become so extended that they have now set up emerging countries for a potential credit bust.

We analysed private credit growth across the asset class. As Exhibit 7 illustrates, credit growth has been fairly heady and there are several countries (Turkey, Brazil, Indonesia) where credit growth has been growing at 20% per year for the past three years.

Amid all of the gloom, our standard valuation metric now looks unambiguously attractive, with EMs moving in a P/B range that historically has been almost invariably positiveEXHIBIT 6A: EMERGING MARKET P/B RATIO, 1993 – JULY 2013

Source: Bloomberg, FactSet, UBS, as of July 7, 2013.

However, we think it is more notable to compare credit growth to nominal GDP. Exhibit 8 plots this relationship. Credit growth has outpaced GDP in countries in the yellow and lavender zones of the chart; below that is where credit growth has lagged GDP. Our rule of thumb for identifying credit cycles is that when you have a three-year cycle where credit outpaces nominal GDP by at least 20% that is when you should become concerned that there is an impending credit bust. In this context, countries in the upper left of the chart are those where the credit cycle looks like it may have become overblown and, as a result, may be poised to bust.

There are a lot of EM countries where credit growth has been above nominal GDP, but generally, there aren’t any where private credit growth has exceeded nominal GDP by more than

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Source: Bloomberg, FactSet, data from January 1999 to end June 2013.Shown for illustrative purposes only.

EXHIBIT 6B: EMERGING MARKET P/B RATIO AND ONE-YEAR FORWARD RETURNS

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Private credit growth has been strong across the EM asset class, driven by domestic demand stimulus EXHIBIT 7: EM PRIVATE CREDIT GROWTH


3-year annualised growth p.a. to end 2012

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Private credit growth has outpaced GDP in most of EM but not to the degree which usually forces busts EXHIBIT 8: PRIVATE CREDIT GROWTH VERSUS GDP


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INVESTMENTINSIGHTS


20%. There are a couple of countries where credit growth has been sufficiently rapid that we would like to see some cooling. Brazil and Turkey are the countries that stand out most from this perspective. Indonesia in the ASEAN region, and Colombia in Latin America have also experienced relatively rapid credit growth of approximately 10% over GDP. However, the good news is that, as rapid as credit growth has been, it does not look like it has been so rapid that there are a series of credit busts poised to unfold in EMs.

The other interesting point to consider is what credit penetration says about future credit growth. Credit intensity still varies widely across EMs and it is not easily predicted by simply looking at economic development. Exhibit 9 looks at GDP per capita (as a proxy for economic development) on the horizontal axis and private credit penetration relative to GDP on the vertical axis. As you can see, a line of best fit would not fit very well onto this chart.

There are two points to note regarding credit intensity. First, countries that previously suffered high inflation have generally experienced retarded credit market growth and, as a result, have tended to have lower credit penetration. This is clear in some of the Latin American countries. The second point is intuitive, which is that those countries that are more fully credit-penetrated have the least room for engineering future credit booms. Two large markets, China and Korea, along with two of the ASEAN markets, Malaysia and Thailand, are notable on this basis and as a result are places where secular credit growth from here is likely to be limited to a rate closer to GDP growth.

Actionable ideas: Business cycle rotation signals for sectors remain neutral

As we do each quarter, we turn now to the key tactical ideas from our sector and country models. Starting at the sector level, our business cycle proxies remain neutral (as they were last quarter). As such, we are not receiving a strong cyclical rotation signal that would favour cyclicals, mid-cycles or defensives.

In this environment, we are still finding cyclical sectors cheap relative to defensives. Consequently, we have a tilt towards front-end cyclicals in our top-down informed portfolios. However, the fact that the Federal Reserve is moving away from QE while the rest of the developed world leans towards QE is supporting continued U.S. dollar strength. Beyond being a general headwind for EMs as a whole, US dollar strength has historically been a particular headwind for the performance of the industrial commodity sector. Conversely, over the past decade information technology (IT) has tended to outperform as the dollar strengthens. In top-down informed portfolios, within front-end sectors we favour consumer discretionary and IT and are underweight materials. Dollar strength is also somewhat unfavourable to energy, although within the broad commodity space we are still more willing to own energy than we are materials.

Actionable ideas: China and Russia remain unambiguously cheap

Let’s turn, finally, to country views within EMs. Exhibit 10 on the next page, shows our usual grid juxtaposing value and momentum at the country level. Value is measured on the horizontal scale (cheap countries appear on the right; expensive on the left), and momentum, as proxied by price action, is captured on the vertical scale. Countries usually rotate counter-clockwise around this grid over the course of a market cycle. As a result, we typically want to own countries that are crossing from the lower right to upper right and start rotating countries out of the portfolio as they move to the upper left and then towards the lower left.

As a value momentum investor, we would like to see a lot of countries in the upper right or lower left. The bad news is currently we have minimal overlap between value and momentum. Instead, there are some cheap countries in the lower right, namely China and Russia, which are two of the overweights in top-down informed portfolios, and expensive countries in the upper left, namely the ASEAN markets and Mexico.

Differing levels of economic development do not easily explain differences in credit intensity EXHIBIT 9: ECONOMIC DEVELOPMENT AND PRIVATE CREDIT INTENSITY, 2012


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Source: J.P. Morgan estimates, data as of June 30, 2013. This information reflects J.P. Morgan Asset Management’s opinion and goals and is subject to change.• Countries ranked on last 12 months price movement on the y-axis and a

composite of valuation metrics on the x-axis.•Units are percentile ranks which go from 0 to 1.

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China and Russia continue to look cheap, while ASEAN markets and Mexico are expensive EXHIBIT 10: COUNTRY VALUE AND MOMENTUM

Exhibit 11 approaches the valuation of EMs from a different angle, looking at where both the asset class and countries within the asset class are trading relative to their own histories rather than relative to each other. What is clear is that both the asset class and BRIC (Brazil, Russia, India, China) valuations are at or near the bottom end of historical valuation ranges. In the case of Russia, the market is trading below the low end of the historical band. We recognise the BRICS may have their own problems, but they currently look quite cheap. Meanwhile, on the right-hand side of the chart, the countries where the business cycles and growth have been more comfortable are trading at relatively expensive levels, even to their own history.

Both the asset class and BRIC valuations are at or near the bottom end of historical valuation ranges

EXHIBIT 11: EM COMPOSITE VALUATIONS RELATIVE TO TEN-YEAR AVERAGE

Source: J.P. Morgan estimates, FactSet, MSCI, as of June 30, 2013.

Composite includes four valuation measures: price-to-forward earnings, price-to-book value, price-to-cash earnings and dividend yield.

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-2

-1

0

1

2

3

4

5

6

World (ACWI)

EM Index

Russia China Brazil India Taiwan Korea South Africa

Thailand Mexico Indonesia

Z Score (standard deviations from trend)

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Conclusion

The earnings weakness that has plagued EM equities over the past two-and-a-half years has yet to turn. Also, the U-shaped recovery we have been looking for appears to have been delayed by the ‘tapering’ of non-bank lending in China and the ‘tapering’ of QE asset purchases that is poised to take place in the US.

The ‘default bid’ to the US dollar (motivated by Bank of Japan QE and European Central Bank dovishness) is being reinforced by growing expectations of Fed tapering. This dollar strength is now putting pressure on debt and currencies in EM countries with either current account or capital account exposures.

The important point we would make is that, against a backdrop of very unfavourable internal news flow and a challenging external environment, asset class valuations have been forced down to levels that historically have almost invariably provided positive returns. At the same time, credit cycles within EMs do not appear to be stretched to levels that suggest impending credit busts.

In view of neutral global business cycle signals we hold a slight tilt towards cyclical sectors but continue to have a negative view on materials given both supercycle reversal concerns and the historical underperformance of the sector during periods of US dollar strength. Instead, we favour the IT sector. From a country perspective, with minimal overlap between value and momentum, we continue to tilt top-down informed portfolios towards China and Russia, while leaning against richer defensive markets in ASEAN and Latin America.

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INVESTMENTINSIGHTS A tale of two taperings

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PORTFOLIO DISCUSSION INVESTMENT EMERGING MARKET …€¦ · A tale of two taperings The second tapering In terms of the EM growth story, one cannot escape focusing on what is happening

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