EM Strategy Monthly

November Strategy Roadmap

Note: The country ratings give preferences relative to our universe of emerging equity markets (i.e., not vs developed market performance). The sector ratings indicate our view of a given sector relative to each country’s overall index. Views are expressed according to a numerical rating ranging from minus 2 to plus 2 that reflects both the expected relative performance (positive or negative) and the degree of conviction (1 = moderate, 2 = strong). Thus -1 describes a moderately held negative view; +2 describes a strongly held positive view. No numerical price performance parameters are implied nor should they be inferred. Trusted Sources only expresses an opinion on sectors on which it has one. The ratings show our view of the next three-six-month period with the view expressed in the previous month in brackets.

Note: Yields and rates are as of 10am GMT 3 November.

Our next Strategy Monthly will appear on 2 December.

Overview of October performance

Although the rebound in EM equities last month was impressive, the limited trading volumes and high volatility lead us to conclude that our warning to investors to beware renewed volatility was fully justified. As we move into November we expect the Greek deal to show increasing signs of strain; we think Greece’s end game includes a disorderly debt restructuring and most probably expulsion from the Eurozone.

EM equities did outperform developed markets but only barely. Thus despite having trailed developed markets in previous months, the performance of EM equities is still struggling – on a three-month view EM equities lagged about 10 per cent behind the US market and 5 per cent behind Europe. Chart 1 confirms that all markets moved very much in tandem during October. Commodities were the laggards.

A look at individual country performance does not provide much insight into fundamental trends (see Chart 2 below). Russia, China and Brazil led the upswing last month, but these were the top underperformers in September. Meanwhile Turkey was the main laggard in October but in September it substantially outperformed other EM markets. In our view there is little evidence in recent market activity to support the argument that fundamental analysis can provide the key to outperformance in the market.

The outlook in a word: Volatile

Turning to the outlook, we anticipate extremely unsettled markets as investors begin to digest the implications and rising risks of a failed Greek rescue. We think investors will rather quickly come to the conclusion that the Eurozone will be better off if Greece exits the euro, although in the short term the process may prove chaotic and costly to the county’s creditors and citizens. In the longer term making an example of Greece could prove extremely salutary to maintaining fiscal discipline in the other peripheral countries. In the absence of movement towards fiscal union, making an example of a misbehaving Eurozone member might seem a second-best solution to imposing greater fiscal discipline, albeit a very expensive one.

Emerging markets would no doubt be roiled by these developments but we believe that the direct impact on growth in major EM economies would be limited. The EM economies most exposed to recession in Europe are probably Turkey and Russia. Neither country is dependent on financing from European banks because of their relatively low overall debt levels. If European banks were to pull financing lines both countries would easily find alternative lenders willing to take their credit.

Turkey is probably more exposed than Russia in terms of export vulnerability, with 38 per cent of its exports going to Europe, mostly manufactured goods. But Turkey is successfully developing new export markets in the Middle East and North Africa, and the substantial devaluation of the lira gives Turkish exporters an advantage in keeping European clients. Russia sends a significant portion of its exports to Europe but these are predominantly commodities such as natural gas and crude oil whose prices have held up relatively well in recent months despite the developing economic slowdown in Europe.

Our bottom line is that the collapse of the Greek rescue mission would have a severe short-term impact on EM equities but underlying EM growth drivers would be relatively unaffected. This is why EM investors should consider using upcoming periods of high volatility to establish and/or add to equity positions in top-rated EM stocks.

EM debt remains a safe haven

We saw EM sovereign fixed income rebound strongly during October, led by our two top picks, Russia and Indonesia. Yields on the respective benchmark 10-year government bonds tightened by 70 bps over the month. Brazil and Turkey followed in the next rank with yields tightening on their 10-year sovereign issues by 35 bps and 20 bps respectively. The overall return on the composite EMBI index was 4.25 per cent. Our top picks in EM debt for this month are Turkey and Russia.

Local market debt also traded up strongly during the month but overall returns were eroded at the beginning of November by the sell-off triggered by the announcement of the Greek referendum. Indonesia was the top performer, followed by Russia. Although interest rates will likely fall in Russia, Indonesia and Brazil during the next month, we anticipate high volatility in EM currencies until year end. Investors will need to pay close attention to market timing to avoid being whipsawed by currency volatility.

Portfolio strategy

Global themes

Prime Minister Papandreou’s flip-flop on his decision to call a referendum on his country’s bailout package shifts the political calculus towards a disorderly default and ejection from the Eurozone for Greece.

Speaking on television on Wednesday night before the Cannes G20 summit, Papandreou said his decision to call a referendum on his country’s bailout package was motivated by a desire to give the Greek people an opportunity to express their opinion. Unwittingly he has put himself and his country on the road to oblivion despite his reversal of this decision on Thursday. In our judgment, the most likely outcome of these events will sooner or later be a disorderly debt default and most probably Greece’s ejection from the euro.

Papandreou’s surprise move has generated intense speculation about possible outcomes and their various permutations. Following his change of mind, markets initially rallied, then slumped.

In our opinion, these developments are beside the point. The most important implication of his action is that it changes the political calculus facing Chancellor Merkel and President Sarkozy. Both politicians must stand in elections (Sarkozy in 2012 and Merkel in 2013), both have put their political careers on the line in attempting to save Greece and both have suffered an erosion of political support for their efforts. Papandreou’s surprising behaviour now gives them the opportunity to rescue their political futures by pushing Greece out of the Eurozone in the name of saving the euro and protecting taxpayers back home.

In comments to the press on Wednesday following a meeting with Papandreou Eurozone leaders did not mince their words. Merkel flatly stated that the only issue was whether Greece wanted to remain part of the Eurozone. Luxembourg Prime Minister Juncker expanded on this position. Speaking on German television, Juncker, who also chairs the Euro Group meeting of finance ministers, said the authorities were “absolutely prepared” for the exit of Greece from the Eurozone in order to ensure that it could be done with the least harm for the region. That clearly sent the message that top Eurozone leaders were prepared to pull the plug on Greece.

For his part, President Sarkozy must be beyond livid. In order to burnish his image as an international statesman he had long planned to turn the G20 meeting into a forum to discuss several of his pet projects such as solving global imbalances and finding alternatives to the dollar as an international reserve currency. Instead Papandreou, whose country is not even a member of the G20, hijacked the summit and turned the attention of the international media to whether or not Greece should accept the billions in aid on offer. Trailing in the polls and facing a battle to preserve France’s AAA rating, Sarkozy must be desperate to find a way out of his bind.

As in so many Eurozone issues, Germany's vote counts for more than all the others. In this regard Merkel’s decision will determine Greece’s future. What is she facing? Her three-pronged scheme to save the euro is not looking adequate to that task:

1. There is no assurance that a 50 per cent debt reduction deal with private creditors can be negotiated amid the turmoil Papandreou has caused.

2. The project to leverage the EFSF facility to provide 20 per cent insurance for new debt issues from Italy and Spain now looks decidedly thin on the necessary funding.

3. Setting up a new special purpose vehicle to channel capital from China and other wealthy sovereigns has failed to gain traction as interest from the short list of potential investors has been lacklustre.

On top of these shortcomings Merkel is aware that German public opinion is strongly against using the balance sheet of the European Central Bank as a fallback option in order to keep Italy and Spain afloat. In recent negotiations she opposed this possibility despite strong pressure from France.

She must now sense that her best political option is to resist pouring good money after bad. Italy cannot be saved with the means that are at the disposal of Eurozone countries. Pushing Greece out of the euro is now her best option to avoid a humiliating defeat and regain the political initiative in domestic German political affairs. Sarkozy must also be desperate to seize this option.

Cutting Greece loose will create huge potential losses but there are now also tangible political benefits for both France and Germany in this course of action. The chaos caused by a Greek exit would undoubtedly have a beneficial influence on wavering politicians such as Italy’s Prime Minister Berlusconi and may even spell his demise as a politician. And although it would be costly to recapitalize Eurozone banks the commitment to fund such an action has already been agreed; those funds would undoubtedly have to be topped up since a disorderly debt default would push recovery values below current levels. Finally, what has hitherto been missing, namely a scapegoat, has now emerged in the person of George Papandreou.

EM sovereign fixed-income securities will be the least volatile option; equities will require close attention to market timing

Although EM equities rebounded strongly during October we think they will struggle to retain these gains in the next two months. A disorderly outcome of attempts to shore up Greece should be expected for the reasons highlighted in the above theme. We expect this shock will roil the markets over the next four-six weeks, undermining EM equity market performance and creating substantial volatility.

Last month’s rally in EM equities was characterized by relatively low trading volumes, highlighting the considerable caution and lack of conviction on the part of investors. This has been translated into high volatility, which puts a premium on market timing. With this in mind, we recommend an opportunistic strategy: investors should wait for periods of high volatility to take positions in top-rated EM stocks. EM equities will not move onto a trajectory of sustained outperformance until the Eurozone crisis finds a more definitive resolution. In our view, this will only happen when another political crisis brings the Eurozone to the edge of the abyss. That event will be the breakdown of Greek rescue efforts, leading to a disorderly debt rescheduling and most probably the ejection of Greece from the euro.

EM sovereign debt offers a much less volatile investment option along with attractive overall returns. We expect EM debt to continue to build on significant progress last month in solidifying its position as a new safe-haven investment for funds fleeing traditional fixed-income sovereign debt in countries such as Italy. We therefore believe that investors should focus on top-rated sovereigns, such as Russia, Indonesia and Brazil. Though rated just below investment grade, Turkish sovereign dollar debt offers an attractive yield advantage on the three previously mentioned sovereigns.

We are not bullish on prospects for local fixed-income securities because currency volatility will be high. In a slowing global economy EM policymakers will not want to see their currencies strengthen against the dollar or euro. Just the opposite is likely – central banks will intervene to dampen volatility but most will welcome currency weakness, since it helps domestic industry and exporters.

The correction in commodity prices that began with base metals and now includes bulks, particularly iron ore, will have run its course when China’s soft landing is confirmed early next year.

Commodities rallied sharply in October as fears of a hard landing for China temporarily receded and markets priced in the possibility of a more long-lasting solution to the Greek debt crisis and indications of stronger Chinese growth. These expectations have since been thrown back into doubt with the aborted Greek referendum on the Eurozone rescue plan and lower-than-expected Chinese manufacturing growth data, with the predictable impact on commodity prices as investors once more pared their exposure to risky assets (see Chart 4 below).

Energy and industrial metals such as copper, which are the commodities that have been heavily traded by financial investors, gained the most in the last month after having led the sharp sell-off in commodity markets in September. We expect continued extreme market volatility as investors continue to seek, but fail to find, any lasting clarity about a resolution to the European crisis and the outlook for global growth over the next three-six months. Our base case scenario of slightly slower growth in China of 8-8.5 per cent in 2012 and no global recession suggests that non-developed country growth will support higher commodity prices over the next six-12 months.

In the meantime, China has continued to restock copper and coal, with imports rising steadily on a month-on-month basis in the May-September period as we anticipated in our July research note “China’s commodity imports at an inflection point”. However, the pace of restocking will be determined by strategic factors, especially China’s desire to acquire raw materials at the lowest prices possible. That is especially the case with iron ore, where prices have fallen an unprecedented 30 per cent in the last month (see Chart 5 below). In our July note we stressed that iron ore restocking would lag because of the high level of inventories. China has indeed maintained inventories near their July levels by increasing domestic production (which rose 33 per cent year on year in the nine months to September) to help offset rising import demand and thereby press its case to move iron ore pricing from the much higher quarterly contract prices to the currently much lower spot market prices.

In this context, it is important to note that even though we suggested in October’s strategy monthly that bulk commodities such as thermal coal and iron ore may be better indicators of underlying demand since they were less "financialized" than other commodities (such as copper) the current weakness in iron ore prices does not reflect a collapse in Chinese demand. Instead, the fall in iron ore prices has in large part been driven by technical factors, the effects of the sell-off being accentuated by a combination of Chinese steel mills going on a buyers’ strike and Brazil’s Vale and Australian producers sending a few extra iron ore ships to China in recent weeks.

That said, there have not been any major demand or supply shifts in the world iron ore market. Even though steel demand in Europe is slowing, Vale has stated that it has not been diverting shipments to China and has not seen the type of drop in production it saw in 2008. Instead, the sell-off in iron ore has been driven by the widening gap between the quarterly reference price used by Vale and Rio – based on the average of the previous three-month period with a one-month lag – and spot prices. According to a Reuters estimate, this means Q4/11 delivery iron ore prices were US$175/tonne vs a spot price of US$117 earlier this week. This discrepancy has been forcing Chinese steel mills to delay buying any iron ore at all as they attempt to renegotiate terms closer to the lower spot price. The resulting temporary absence of demand has removed the floor from spot prices. China’s iron ore import demand will return – domestic iron ore is now more expensive than imports – but only after the producers and buyers find a better way to address the discrepancy between long-term contracts and spot market pricing.

Country strategy and portfolio allocation

• Brazil – Slowing growth amid stubbornly high inflation and a worsening fiscal position suggest caution. We retain a moderate negative outlook.

• Russia – Although Russia will be buffeted by the fallout from the Eurozone crisis solid fundamentals and cheap valuations argue for retaining our moderate positive outlook.

• India – Policy paralysis, slowing growth and high inflation leave no reason to change our outlook. We retain a moderate negative rating.

• China – Inflation is peaking and expectations of monetary easing are growing. We expect short-term outperformance and retain our moderate positive outlook.

• Taiwan – We reduce our rating to neutral due to uncertainty about the impact of the global economic slowdown on Taiwan’s important export sector.

• Indonesia – The economic outlook is positive with low inflation and sustained domestic consumption and exports. We keep our moderate positive outlook.

• Turkey – Turkey is exposed to the recession in Europe. Although valuations have bottomed out we retain a neutral outlook for now.

Brazil

Brazil’s economic data continue to reflect contrasting trends. Signs of weaker growth are evident in September’s 2 per cent fall in industrial production, which surprised analysts who were generally expecting a much smaller decline. Weakness is also showing up in retail sales, whose growth fell to 6.1 per cent in August from 10.2 per cent the year before.

At the same time other data paint a more positive picture. For example, employment shows relatively strong expansion – new jobs created in September totalled 209,000, down from last year’s 247.000 but still relatively strong. Other positive data releases highlighted Brazil’s impressive trade performance: October’s trade surplus came in well above market expectations at US$2.4 billion and FDI set a new record with a US$6.3 billion inflow.

Recent inflation data also fail to show any signs of a weakening economy. The consumer price index (IPCA) rose slightly to 7.3 per cent in September, well above the 6.5 per cent upper limit of the Banco Central’s (BC) inflation-targeting band. In its most recent COPOM meeting the BC reduced its Selic policy rate by 50 bps to 11.5 per cent and said that the global economic slowdown would help push down inflation to 4.7 per cent by the end of 2012, close to the 4.5 per cent midpoint of its targeting band.

Where should investors place their trust − in the BC’s expectations of falling inflation or in the data that show no evidence of this happening so far?

Our assessment highlights the following points:

1. The Brazilian economy is indeed slowing but the weakness is now primarily affecting industrial output rather than other sectors such as exports or services. The slowdown will gradually spread to other sectors in the next two-three months due to a downturn in Brazil’s terms of trade (i.e. lower export prices) and consumers’ real incomes. Growth next year will be around 3 per cent.

2. Despite slower growth ahead, we expect inflation to remain relatively high at 6-7 per cent next year due to supply-side bottlenecks, especially in the labour market.

3. We do not believe the pre-emptive BC policy action to cut interest rates will achieve its goal of lower inflation. We do agree that weaker growth lies ahead for the economy, but we think this will have a limited effect on lowering inflation, which is driven more by supply bottlenecks and a cheaper Real than by aggregate demand factors.

4. The government’s primary policy goal is to sustain growth, not reduce inflation. The onset of the current global economic slowdown provides a convenient excuse to sustain budget spending while lowering interest rates. This is also a reason why the government wants a cheaper Real, not today’s R$1.75/US$ level. The big worry for 2012 is that fiscal performance will deteriorate while at the same time inflation remains stubbornly high.

Our economic policy scenario sees the BC implementing periodic interest rate reductions over the next six months, bringing the Selic rate to 9.5-10 per cent by Q2/12. Despite a slowing of economic growth to around 3 per cent in 2012 we expect inflation to continue at over 6 per cent. Inflation at these levels will force the BC to put its easing policy on hold rather than attempt to squeeze domestic credit and inflation by introducing macroprudential measures. With local elections scheduled for October 2012, we expect Dilma Rousseff’s government to look for ways of sustaining fiscal spending rather than cutting it. This points to a deteriorating fiscal performance as we move into H2/12.

The contradictions we highlight in our scenario lead us to a more cautious and pessimistic outlook for Brazilian equities than the consensus. Even though Brazilian equities performed relatively well last month (coming in second among the emerging markets that we monitor) we have a moderate negative outlook for the coming three-six months.

We would, however, point to potential opportunities that a continuing strong inflow of FDI will create for bottom-up investors. A significant portion of these inflows are driven by Brazil’s domestic content requirements, which will create attractive investment opportunities in local companies that partner with these foreign investors.

Among sectors we keep a moderate positive rating on financials, especially the large banks, because we believe they will manage relatively well in an inflationary environment on account of their strong retail funding bases. We raise consumer discretionary to neutral because housing, which is its largest component, could benefit from new regulations to create a stable source of funding for home mortgages. At the same time we reduce consumer staples to neutral in view of our expectations of high inflation and a squeeze on consumers’ real incomes. Falling global prices of hard commodities will adversely affect materials stocks; we keep a moderate negative outlook.

Note: Key to rating system can be found on p. 2.

Russia

Although Russia will continue to be buffeted by volatile European markets we retain a positive perspective on economic developments. This view rests on a judgment that economic policy has taken a definite turn for the better and on evidence that moderate growth and lower inflation will be sustained over the forecast period. Despite Eurozone turmoil and short-term ruble weakness we believe that these two factors will lead to outperformance in Russian equities over the next three-six months given today’s substantial discounts of these stocks to EM peers.

The improvement in economic policy can be seen in the monetary sphere. During the past three months when European markets were gyrating wildly the Central Bank (CBR) resisted the temptation to intervene heavily to support the ruble; there was limited intervention over the last two months of about US$14 billion, but this was much less than occurred in past periods when the ruble was under pressure. The CBR’s more flexible FX policy of letting the ruble fluctuate to absorb external shocks is a significant improvement in Russia’s economic policy environment. The positive benefits of this new policy are that imports and domestic prices adjust more rapidly to such external shocks. The policy also encourages domestic firms to reduce their external liabilities rather than wait for CBR intervention to limit their FX losses. For example, during Q3/11 new private capital outflows roughly matched the external debt retired by Russian borrowers.

Once financial markets settle down therefore, prospects for renewed inflows of both portfolio capital and new borrowing are quite good. This is why investors should not worry unduly about the recent upward revision of the CBR’s forecasts of capital outflows from US$36 billion to US$70 billion for this year. In a submission to the Duma the CBR emphasized that the upward revision reflected the country’s unfavourable investment climate, which deters both foreign and domestic investors. The message to the politicians is pitched to an issue the politicians might do something about, rather than to the more optimistic interpretation that we offer here. The bottom line is that a return to positive inflows of private capital next year will obviously be positive for the ruble.

Recent economic data show strong economic growth and a steady fall in inflation. Q3/11 GDP growth is expected to come in around 5 per cent led by consumption, construction investment and a good harvest. We think the year-to-year change is somewhat misleading on account of the impact of the harvest failure last year. We still expect growth this year and next of about 4 per cent. Inflation meanwhile is on track to fall to around 6.5 per cent by December, the lowest end-year rate since 1991.

Last month Russia led EM equity markets with a 20 per cent rise. We retain our moderate positive outlook for the next three-six months. Most Russian stocks trade at a substantial discount to their EM peers, but in view of our economic outlook we expect them to make up part of this valuation shortfall over the forecast period. However, Eurozone turmoil will undoubtedly spill over into Russian markets in the next two-three months and investors should use sell-offs to add selectively to positions.

Our favourite sector remains financials; in particular the large state-run banks appear oversold. We upgrade energy to strong positive but caution that outperformance is likely to occur in the short term given recent relatively strong prices and sporadic shortages of crude in major markets. We maintain our moderate positive rating on consumer staples based on relatively attractive valuations vs their EM peers.

Note: Key to rating system can be found on p. 2.

India

India’s financial prospects continue to be dominated by policy paralysis, slowing growth and stubborn inflation. The lack of effective leadership from the current government is widely acknowledged but there is so far little to suggest how the current political impasse will be resolved. Meanwhile inflation remains stuck at just below 10 per cent; though still relatively high, growth is trending down and will likely dip below 7 per cent in the next two-three quarters.

The disappointing lack of policy action to address long-standing reform needs suggests backroom manoeuvring within the ruling Congress Party (CP) to determine a new political direction in the run-up to important state elections next year. A decision to retain the status quo cannot be ruled out but there is a sense that the CP wants to find another option, either to replace Prime Minister Manmohan Singh with another senior Congress Party official or to anoint Rahul Gandhi as Sonia Gandhi’s heir to the party leadership or prime ministership. In the meantime the lack of action is eroding market confidence and feeding volatility.

The problems caused by this political paralysis are amply illustrated by the full-fledged coal supply crisis that erupted last month with blackouts in New Delhi and other major cities and dangerously low coal stocks at Indian thermal power plants. The crisis reflects the dire predicament of state-owned Coal India and its inability to keep pace with rising demand. Coal India blames its shortcomings on a long list of problems, namely difficulties in arranging environmental clearances for new mines, inadequate transport infrastructure, strikes, bad weather and political agitation. Its solution to these problems is to go abroad to find new supplies of coal. While a crisis such as this will force government action there is little expectation that the fundamental issues will be resolved or even addressed by this government.

Where policy is driven by having to respond to crises, inflation inevitably follows. In this case the power sector is being forced into increasing dependence on more expensive foreign coal imports and the blackouts leave the government with little option but to let the companies pass on the higher costs to consumers. While the crisis may have a limited impact on economic growth it will certainly feed inflation and thereby weaken the effectiveness of the Reserve Bank’s anti-inflation policies.

We maintain a moderate negative outlook for Indian equities. Action to break the current political paralysis could provide a positive impetus to the market but only if investors are persuaded that a new government team will tackle the many longstanding structural bottlenecks that weigh on the economy. Stronger growth and significantly lower inflation could also provide a positive boost to the market but our expectation is that growth will continue to slow amid continuing high inflation.

Last month we reduced financials to moderate negative due to rising NPLs faced by the sector. Early in November the Finance Ministry announced a major capital infusion into the State Bank of India, the country’s largest bank, and several other state-run lenders. While this action will add a cushion to help absorb bad loans the extent of the NPLs faced by these lenders is still unknown. We retain our moderate negative rating for financials.

We continue with a moderate positive rating on consumer staples. Although these stocks have seen impressive relative outperformance over the past six months and high multiples consumer companies do continue to enjoy strong earnings growth.

Note: Key to rating system can be found on p. 2.

China

The performance of Chinese equities in October reversed many months of lacklustre price action thanks to evidence that inflation was peaking and expectations of monetary easing in the next two-three months. We expect inflation for October to fall to 5.2-5.3 per cent, down from September’s 6.2 per cent. Preliminary data confirm that pork prices fell sharply last month, which will drive down the overall inflation rate. We think December inflation will fall below 5 per cent and then stabilize in the 4.5-5 per cent range early in 2012. We think inflation will remain above 4 per cent next year due to continuing rapid increases in food prices.

Market expectations of imminent monetary easing have been fuelled by widespread reports of a credit squeeze being experienced by SMEs. We think these media reports should be taken with a grain of salt – while some SMEs are facing difficulty accessing credit, conditions vary widely in different regions. We do agree that policy easing is likely but we think such initiatives will be announced as part of the government’s annual Work Council meeting, usually held in early December. We think a cautious easing will actually be implemented after the New Year, not before.

The hard vs soft landing debate continues. We count ourselves in the soft landing camp, though our 8-8.5 per cent growth expectation for next year puts us at the low end of the range.

Left to its own devices, the economy is vulnerable to any number of potential pitfalls. Yes, there are problems with unrecognized NPLs in the banking system but all the major banks are on track to report record full-year profits. This will give them the ability to recognize major loan losses over the next three-four years if that should be required. Property prices meanwhile are correcting, as the government wishes, but in our view a real estate crash is unlikely because the government will step in to boost demand by reducing restrictions should price declines get out of hand.

Rather than worry about the media headlines trumpeting some imminent Chinese disaster, we recommend that investors focus on the new growth strategy that is beginning to take shape. Our perspective is that exports, infrastructure and property are all being de-emphasized in favour of consumption and new industries, what we call the “going-up-the-value-chain” strategy.

Although infrastructure provided the bulk of the stimulus during the 2008-09 crisis, we expect infrastructure investment to show little or no growth in the next two-three years. Fixed asset investment in property, which accounts for about one-third of total investment today, will also slow dramatically. Growth in property investment will derive mostly from the government’s social housing programme, while private investment will decline sharply, possibly into negative rates of change. The main driver of investment will be provided by manufacturing, which includes the “going-west” initiatives launched recently and the “new industries” strategy. We expect growth of about 35 per cent in manufacturing fixed asset investment next year.

The combination of falling inflation and policy easing are key elements to stronger equity market performance in the next six months. The other element to complete the picture is the relative cheapness of Chinese equities. The price-to-book of the MSCI China Index is currently 1.6 – among the cheapest in the EM universe (Russia and Brazil are cheaper). We retain our moderate positive rating on the overall market although we do expect China to outperform strongly during the upcoming period of Eurozone turbulence as investors will likely view it as relatively immune to external shocks.

Among sector calls we raise financials to moderate positive, based on strong earnings and relatively cheap valuations. We think the pessimism regarding the impact of NPLs on the major banks is overdone. We remain positive on energy because falling inflation will likely lead to upward adjustments in administrative prices for fuels. We also retain a moderate positive outlook for consumer sectors.

Note: Key to rating system can be found on p. 2.

Taiwan

The government’s advance Q3/11 GDP growth estimate of 3.4 per cent year on year has highlighted the slowing of economic activity. Gross capital formation dragged down the overall pace of growth with a decline of 13.5 per cent in Q3, reducing overall growth by 2.7 per cent. Net exports held up with a positive 4.5 per cent contribution. Private consumption, which we consider the only stable driver of growth in H2/11, contributed 1.4 per cent to headline growth.

Economic momentum has slowed noticeably, most likely driven by concerns about the global environment which are in turn leading to reduced inventory investment. The outlook is for continued sluggish export performance and declining investment, while private consumption will provide the underlying support of economic expansion.

The statistics bureau revised down its GDP forecast to 4.6 per cent for 2011 and to 4.4 per cent for 2012. This change is in line with our September forecast of annual growth of 4.5 per cent. The consensus of local financial analysts has been revised downward to our earlier projection.

We think the prospect of slowing exports has already been priced in by markets. Our concern now is whether consumption, which is the remaining growth driver, may weaken more than we previously expected. So far figures on consumption have remained stable this year with few signs of potential weakness. We are concerned, however, about signs that an increasing number of high-tech companies, including major electronics and information technology manufacturers, have notified the Council of Labour Affairs of plans to put employees on leave as a means of coping with falling orders. Furthermore, several cases of involuntary paid or unpaid leave were reported in the local media, highlighting worsening tensions caused by eroding profits due to low capacity utilization rates amid deteriorating global demand.

We view this as the greatest risk to the outlook over the next three to six months. Although some companies’ plans to put workers on leave have been reversed because of either government intervention or public criticism, the potential for the problem to spread to other companies in the supply chain is high. The solution to these problems depends on an improved global economic outlook and sustained growth in China, which accounts for the largest share of Taiwan’s exports. Although we anticipate a recession in Europe, US growth should continue to be moderate and China will in our view experience a soft landing. For now, we expect these risks to the outlook to be manageable.

We believe that an important political factor should help sustain domestic demand in the short term. The current administration will not want to dampen consumer sentiment before the upcoming January elections. This suggests that the government will take targeted measures in the coming weeks to protect consumption. We stay cautious and will continue to monitor developments in the labour market.

The MSCI Taiwan Index rebounded by 8.2 per cent in October, less than other EM markets largely because of market concerns with the potential impact of slowing global growth on the island’s export sector. Although we are less pessimistic than most, we downgrade our outlook for the Taiwanese market to neutral.

Among sectors, we retain a moderate positive outlook for consumer sectors and telecommunication services, which we view as defensive weightings. Elsewhere we retain a neutral weighting on financial and IT.

Note: Key to rating system can be found on p. 2.

Indonesia

As expected, Indonesian stocks recovered strongly when global sentiment improved, rallying 8 per cent in dollar terms in October. We believe that, although volatility both in the local JCI index and the rupiah exchange rate will continue as the European crisis enters another phase, domestic factors should lead to relative outperformance.

Bank Indonesia (BI) surprised markets (and Trusted Sources) by cutting its policy rate from 6.75 to 6.5 per cent on 11 October. This move confirmed that its priority is protecting growth from a global slowdown and that it is less worried about inflation. We therefore expect a further 25 bps rate cut at the monetary policy meeting on 10 November and at least another 25 bps before February 2012. BI is much better positioned to provide monetary stimulus than the central banks of other emerging markets such as India and Brazil, because inflation has fallen significantly.

October inflation came in at a surprisingly low 4.3 per cent. A major contributor to this was the decrease in the price of gold, which is included in core inflation, causing it to drop from 4.9 per cent in September to 4.3 per cent in October. Although non-gold core inflation is on an upward trend driven by buoyant demand, we believe that inflationary pressures are likely to remain subdued in the next three-four months. High food prices in December 2010 and January 2011 will provide some relief to food inflation through base effects. This will give BI room to cut rates by at least a further 50 bps from today’s level.

This monetary easing will support robust growth and further boost already strong consumption and investment, making up for slowing external demand. Government spending will be high in the last months of the year (only 63 per cent of the budget was spent up to September), but fiscal stimulus will be limited unless the global slowdown is much worse than expected. So far, exports have held up, growing 46.3 per cent in September vs 37.1 per cent in August.

Growth and inflation prospects are therefore positive for Q4/11 and Q1/12. However, the danger is that BI is using the global slowdown as an excuse to focus on stimulating growth instead of keeping inflation within its target. Demand pressures in the economy are strong, with consumer confidence at a record high, credit growth at 23 per cent and retail sales growth at 18.1 per cent in September. Core inflation is on an upward trend and more easing is likely to lead to an acceleration in the absence of a significant slowdown of exports. On top of that, depending on the harvest, food inflation is likely to return to above 10 per cent from March 2012, bringing headline inflation back to the 6-7 per cent range.

After we upgraded the energy sector to strong overweight last month, it outperformed the index by nearly 15 per cent in October. China’s coal imports hit a record high in September, and we believe they will continue to be strong as China builds stocks in advance of the winter season. We therefore keep our strong overweight on the energy sector. We maintain our moderate positive outlook on the consumer and financial sectors. We keep the overall outlook at moderate positive.

Note: Key to rating system can be found on p. 2.

Turkey

Turkey’s economic outlook is dominated by worries about inflation and a still-high current account deficit. We expect inflation to worsen in November due to substantial hikes in excise taxes, but inflationary pressures will weaken as slower growth and tighter fiscal policy begin to dampen demand in Q1/12. The Central Bank of Turkey (CBT) forecasts that inflation will fall to 5 per cent by the end of 2012, but we believe that a rate closer to 6.5-7 per cent is more likely.

The current account deficit is now around 9 per cent of GDP, one of the highest deficits in the emerging markets. We think the effects of lira depreciation and a sharp fall in GDP growth will gradually push the deficit down during the course of 2012 but a large shortfall is likely given continuing relatively strong domestic growth. The problem is that the weaker lira and the recent slowdown in loan growth affect the trade balance with a sizeable lag.

Current trade data remain more than a bit alarming: September figures released last week took the market by surprise due to the strong underlying growth of imports. The trade deficit for September widened by 74 per cent to US$105 billion on an annualized basis. We expect the trend in imports (at least in terms of quantity) to be reversed in a few months’ time as the weak lira and slowdown in consumer spending have their impact.

The CBT’s Inflation Report last week served to deliver the bank’s new policy package to financial markets. The CBT raised overnight interest rates from 9 per cent to 12.5 per cent in a move that was aimed to stabilize the currency. This was followed by a substantial reduction in banks’ required reserve ratios (RRRs) by a weighted average of 210 bps. The reduction of RRRs was focused on short-term deposits. As a result of these new measures, banks' funding costs on demand deposits fell to 11 per cent from 16 per cent.

Although CBT Governor Basci confirmed in his press conference that a hike in overnight lending rates was tantamount to a tightening move in monetary policy, we do not think this is his ulterior motive for increasing overnight rates. Rather, we interpret his moves as an effort to dampen speculation against the lira but at the same time to ease the squeeze on banks’ funding costs by easing reserve requirements. With prospects for more financial turmoil in Europe, we expect further monetary easing, most likely in Q1/12.

We retain a neutral outlook for Turkish equities. Although the developing recession in Europe will affect exports, Turkey has been successful in diversifying into new markets in the Middle East and North Africa (MENA). The MENA region now takes 25 per cent of exports (up from 20 per cent last year) compared with 38 per cent for Europe (50 per cent last year). We think the Eurozone crisis will lead to further monetary easing from the CBT. Turkish banks will be the primary beneficiaries of these policy changes. We raise our outlook for financials to moderate positive based on a judgment that expectations are unduly pessimistic with regard to bank profitability.

We also raise the energy sector to moderate positive given recent positive developments. The Czech power group CEZ said it had decided to evaluate investors' bids for its stake in Turkish power producer Akenerji. Further, a law regarding Turkey’s cooperation with Russia in building the country’s first nuclear power plant in Akkuyu has now entered into force. A second MOU was signed with Japan for building a second nuclear power plant on the north coast of Turkey.

Note: Key to rating system can be found on p. 2.

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