EM Strategy Monthly

Portfolio strategy

Overview

BRIC equity market performance moved very much in tandem with that of developed markets last month, trailing the US slightly but outperforming Europe. Chart 1 below shows that all markets suffered a roughly 5 per cent decline by mid-month before rallying sharply to close June only slightly down. Unsurprisingly, the commodities market was the laggard.

Among the emerging markets that we monitor, three countries led the group: Indonesia, Russia, and India. This trio recorded a roughly 3 per cent gain from 1 June to 7 July. China and Taiwan finished at the bottom of the list with a 3 per cent decline for the period.

Turning to the outlook, Table 1 below sets out our preferences for countries and sectors over the coming three-six months. Our overweight picks remain unchanged: China and Indonesia are strong overweights and Russia remains a moderate overweight. Last month China was dragged down by speculation over possible loan losses of its major banks to provincial and local governments. As we explain below, we think the market has overreacted; there are problems but we believe they will be managed and we think today’s valuations incorporate possible losses.

Our underweight recommendations have changed: we upgrade Brazil to moderate underweight and keep Turkey at strong underweight. India remains at neutral. The rationale for these ratings is explained in detail in each country section below.

We have a strong preference at this time for equity over fixed income and local markets exposure. With the exception of Russia and Indonesia, emerging economies are still struggling to contain inflation, so further interest rate hikes are probable. In Russia we forecast that 10-year local yields will decline by 50 bps over the next three-six months; in Indonesia we expect a smaller 20 bps reduction.

As explained in greater detail below, we think Russia provides the best opportunities in local markets at this time. We also like Russian and Indonesian sovereign dollar bonds but projected returns over the forecast period will be substantially lower than for local investments.

Note: Values and rates as of 7 July

Global themes for portfolio allocation

EM equities are poised for outperformance during H2/11. Performance in developed economies will be hampered ever more seriously by their debt problems.

The argument for EM outperformance is all about debt and its restraining influence on growth: Europe and the US are inexorably being dragged down by debt problems that will limit their ability to grow in the future. By contrast, the economic barriers to growth in major emerging economies are much less daunting. The debt burdens of the top emerging market economies are easily managed – debt-to-GDP levels are half those in developed economies – and although inflation is a worry, policy has largely capped its further rise.

The evolution of the Greek debt drama is a perfect example of the primacy of the political calculations of Eurozone leaders over economic reality – what most of us call common sense. The pattern by now is well known: Eurozone leaders meet for a weekend in order to develop a new wrinkle in their plans for saving the crisis-hit country of the moment. Those who are conspicuous by their absence at these meetings are the economic experts and bankers who might tell the politicians what is actually going on in what passes for the “real world”.

Should anyone be surprised when the Wall Street Journal reports that in fact major European banks have substantially fewer Greek bonds than everyone was assuming? It transpires that many banks have sold out their positions despite pledges by many of them not to do so. Der Spiegel reported this week that one major German creditor (Allianz) agreed not to sell but only for as long as this made “economic sense”. If the Greek bailout ever made sense, that time is long past.

If banks have much less debt than was believed, hopes that they will make a significant contribution to rolling over maturing debt will probably be dashed. The buyers of the debt are likely hedge funds and other distressed investors who are unafraid of playing hard ball with politicians desperate to avoid “unpleasant” outcomes. The UK Supreme Court ruled this week that a UK hedge fund (NML Capital) is entitled to pursue the Argentine government for full payment on defaulted sovereign debt it purchased between 2001 and 2003 (at a substantial discount to par): this news should give the politicians a hint of how the inevitable legal battles over Greek debt may go if it comes to default (details here). Anyone who adopts moral hazard as their working principle − as the Eurozone politicians have − should not be surprised (as Shakespeare reminds us) if they are hoist by their own petard.

The most important lesson I took away from nearly 10 years of working on the 1980s debt reschedulings is that countries cannot service debt if they cannot grow. Piling new debt upon old debt that cannot be repaid is a fool’s errand. Greece cannot service this debt burden and therefore cannot grow. The market knows this. The politicians probably know this too but they are driven by political calculation to protect their reputations and egos, not by rational economic calculus.

How long this charade will take to play out is impossible to say. What is clear, however, is that the debt will increasingly wind up in the hands of the Eurozone mostly through the European Central Bank (ECB). Whether Portugal and possibly Spain and Italy will be dragged down by policies that demonstrably do not work is debatable but a prudent investor would clearly think twice before exposing his or his clients’ money to such risks. What seems likely therefore is that the ECB will be forced to repurchase more and more Portuguese/Italian/Spanish debt (i.e., whatever the market views as peripheral debt), which will only feed the gradual downward spiral.

The end game of this process may be painfully slow but it is heading towards a bailout of the banks and the speculators by the taxpayers. This prospect is already fuelling capital flight. The decline of Greek bank deposits over the past two years mirrors trends that occurred in previous debt debacles such as Argentina and Uruguay (details here). The first stop of this flight capital appears to be Cyprus, but the larger risk is that investment capital will flee Europe entirely as these trends develop. Considering the continuing US debt problems (see below), we think that ever more of this flight capital will move into emerging economies.

The US debt problems appear on the surface to be rather different from those in Europe. But the underlying cause of economic risk is the same: a dysfunctional political system that is unable to fix the problem. The current meetings between President Obama and congressional leaders are about raising the country’s self-imposed debt ceiling. What the discussions appear to ignore is that the scale of the proposed cutbacks that are being thrown around – some US$2 trillion over 10 years – assume that interest rates on Treasuries will remain near current levels far into the future.

But the US debt burden is now so high – nearly 90 per cent of GDP – that a normalization of interest rates on new debt issuance from today’s unsustainably low levels would entirely wipe out the potential “savings” that are being negotiated. Projections by Lawrence Lindsay, a former Federal Reserve governor, show that if the average cost of Treasury borrowing goes back to the 20-year average of 5.7 per cent (up from 2.5 per cent today) the 10-year rise in interest expense would be nearly US$5 trillion, substantially more than the US$ 2 trillion in “savings” that will likely come out of the current White House talks.

But with posturing already well under way ahead of next year’s elections neither the Democrats nor the Republicans are eager to look in more detail at alternative paths for the debt in the next five-10 years. This all but guarantees that whatever near-term fix comes out of the current negotiations will have to be revisited in short order.

Although the focus of markets is today on Eurozone debt we do not think the US will be exempt from a market fallout tied to its evolving debt crisis. The US will benefit in the short run as a safe haven from Europe’s woes but this could prove to be short- lived. The ultimate beneficiaries of these dual debt crises will be the well-managed emerging markets that are able to grow.

Commodity prices will recover in H2/11 as China starts rebuilding inventories; the medium-term outlook remains bullish.

Commodity prices fell further in June after having temporarily stabilized following their initial sell-off in early May (see Chart 3 below). Investors withdrew approximately US$7 billion from the asset class in May and continued to unwind net-long positions in June in response to growing fears of slowing growth in both developed and emerging markets and a hard landing in China. The June decision by the International Energy Agency (IEA) to release 60 million bbls of crude from member-country strategic reserves weighed for a while on energy prices, while prices of agricultural commodities fell sharply following the US Department of Agriculture’s 30 June report of much higher-than-expected US corn acreage and stockpiles.

As discussed in this week’s TS View, we expect prices of key commodities to rebound in H2/11 as China stops drawing down raw material inventories and begins restocking via imports (iron ore is an exception, see below). Recovery in China’s growth as its monetary tightening cycle ends will contribute to demand, with supply- constrained commodities such as copper, coal and oil best positioned to outperform. Coal restocking is already under way and copper inventory rebuilding is likely to begin soon. The impact of the IEA's release of crude oil stocks will be transitory and continued strong oil demand in China and India will be positive for the market in the medium term.

The recent weakness in prices of agricultural commodities, particularly of corn, could be overdone. Led by China, Asian importers are taking advantage of lower prices to buy corn to rebuild inventories and US acreage estimates could yet be revised later this summer. We remain confident in our view that strong demand for commodities from China, India and other emerging markets will support higher prices in the medium term.

Russia provides the best opportunities in local currency investments at the moment.

Russia is approaching a major inflection point with regard to inflation. Last year there was a sharp increase in inflation due to the effects of a serious drought on grain prices: the CPI index measured on a year-on-year basis rose from a low of 5.5 per cent in July to a high of 9.6 per cent in January 2011.

This year Russia is experiencing better-than-average weather, with the result that agricultural prices will likely fall in nominal terms in contrast to last year’s sharp rises. Agricultural prices already fell 0.2 per cent in June, a month earlier than the usual seasonal pattern. This means that there will be a very rapid decline in the usual year-on-year measure of inflation beginning in August. This decline will be largely due to the base effect but investors could nonetheless be surprised by the speed of the decline.

Currently quasi-sovereign ruble bonds are trading with yields of 8.5-9 per cent while investment-grade private paper is at 7.5-8 per cent. If our projections of an appreciation of up to 4 per cent in the ruble vs the dollar by year end and a 50 bps decline in local rates are accurate, investors can expect annualized percentage returns in the mid-teens to low twenties.

EM themes – Investment ideas

Brazil

One month after the departure of Antonio Palocci from Dilma Rousseff’s cabinet it appears from the outside that economic policy is on autopilot. Take the Banco Central (BC), for example – it has reverted to form, talking tough on inflation but nudging up interest rates only 25 bps after each COPOM meeting. This strategy signals a “wait and see” stance more than aggressive moves to tackle rising inflationary pressures.

A sense of ineffective policy is also evident regarding the Real. Finance Minister Guido Mantega this week threatened new actions to counter the rising Real, which had touched a record high against the dollar − slightly below R$1.55/US$. A look at the capital flows data over the past three months reveals that portfolio flows for fixed income are slightly negative and for equities inflows are running at US$8 billion at an annualized rate well below last year’s figures. By contrast, inflows associated with FDI and trade finance are at record highs: US$64 billion and US$78 billion respectively (annualized three-month data). The government is unwilling to take action to dampen inflows in these categories, so the tough talk on fighting appreciation will be unlikely to convince markets that the new measures will be any more effective than earlier ones.

The real battles on policy are taking place in Dilma's offices in the Palácio do Planalto. She has appointed two trusted aides to step into the breach caused by Palocci’s exit. Gleisi Hoffmann, a Workers’ Party (PT) senator from the southern state of Parana, has replaced Palocci as Chief of Staff and Ideli Salvatti, formerly the Minister of Fisheries, has been put in charge of Dilma’s liaison with Congress. Salvatti’s role is the more important one, given the fragile state of Dilma’s governing coalition.

The challenge facing Dilma is to maintain the basic policy line of her administration while deflecting strong pressure from the Brazilian Democratic Movement Party (PMDB), her main coalition partner. The PMDB is testing the limits of its new-found power by attempting to fill the vacuum caused by Palocci’s departure. Dilma is determined to give as little ground as possible but it is unclear how successful she will be.

The implications of these behind-the-scenes struggles are that Dilma will be forced into adopting a more populist posture than she might have wished. The BC has been left alone to follow its own policy line, but elsewhere government policy continues to target rapid growth. Last week the National Monetary Council kept the loan rate of the state development bank (BNDES) at 6 per cent even though the BC has raised its policy rate 150 bps so far this year to 12.25 per cent. The government claims that funding for the BNDES will be cut back this year to slow lending but there is little sign of this happening – in the first four months of 2011 the BNDES lent only 5 per cent less than in the same period last year. That reduction is hardly meaningful given the scale of BNDES lending: in calendar 2010 the BNDES lent Brazilian companies over US$100 billion, 40 per cent more than the World Bank lent globally in a similar 12-month period.

The BNDES situation illustrates what we believe is a major problem facing Brazil: the lack of a coherent economic strategy. While the BC talks tough on inflation, overall credit volumes continue to expand well in excess of rates deemed desirable by the government itself. Total credit rose 20.4 per cent in May compared to the 10-15 per cent target mentioned by the authorities. The reality is that achieving low inflation and sustaining rapid growth are incompatible policy goals and Dilma’s political calculation inevitably puts rapid growth ahead of price stability at this time.

We think that surface tranquillity will mask these fundamental policy contradictions for now. Municipal elections are scheduled for October, so it is a certainty that the government will spend more in advance of that date. What will bring this “silly season” to an end is the market’s realization that ever higher interest rates from the BC cannot address the causes of the country’s inflation. The time for this is coming, but probably not for another three or four months.

We think Brazilian equities will probably do a bit better than we predicted last month because we are now less negative on the energy sector. We remain negative on the outlook but we raise the rating to moderate underweight. Utilities remain our top sector recommendation in a most likely scenario of moderate growth with persistent inflation (the tariffs of most utilities are inflation-linked). We upgrade energy to neutral, based on evidence that the government will take an easier position on approving higher gasoline prices; this will be favourable for Petrobras. We downgrade basic materials because of our more pessimistic view on the outlook for iron ore prices as a result of record inventories in China.

Note: Key to rating system can be found on p. 4.

Russia

A solid cyclical rebound in the Russian economy has become increasingly evident in recent data. After hovering at 9.6 per cent for several months, consumer inflation has now eased to 9.4 per cent, helped by falling agricultural prices. From a year-on-year comparison we expect the declining trend in the CPI to gain momentum in Q3/11 due to a strong base effect associated with the surge in grain prices during last year’s drought; CPI inflation should be well below 8 per cent by December. This lessens the risk that the Central Bank of Russia (CBR) will tighten monetary policy and it should bolster confidence in the sustainability of the recovery.

Growth in May was relatively strong, led by retail spending and investment. Retail sales were up 5.2 per cent year-to-date in May and a moderating trend in inflation will likely boost spending further during H2/11. Official figures show that investment was up only 2 per cent in the first five months of 2011 but these data appear to underestimate activity: the output of building materials such as cement and bricks soared 15-20 per cent during this period. Over the next 12 months we expect to see sustained strong expansion of residential construction and a noticeable recovery in capex led by major state-controlled firms.

A developing trend with important implications for Russian assets is the slowing of private capital outflows and the resumption in June of net inflows estimated at US$ 3 billion (our analysis of this topic may be found here). Net private capital outflows since mid-2010 totalled US$70 billion, driven by political uncertainty in advance of the coming national elections and negative real interest rates. As the inflation down-cycle gathers momentum in H2/11 we expect the CBR to refrain from micro-management of the nominal ruble exchange rate. This will facilitate a gradual appreciation of the ruble as private capital flows turn positive. We project ruble appreciation of about 4 per cent by year end.

This positive outlook for Russian securities is also supported by government activity to improve the country’s investment climate. President Dmitry Medvedev signed a decree last month lifting restrictions on domestic companies listing abroad and he ordered that agreement on a central securities deposit be reached in the next three months (discussions have been ongoing over the last four years). Last week the CBR announced that ruble-denominated domestic bonds would be available to be settled through Euroclear before the end of next year. In effect this will greatly ease the access of foreign investors to the domestic ruble bond market. Finally, Medvedev has given the government a deadline of 1 August to produce a revised privatization programme up to 2015. The original draft of the programme included a revenue target of Rb1.8 trillion (US$60 billion) but he wants the programme liberalized to permit sales of controlling interests over the 50 per cent level.

Greater clarity on the near-term political outlook has also emerged. Last month Prime Minister Vladimir Putin announced that the pre-election congress of the party that he leads – United Russia – will now take place on 3-4 September. The congress will be the moment when Putin finally dispels all or most of the uncertainty over how he and Medvedev will handle the forthcoming parliamentary and presidential elections.

We retain our moderate overweight recommendation for the coming three to six months. We think the best way for investors to play the positive Russian story is via stocks other than the major oil companies – we are concerned that continued volatility in oil prices may weigh on oil-related equities. Our top pick remains Russian financials because they are particularly well situated to benefit from a cyclical economic recovery. We also think materials and consumer stocks will do well during this phase of the recovery.

Note: Key to rating system can be found on p. 4.

India

The Indian economy continues to be characterized by slowing growth amid persistent inflation. Progress on reforms is evident even if their pace is disappointing to most investors. This is positive for the outlook but the real test of the government’s reform resolve will come when the much-discussed privatization programme is finally launched, which we expect to happen in the next two-three months. Several successful transactions would boost market confidence but it is still too early to venture an assessment of prospects.

Meanwhile inflation continues to be the major worry for the markets. The Reserve Bank of India (RBI) has taken the lead in fighting inflation and it appears on course to hike interest rates another 25 bps at its 26 July meeting. Some analysts expect this to be the end of the bank’s tightening cycle but we are unconvinced. The recent hike of diesel and other fuel prices will raise inflation to the 10 per cent level in the next two to three months. We then expect another one or two rate hikes. Despite these actions by the RBI, we think inflation will continue relatively high for the near term at around 8-9 per cent even if a normal monsoon occurs as seems likely.

A key question for investors is whether we will see a traditional interest rate cycle once the RBI is finished with its monetary tightening. We would advise against trying to position for such a cycle. Even though the RBI is likely to pause in pushing up interest rates later in H2/11 we think inflation will remain relatively high because of supply bottlenecks. Sustained demand increases for high-protein foods will keep upward pressure on food prices no matter what the RBI does. This will dampen any inflation cycle.

On the political front the government is expected to announce a cabinet reshuffle at any time in the coming four-six weeks. Our assumption is that the Congress Party’s leadership will focus on weeding out underperforming ministers while preserving a balance among the various coalition members. This week a second minister resigned after being associated with corruption scandals in the auction of mobile phone licenses. This suggests that the reshuffle could be imminent. Our hope is that a reformist finance minister will be appointed, but there are few signs yet of any front runners for the job.

This month we retain our neutral rating of the Indian market with a positive call for consumer staples only. Persistent inflation will be negative for financials and we maintain our moderate negative rating for the next three-six months.

Note: Key to rating system can be found on p. 4.

China

China’s economy appears to be approaching an inflection point. Economic growth slowed during Q2/11, partly because of a moderate tightening of monetary policy so far this year and partly due to widespread destocking by industry. A recent research report by Deepak Gopinath concluded that China is ending inventory draw-downs and will begin restocking major hard commodities − with the exception of iron ore, whose inventories are still at record highs.

We expect inflation to peak at around 6.5 per cent when data for June are released next week. Food prices will be the cause of much of the rise over the 5.5 per cent rate recorded for May. From this point, however, we expect to see a gradual decline in the year-over-year inflation rate during H2/11 to 4.5-5 per cent by December. This will reflect a base effect rather than a sustainable lower inflation rate. Upward pressure on inflation will likely return early next year.

The issue of potential non-performing loans in the banking system has emerged this month as a major topic in the financial media. Various reports claim that the banking sector’s exposure is substantially higher than generally assumed, implying that the government will eventually be forced to bail out a substantial portion of the banks’ loans to local authorities’ loan production platforms. We suggest that investors focus on several important questions:

1. Can the monetary authorities manage potential debt problems? If so, what time period would be required to resolve the problems?
2. Do valuations for the major banks reflect the potential jump in bad loans that has been suggested?

We believe China’s monetary authorities will try to maintain the banks’ net interest margins at levels sufficient to permit adequate provisioning by the banks over the coming three-five years. The authorities’ tight control over deposit interest rates together with the Communist Party’s influence over both lenders and borrowers should facilitate meeting this goal. A worst-case scenario might involve official purchases of bad loans out of the banks’ portfolios, as happened after the 1997 Asian debt crisis. We doubt that any such action is imminent despite the numerous news items suggesting the government is about to bail out the banks.

The second point is that the valuations of bank stocks already reflect a substantial increase in costs of provisioning and potential dividend cuts. According to Bloomberg this week, the MSCI China Financials price-to-book ratio fell below the MSCI Emerging Markets Index’s ratio for the first time since December 2005. We are not big fans of Chinese bank equities but our judgment is that markets have overreacted to potential future problems for the banks. For this reason we maintain a neutral rating for China financials.

We maintain our strong positive rating on Chinese equities for the next three-six months. In recent weeks several major investment banks have upgraded their outlooks to overweight, so the consensus has now come round to our call. Among sector calls we upgrade consumer discretionary to neutral; this is based on expectations that consumer confidence will improve over H2/11 as inflation gradually falls. Previously our negative view on the sector reflected concerns about high valuations of these stocks.

Note: Key to rating system can be found on p. 4.

Taiwan

Taiwan has achieved what most other countries can only dream of – stable growth with low inflation. Inflation in Taiwan so far this year has hovered just below 2 per cent, the lowest among major EM economies. We project that the CPI will accelerate slightly in H2/11 to above 2 per cent due to higher prices for imported grain and fuel. We expect the central bank to increase its 1.875 per cent policy rate by 12.5 bps at the end of each of the next two quarters as a precautionary move to dampen inflationary expectations. Further small increases will probably follow next year.

Economic growth is facing headwinds from the current slowdown of Chinese growth and more moderate growth in demand from developed countries. Consumption will be growing at a steady pace, however, thanks to the recent 3 per cent wage increase for public sector workers and recovering employment demand reflected in the steady decline in the jobless rate. In addition, the opening of Mainland China individual visitor travel from the end of June will strengthen demand for tourism-related services. For the year as a whole we project GDP growth of 5 per cent, slightly higher than Taiwan’s major competitor in the region, South Korea.

Last month overall equity market performance was dragged down by the IT sector as a result of widespread downgrading of analysts’ earnings forecasts for semiconductor companies. Buoyant demand for portable electronic networking devices (e.g., smartphones and iPhone components), however, caused the communications equipment subsector to stand out within the IT sector. The impressive outperformance of telecommunication services was driven by the cloud computing theme, which has been embraced by the market.

We suggest that in the next three to six months investors focus on financials because of developments associated with an opening for Taiwanese banks and other financial services firms to get involved both in the offshore renminbi market and directly on the Mainland. The Executive Yuan approved on 30 June the establishment of offshore banking units of Taiwanese banks on the Mainland. We expect a stream of positive news from the ongoing process of cross-Strait financial deregulation in the run-up to the presidential election next January. President Ma will likely try to strengthen his pro-China economic policy as part of his election campaign.

Note: Key to rating system can be found on p. 4.

Indonesia

Optimism continues to reign in Indonesia. After inflation slowed further in June – to 5.5 per cent from 6 per cent in May – Bank Indonesia (BI) declared that it is confident inflation will ease to 5 per cent by the end of 2011, at the midpoint of its 4-6 per cent target. Even before the June numbers, BI’s tone had become more dovish. In its latest monetary policy review it no longer stated that it had a tightening bias as it had done in previous months. This confirms our view that BI is unlikely to raise rates more than 25 bps this year.

The government, too, is optimistic. Debate in parliament on the macroeconomic assumptions for the 2012 budget has resulted in an upward revision of the growth target to 6.6-7 per cent while inflation is projected at 4-5.3 per cent and the exchange rate at 8,600 to 9,100 rupiah per dollar. President Yudhoyono targets growth of 6.6 per cent on average for the remainder of his term (2011-2014) in order to stay on track for his Master Plan for Economic Growth Acceleration 2011-2025, which was presented at the end of May.

Although we believe in the stability and potential of the Indonesian economy, we think policymakers – and perhaps investors – are currently overly optimistic. Once the base effects from high food prices last year have disappeared, inflation will start to increase again. The July number is likely to be lower, but then inflation will edge up towards 6 per cent this year and 6-7 per cent next year. Moreover, we expect continued inaction from the government so that progress on the Growth Acceleration Programme will be slow and reforms will be stalled. We therefore foresee a correction in equities either late this year or early next year. However, in the next month or two optimism will likely prevail as inflation reaches its trough.

As regards the currency, the government is still relatively relaxed about appreciation. A surprise boost of the trade surplus to US$3.5 billion in May eased any concerns that the strength of the currency might hurt competitiveness. Moreover, BI said it expects more appreciation in H2/11, but continues to stress that the rupiah should move in line with other Asian currencies.

Note: Key to rating system can be found on p. 4.

Turkey

Elections last month brought the ruling Justice and Development Party (AKP) back to power with nearly 50 per cent of the popular vote. Despite increasing its vote total compared to the election four years ago, the AKP wound up with 14 fewer MPs due to a stronger performance from the second-ranked Republican People’s Party (CHP) and independents. The AKP is three MPs short of the 330 votes necessary for calling a public referendum to adopt its goal of a presidential governmental system in place of the current parliamentary one. This shortfall will force Prime Minister Recep Erdogan to seek cooperation from opposition MPs in order to secure the votes necessary to authorize the referendum. We view this outcome as positive: the Prime Minister will likely succeed in calling the referendum but it will evolve as a gradual process rather than a quick, forced political act, as would have been the case if the AKP had won over 330 seats.

In the meantime political activity reached a stalemate as a result of a boycott of parliament by a significant number of newly elected CHP and independent MPs (the independents are associated with the Kurdish nationalist Peace and Democracy Party). At issue is the seating of two CHP MPs and a further six Kurdish MPs who have been detained but not charged in terrorism-related cases. Although tempers have flared with veiled threats on the part of Erdogan to proceed without the protesting MPs, we expect a negotiated resolution ultimately to be found with the involvement of President Abdullah Gul and the constitutional court.

The economy last month delivered a mix of conflicting signals. Inflation in June fell to 6.2 per cent, well below expectations and last month’s 7.2 per cent result. This lent support to the Central Bank of Turkey’s (CBT) longer-term forecasts that inflation would ease in the coming months. In our view this outcome will keep monetary policy on hold for the next two to three months, despite widespread calls in the market for the CBT to push up interest rates to corral an overheating economy.

Of more concern for the markets was the release in late June of Q1/11 GDP growth, which soared to 11 per cent, substantially higher than market consensus. This appeared to confirm market fears that the economy is seriously in need of strong fiscal and monetary policy responses. Other data added to the evidence pointing towards overheating: the country’s trade deficit in May reached US$10.1 billion, a figure that is roughly twice the deficit in the same period of 2010. Although higher oil prices were partly to blame for the rising deficit, the deterioration in the country’s non-energy trade balance was equally dramatic, recording a shortfall of US$26 billion in the first five months of the year compared with US$10 billion in the same period in 2010.

The outlook for Turkish markets will be strongly influenced by the growing gulf between market players, who view recent economic data with alarm, and the monetary authorities, who remain convinced that the economy is on track to slow by Q4/11. The market wants to see the CBT raise rates very soon but we doubt this will happen. As a result, markets will continue to fear that even more radical remedial policy measures will be required to cool off the economy. This points to a period of underperformance for equities in the near term. We retain our strong underweight recommendation.

Turkish equities were on a rollercoaster last month, rallying strongly ahead of the 12 June elections before falling in mid-month and then moving up in line with global markets at the end of June (see Chart 2 above). We maintain our negative outlook on Turkish financials because of their vulnerability to possible further macroprudential measures to rein in lending activity. We upgrade energy from slight underweight to neutral because substantial underperformance over the past two months has reduced downside risk for the forecast period.

Note: Key to rating system can be found on p. 4.

Sector and country insights

EM leaders and laggards in the financials sector

In Chart 12 below we show MSCI performance indices for financial stocks for seven emerging markets over the past month.

Financials were one of the strongest-performing sectors in our group, with the exception of China. Russia led the group with a 7 per cent gain since 1 June, and Indonesia, India and Brazil followed close behind.

China’s banking stocks were pummeled by speculation about potential non-performing loan losses after official exposure data were released. As we explained in the China section above, we think potential loan losses will be managed with write-offs spread over a three to five-year period. We think the potential impairment to the banks’ profitability and dividend performance is already reflected in today’s distressed prices.