EM Strategy Monthly

October 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 10 am BST, 6 October.

Our next Strategy Monthly will appear on 4 November.

Overview of September performance

We warned investors last month to prepare for a full-blown Eurozone financial crisis but we failed to anticipate the pummelling that EM equities suffered last month. When panic hits, investors sell what they can. This means that selling is indiscriminate, taking no account of economic fundamentals. It also means that the best investments tend to be hit harder because they can be sold while weaker credits may fail to find a bid.

Every EM investor is asking whether markets will continue to ignore the relatively better economic fundamentals of EM economies and firms or whether we are in for a repeat of last month’s roller-coaster ride. As we spell out in more detail below, we are now moving into a new phase of the Eurozone crisis: policymakers have got the message – Greek debt will have to written down at least 50 per cent and Eurozone banks will have to be recapitalized. But the solutions they are coming up with so far fall short of what will be needed to put the problems on a path towards resolution.

This state of affairs promises continued volatility and downside risk for EM equities. We are optimistic that the road to a viable resolution of the crisis will be found, but we think policymakers will be brought to the brink of the abyss before they act to avoid a collapse.

As Chart 1 makes clear, EM equities suffered substantially more last month than either the US or Europe. A three- or 12-month view would show EM equities at almost the identical end point to European stocks: down 22 per cent over three months and about 15 per cent over 12 months.

So whose crisis is it, Europe’s or the emerging markets’? We would argue that if EM equities were pricey 12 months ago they now represent substantial long-term value given prospects of sustained, albeit more moderate, growth. Investors must be patient, however, because the next two-three months will bring renewed stress to global equity markets.

The top performers last month were Turkey and India. Turkey proves the adage that if bad news is coming it is better to get it out of the way sooner rather than later. The Turkish market has underperformed other EM markets consistently since earlier in the year, following the Central Bank’s introduction of unorthodox monetary policies last December. The Turkish lira had already depreciated by 25 per cent from January to August, i.e., before the September upheaval in markets. As a result, Turkish exporters are in a much stronger competitive position going into the current economic slowdown; this will help cushion the impact of Europe’s reduced demand for Turkish exports.

India has also been a laggard this year, partly because of perceived overvaluation but also because the Singh government has failed to implement necessary economic reforms. The relative outperformance is mostly due to India’s more modest exposure to global economic shocks. This continues to be true though to a lesser extent following the substantial inroads Indian manufactures have made in global markets.

Russia and Brazil were the biggest laggards last month – Russia because the global panic coincided with Prime Minister Putin’s upcoming move back into the Kremlin, while Brazil represented nearly everybody’s favourite overweight allocation (we carried a neutral rating). Both countries’ currencies suffered the largest declines during the sell-off, nearly 15 per cent.

Turning to the outlook, we believe last month’s turmoil has led to significant capital outflows on the part of foreign investors, though there are still potential further outflows in the pipeline. This is because some investors react with a lag (e.g., retail investors in EM funds) and because we anticipate renewed volatility ahead for global markets.

On a three-six month horizon we expect investors to re-establish long positions in the markets with the best fundamentals and the most compelling valuations. We include Indonesia and Taiwan in the first group and China and Russia in the second. All these countries carry a moderate positive rating. Were it not for the uncertainty surrounding the timing of policy actions to resolve the Eurozone crisis we would have awarded even higher ratings to Indonesia and Russia. We also raise Turkey to neutral. Although Turkey will be hit by the European economic slowdown Turkish exporters are well positioned because of both the substantial depreciation in the lira and the rapid shift of trade away from Europe into North Africa and the Middle East.

At the other end of the spectrum we reduce both Brazil and India from neutral to moderate negative. While we expect both countries’ markets to participate in any EM rally we think they will lag other markets because of their continuing problems with high inflation.

In fixed income we saw EM debt lose its “safe haven” status as selling pushed prices down and yields up anywhere from 30 bps (Brazil) to over 100 bps (Russia). We view these moves as irrational and expect substantial spread tightening over the next six months. We think EM debt will be among the top-performing asset classes during this period. Local market debt offers good prospects for rising prices, but currency volatility will also remain high for the near term. Market timing will be crucial for investors contemplating entering these markets.

Portfolio strategy

Global themes

EM face another period of heightened volatility before the Eurozone financial crisis is put onto a viable path towards eventual resolution.

Recent developments in thinking about how to resolve the Eurozone financial crisis have gained a momentum that could not have been anticipated as recently as two weeks ago when the IMF/World Bank annual meetings ended. The main conclusion that has buoyed markets is that Eurozone policymakers “get it” and are preparing measures to manage the crisis, if not to put it on the road to resolution.

Leaks to the press imply the following conclusions:

1. The banks’ current deal to grant Greece 21 per cent debt relief (in net present value terms) is unviable and will have to be renegotiated once final approval of the €440 billion augmentation of the EFSF is approved (not later than 15 October). The “haircut” facing banks holding Greek debt will likely be raised to at least 50 per cent.

2. A coordinated, Eurozone-wide recapitalization of banks will be launched.

3. The IMF is exploring ways to increase its lending capabilities, including market and bilateral borrowing (from China and other countries possessing “excess” FX reserves).

4. Debate on ways to leverage the EFSF is continuing, although senior Eurozone leaders have said this is unlikely to happen.

Should these developments give EM investors enough confidence to grab some of the obvious cheap assets that have suffered during the September panic? Should the rapid escalation of new initiatives give us confidence that policymakers will do what has to be done to deal with the crisis?

Alas, our answer to both questions is no. Even if Eurozone policymakers are now sufficiently engaged to begin working out contingency plans, they are still insufficiently aware of the scope of the problem they are facing.

By any measure European banks have exposures to European sovereigns that far outstrip their ability to absorb potential losses. The €350 billion in Greek debt is a drop in the ocean. Consider Italy, a country with a debt burden of 120 per cent of GDP, which is paying over 5 per cent on its new debt placements. Even the most optimistic economic forecasts see little if any GDP growth for Italy in the medium term. Italy may not face any short-term liquidity problem today but in the long run the country is bankrupt: paying 5 per cent on the debt out of a stagnant income stream implies an ever-growing burden of debt service.

Even the most creative bank recapitalization scheme will not solve Europe’s problem of excessive sovereign indebtedness – the debts are too large relative to the underlying cash flow (i.e., economic growth) that must be tapped to service the interest. One implication is that the debts of many European sovereigns will have to be written down by the banks.

Yes, economic reforms could help revive domestic growth and potentially restore confidence in European countries’ ability to pay. After all, most of the emerging market countries that defaulted in the 1980s succeeded in restoring growth and they are benefiting from large declines in their debt burdens. For example, the countries included in the JP Morgan Emerging Market Bond Index have reduced their debt-to-GDP ratios to 34 per cent, less than half the comparable figure for developed economies. But remember that most of these countries obtained substantial debt forgiveness, enacted wide-ranging economic reforms and subsequently grew faster than developed economies.

Does anyone believe the Italian political system is capable of making the wrenching adjustments that would be required to put the country’s debt on a sound footing? We doubt it. Only a substantial fall in market interest rates would stabilize the level of Italy’s sovereign debt and this seems unlikely given the banks’ problems. The feedback loop of too much sovereign debt and bank capital shortfalls appears daunting.

The inescapable conclusion is that no amount of prospective bank recapitalizations will bring a final resolution to the crisis without massive debt deleveraging; this is Europe’s sovereign sub-prime debt trap. The management of this problem will likely involve widespread government interventions via equity injections in many of the banks along with structures to deleverage the banks over a long-term horizon. The involvement of billions in IMF lending in this adventure goes without saying. Whether the Chinese are up to participating in this exercise may be doubted; they have their own debt mountain to worry about.

EM sovereign fixed-income securities are in a position to become the top-performing asset class in the next quarter.

Last month we waxed lyrical about why EM sovereign debt had become the new safe-haven investment. September’s market action effectively erased August’s outperformance and then some. Part of the reason for the dismal performance was simply that many EM debt funds were overloaded with high-beta, less-creditworthy names such as Argentina and Venezuela. In order to meet a rising tide of redemptions such funds were forced to sell more creditworthy names in the face of almost total illiquidity in lesser credits.

We recommend that investors focus on the JP Morgan Emerging Market Bond Index (EMBI) as the bellwether for this asset class. The EMBI’s average credit rating today is that of a weak BBB security, so it is not overly weighted down by dodgy sovereign credits. Further, the average debt-to-GDP ratio for the EMBI sovereigns is about 34 per cent, less than half the comparable figure for developed sovereigns.

We think the top EM sovereigns will regain their status as safe havens following the recent sell-off because of the compelling evidence of their ability to pay, especially in the context of sovereign write-offs likely to emerge from Europe. In essence, these issues should track US Treasuries but with the added kicker of potential spread tightening; they are essentially a Treasury-plus asset class.

Among the sovereigns that we monitor our top picks are Russia, followed by Indonesia, Turkey and Brazil in that order. With prospects of volatile equity markets ahead the attraction of locking in favourable rates should propel these securities to outperformance in the next three months.

We are considerably less bullish on prospects for local fixed-income securities. We do expect local rates to decline over the next six months, but currency volatility will also be high. We do not expect major EM central banks to go out of their way to push up their currencies. On the contrary, although central banks will intervene to dampen volatility many of them will welcome currency weakness, since it helps domestic industry at an opportune time.

The recent sell-off in commodities has outpaced fundamentals, which continue to point to weaker but still relatively robust emerging market demand

The decline in commodity prices that began in April accelerated sharply in September as the flight out of risk assets intensified (see Chart 4 below). Fears that China is heading for a hard landing against a background of deteriorating prospects for demand growth from developed countries has prompted speculators to dramatically cut their exposure to commodities. Speculative long positions fell by a record US$34 billion in the two weeks ending 27 September. Not surprisingly, industrial metals such as copper, which are the commodities that have been heavily traded by financial investors, led the decline, falling almost 20 per cent over the last month. Meanwhile commodity markets have been whipsawed by extreme volatility, with copper experiencing intra-day swings of up to 7 per cent. Agricultural commodities, which until last month had been outperforming, also succumbed to broader concerns about slowing global growth and demand contraction.

As we argue in detail in the China section below, we believe investor concerns about Chinese growth hitting a wall are unwarranted. As a result, commodities risk being oversold. Our base case scenario of Chinese growth at 9-9.5 per cent this year, slowing only to 8-8.5 per cent in 2012, along with the US and EU avoiding outright recession, will prevent a collapse in prices. Even our worst-case, hard-landing scenario for Chinese growth of 6.5-7 per cent in 2012 is still above the 5 per cent benchmark that the base metals community uses as the minimum level of Chinese growth required to support prices.

Meanwhile bulk commodities − thermal coal and iron ore in particular − have very substantially outperformed other commodities in the last month (see Chart 5 below). Prices of thermal coal have remained steady in September, while iron ore prices have fallen less than 5 per cent, compared to a drop of almost 25 per cent for copper. Both thermal coal and iron ore are less financialized than copper, and their relative outperformance highlights the buoyancy of underlying demand so far. Weakness in European steel production has had a negative impact on global steel output despite continuing strong production in Asia, and slower Chinese growth can be expected to affect prices of iron ore and thermal coal at the margin. However, we do not anticipate a drop in prices similar to what we have seen in the base metals complex.

As we had suggested in our recent research note, market participants have begun wondering whether the fall in base metals prices will delay production capacity additions or even prompt production cuts. So far, miners are reporting that their capacity investment plans remain unchanged. However, a period of continued volatility and lower prices in combination with the sharp increase in costs (for labour, capital, equipment and infrastructure) that threaten to erode profit margins, could force miners to reassess their capex decisions. Such a development would be positive for prices in the medium term. Overall, our base case scenario of slightly slower growth in China and no global recession suggests we can expect to see continued weakness and volatility in commodity prices over the next three months, but EM growth will support higher prices over the next six-12 months.

Country strategy and portfolio allocation

• Brazil – The government turns to interventionist policies amid rising uncertainty about the Banco Central’s move to ease interest rates. We cut the outlook to moderate negative.

• Russia – Economic fundamentals are improving but Russia remains vulnerable to the fallout from the European crisis. We reduce the outlook to moderate positive.

• India – Pessimism about prospects for reforms and continuing high inflation cloud the picture. We reduce the outlook to moderate negative.

• China – Declining inflation and prospects of monetary easing should buoy equities. We retain a moderate positive rating.

• Taiwan – Taiwan is vulnerable to a global slowdown but exports of “smart” devices should cushion the impact. We retain a moderate positive rating.

• Indonesia – Economic fundamentals remain strong; the market reaction was overdone. We keep our moderate positive outlook.

• Turkey – Depreciation of the Turkish lira earlier this year has put the country in a good position to weather the European economic slowdown. We upgrade to neutral.

Brazil

Uncertainty about the outlook for economic policy has escalated markedly. The decision by the Banco Central (BC) to initiate an easing in monetary policy in August was followed by conflicting statements from government officials about the scope of fiscal tightening and the desired extent of prospective interest rate reductions over the next three-six months. This has altered market views of what the BC is trying to achieve with its unexpected easing. At first government statements emphasized the coming fiscal tightening but interest rate reductions subsequently became the leitmotif.

In the past the BC has been the anchor of financial stability by virtue of its willingness to implement tough interest rate policies. Now it appears that the BC is following the government down the road of interventionism. The government has introduced financial repression via taxes on both derivative contracts and capital inflows, along with protectionism in the form of tax hikes on manufactured goods imports. If, as we expect, monetary easing fails to bring inflation down then the BC will have to introduce interventionist policies of its own.

During a European visit President Dilma Rousseff stated that Brazil must “take advantage” of the global economic slowdown to align interest rates with its EM peers. Finance Minister Guido Mantega added further details of the government’s current thinking by specifying that inflation-adjusted rates should fall to 2-3 per cent (from roughly 5 per cent currently). This implies the government wants to see another 300 bps in rate cuts by next April, which would bring the Selic rate to about 9 per cent from 12 per cent today.

The BC appears to have tried to defend its de facto policy freedoms by countering market speculation that its rates policy was being dictated by the government. In an interview with Bloomberg News, an unnamed government official “familiar with monetary policy” said that such speculation should be dismissed. We cannot be sure that this official was speaking for the BC but it sounded like that to us. The message to markets is that monetary policy easing would be more moderate than suggested by the government. It certainly appears that the BC is worried about being dragged down the road of rapid policy easing.

The problem the BC faces is simply that markets are steadily losing confidence in the effectiveness of its new policy direction. A charitable view of the BC’s dilemma is that it has a communications problem – markets lack a clear idea of what the BC is doing and how it will achieve its inflation target, but they trust the BC will still do the “right thing” to achieve its 4.5 per cent target by the end of 2012.

We favour a different interpretation. We think there is an asymmetry in the BC’s influence on government policy and the economy. The BC has leverage over government policy when it threatens to hike interest rates to fight inflation. But when it began easing it lost this leverage and now the tables are turned – the move to easing has given the government leverage over the BC. If inflation remains above 6 per cent as we expect, then the BC will be forced down an interventionist path implementing new macroprudential measures while continuing to push down interest rates. This portends an erosion of BC credibility.

The government’s view of the outlook is that the global economic slowdown will dampen inflationary pressures in the economy over the coming months. Although economic growth has moderated to well below 4 per cent currently, inflation remains high at 7.3 per cent, buoyed by supply side bottlenecks. The unemployment rate in August was 6 per cent, the lowest August reading on record. Meanwhile average wages continue to grow rapidly, up 10.7 per cent in August (down from 11 per cent in July). The 15 per cent depreciation in the Real over the month of September will also add to inflationary pressures at the margin.

We expect inflation to remain in the 6-7 per cent range over the next three-six months. Nevertheless, we think the BC will move rates lower, down 50 bps at the upcoming 19 October COPOM meeting and a further 150 bps over the following six months, bringing the Selic rate to 10 per cent by next April. We foresee a temporary pause after that but new efforts to dampen inflation via macroprudential measures. We also expect current taxes on portfolio inflows will be lowered.

Despite the significant sell-off in Brazilian equities and the Real, we do not anticipate that Brazil will lead a future rebound in EM markets. Last month the Real was the worst currency performer among the seven countries that we monitor and the MSCI Brazil index also underperformed, trailing all but Russia. We think Mantega favours further currency weakness because it helps domestic industry compete with imports. Intervention, if any, will aim to lessen currency volatility, not push up Real valuations.

We lower our rating for Brazilian equities to moderate negative over the three-six month forecast horizon. Much of the negative news is already reflected in current valuations but we are concerned that persistently high inflation will undermine investors’ confidence in any eventual economic rebound.

Among sectors we keep a moderate positive rating on financials that will likely outperform in an environment of continued high inflation by virtue of the banks’ strong funding bases. We reduce consumer discretionary stocks to moderate negative and raise consumer staples to moderate positive. We no longer believe that falling interest rates will benefit consumer discretionary over consumer staples stocks – higher inflation will hit discretionary purchases but consumer staples such as food producers will be helped by the recent depreciation of the Real.

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

Russia

The contrast between Russia’s improving domestic economic outlook and the dire situation of its equity and currency market is striking. The only possible interpretation is that investors fear that a recession in Europe will expose the vulnerability of the country’s fiscal situation and precipitate a dramatic reversal in economic fortunes. Our impression is that the sharp sell-off was driven more by sentiment than by current or prospective trends in economic fundamentals.

While recognizing the potential risks to the outlook, we believe the market reaction overstates the likely path of the economy over the next six-12 months. Although Russia was hit hard by the 2008 crisis the economy is in much better shape today with much less exposure to external borrowing on the part of the corporate sector (average exposure is now 2.5 years) and a much improved fiscal position of the sovereign. Russia’s debt-to-GDP ratio is the lowest of any major developed or emerging country, less than 10 per cent for the sovereign and 72 per cent if public and private debt is included (vs 150 per cent for the other BRICs and 350 per cent for developed economies).

The fiscal deficit expected for this year will be around 0.5 per cent despite the recent softening in oil prices. This is lower than any other major economy. Chris Weafer of Troika Dialog estimates that at current valuations the Russian equity market is pricing in Urals crude at US$65/bbl rather than the current price of roughly US$100/bbl. In other words, current valuations are factoring in another 30-35 per cent decline in oil prices, an outcome we do not view as likely. There is little doubt that a collapse of oil prices to below US$70/bbl would necessitate a sharp and painful adjustment, but today’s valuations already reflect this potentiality.

Current economic data are reasonably robust. We expect moderate GDP growth this year and next of 3.5-4 per cent, buoyed by a recovery in domestic investment and steady growth in consumption. Inflation is falling and will move below 7 per cent late this year before stabilizing and turning up again modestly next year. The government will inject additional stimulus before the December Duma elections – a 6.5 per cent increase in public sector wages has already been announced and further increases in pensions are certain. Capital flows have remained negative so far this year with a total outflow of around US$60 billion likely for the full year. We believe next year will see a modest reversal in capital flows.

Looking further into the future, our primary concern is how the new government will manage the country’s fiscal accounts. This week Christopher Granville, TS’s Director of Russian/FSU Research, spelled out his assessment of how the next Putin administration will manage the country’s fiscal accounts (see The consequences of Putin’s big spend). He concludes that Putin will undertake to boost government spending on the assumption that the resulting fiscal deficits will be financeable. (Former Finance Minister Alexey Kudrin resigned because his goal of further fiscal consolidation was clearly not on the cards under the new Putin/Medvedev regime.)

Although Putin’s return to the presidency implies a continuing structural fiscal deficit there are several offsetting factors. One is the opening of new channels for foreign participation in the local debt market by making ruble instruments clearable through Euroclear. The assumption that the ease of access will facilitate increased foreign inflows is based on Russia’s low overall debt burden, the Central Bank’s commitment to keep real interest rates positive and the prospect of ruble appreciation on the six-12-month horizon. The second source of deficit financing will come from a stepped- up privatization programme. Christopher believes the high-level political commitment to making privatization work is strong, not the least because Putin will likely seek to burnish his reformist credentials after assuming office. A final positive event would be an agreement to join the World Trade Organization. Statements from government officials have turned quite positive recently, although Putin himself was less than enthusiastic about the prospect at a conference organized by VTB in Moscow on 6 October; moreover, we have been disappointed repeatedly in the past. We will simply say that if WTO membership is confirmed it would be a positive for equity markets.

On a six-month view, we believe prospects for a rebound in Russian equities are good but we also note that the timing of such a move is rather uncertain. The next few months will likely see continued turmoil in Europe and a slide into economic stagnation or recession. This will keep downward pressure on Russian equities for the near term. On the assumption of a managed Greek default and an initiative to recapitalize European banks we expect Russian equities to be a major beneficiary in view of their high-beta characteristics. This could come ahead of the presidential elections next March, but it could also fall after the six-month horizon if events in Europe drag out.

Because of these uncertainties we reduce our overall rating on Russian equities to moderate positive. We believe financials will outperform during this period as they have borne the brunt of selling recently from dedicated EMEA and GEM funds; we retain our strong conviction positive rating and suggest that investors focus on the big state-controlled banks.

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

India

In a down month for global equity markets Indian equities performed better than most other EM markets. The reason for this outcome is not better fundamentals but the fact that India is perceived to be less vulnerable to global economic trends than other EM economies. We do not see this as a compelling reason for investors to move off the sidelines and increase allocations to Indian equities. Discussions with potential investors convince us that they are looking for reasons to invest and still have not found them.

In politics there is a palpable sense of gridlock. Last month’s incompetent handling of the anti-corruption protests sent a message that the government’s policy agenda can be upset by grandstanding activists. The fact that such stunts generate widespread popular following weakens the government’s credibility. This is fuelling speculation of growing tensions between Prime Minister Manmohan Singh and the top leadership of the Congress Party. The impression from the outside is that Mr Singh lacks the political authority to promote his reform agenda while the political heavyweights who run the Party cannot make up their minds whether to reform at all or play it safe in a bid for votes before upcoming elections.

The best prospects for policy action lie in decisions to reduce certain subsidies and relax FDI restrictions in multi-brand retail. Finance Minister Pranab Mukherjee said this week that it will be difficult for him to meet the budget deficit target and that the government will have to resort to increased domestic borrowing to fill the gap, thus pushing up interest rates. The deteriorating budget position adds to the pressure to bring tighter control on expenditures, so there are reasonable prospects that reductions in subsidies for urea will finally be enacted. The approaching Uttar Pradesh elections next February-March, though, could put new obstacles in the path of these measures.

The economic outlook is likewise less than exciting. Inflation continues to be high at just under 10 per cent despite continuing rate hikes by the Reserve Bank (RBI). We expect the RBI to pause at its upcoming 25 October meeting not because of falling inflation but because of concerns of slowing global growth. Inflation is increasingly driven by sustained increases in non-cyclical food prices, e.g., eggs, milk, meat, fish and vegetables. Although growth is slowing we believe there is little prospect that inflation will head down below the 8-10 range that it has been in for the past six months.

For the current fiscal year GDP growth will likely come in around 7 per cent, below government expectations. While 7 per cent growth is impressive viewed against near stagnation in the developed world, India’s high inflation and lack of progress in clearing supply-side bottlenecks suggest that these rates will not be sustainable in the future. Although there is a consensus on the reforms needed to break down supply-side bottlenecks there is little expectation that the current government will act to implement them.

We reduce our rating on India to moderate negative for the forecast period. We think the current political gridlock will dampen investors’ enthusiasm for Indian equities despite the recent depreciation of the rupee. We expect India to rebound once the European crisis appears to be resolved but we think it will lag other EM markets.

Regarding sector allocations, we reduce financials from neutral to moderate negative. We expect major banks to face rising NPLs over the coming three-six months and upward pressure on funding costs. Although consumer staples tracked the index last month we expect these stocks to resume their recent months’ trend of outperformance in the forecast horizon.

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

China

As we argued (see What coming collapse of China?) earlier this week market alarm over China's outlook is overstated. Although weaker external demand, falling property construction and infrastructure spending will reduce GDP growth in 2012 from this year's 9-9.5 per cent, we believe that the fall will only be to 8-8.5 per cent. We see no case for a hard landing as China moves into the politically important period of leadership change next autumn.

Along with a slowdown in the top-line growth number the composition of growth will change markedly. The growth in infrastructure spending will fall to zero, because of the overhang of local government debt and expected slower railway construction. Real estate investment will also slow, though by less than infrastructure owing to continued spending on social housing. Sustained growth in private manufacturing investment will largely offset these declines. This will be generated by the widespread shift of operations inland, by industrial upgrading (particularly in the seven strategic emerging sectors highlighted in the new Five-Year Plan) and by urbanization, in particular the construction of infrastructure such as metro railways, urban infrastructure and public services.

Inflation remains a significant long-term risk and this explains the increasing number of scare stories appearing in the press about China’s “wobbling” property sector and credit crunch for small private sector firms. While the government is concerned about a potential downturn in export demand we believe it is reasonably satisfied with domestic economic developments, including the difficulties being experienced by some property developers and SMEs. This in our view is all part of the country’s Darwinian approach to economic policy.

We do not believe the government wants the property sector to experience a sharp downturn as happened in 2008-09 but it is not particularly concerned if smaller property firms go bust or are forced into mergers with larger players. As regards the access of SMEs to credit, we would point to decisions in July by the monetary authorities to effectively shut down shadow banking activities that many of the small entrepreneurs depend upon. Prior to these decisions, many analysts pointed to the apparent out-of-control growth in shadow banking as a major risk; this risk has now been transformed into a different risk – that the resulting credit squeeze will force many SMEs into bankruptcy. In the absence of on-the-ground intelligence we are not able to judge how serious this credit squeeze will turn out to be. Reports from the region highlight that Wenzhou investors are frantically pulling out of their speculative investments in Hong Kong real estate in order to raise cash.

We are not proponents of Darwinian economics but we would suggest that some of the seemingly scary developments in China happen because policymakers want them to happen: i.e., they are not potential crises that demand action by the authorities but crises triggered by the action of policymakers. Investors should not be surprised that China’s monetary authorities are eager to stamp out rampant market speculation and even to force widespread bankruptcies among smaller private sector players. Even though SMEs provide a significant portion of the country’s employment they lack an effective voice in senior leadership fora.

CPI inflation peaked in July when it hit a three-year high of 6.5 per cent. We expect it to fall below 5 per cent in the next three-four months thanks to lower food prices, stable non-food prices, softer commodity prices and the base effect. We strongly believe that further tightening is unlikely in view of significant external uncertainties, a slowing domestic economy and easing inflation. We also believe that monetary policy will become more flexible. External developments will hold the key to policy direction in the next few quarters. Targeted or selective easing, in the form of support for vulnerable sectors such as SMEs and social housing via local government financing, will get under way once headline inflation drops below 5 per cent, probably in October-November.

If the global economy weakens more significantly than we anticipate, Chinese policymakers can be expected to respond quickly as they remain concerned about growth and job creation, and their effect on political and social stability during the leadership transition. In such a scenario, we expect the first response to be the reduction of reserve requirements for banks and targeted credit easing. The focus of a new stimulus plan this time would move away from the infrastructure projects that took the prime role in 2008-10 and towards social housing, water supply and irrigation, consumption and high-tech sectors. The government's fiscal and monetary flexibility is more constrained than it was three years ago, owing to greater leveraging on central and local government balance sheets and a weaker banking system. Therefore we do not think that China could repeat the vast 2008 fiscal and monetary stimulus package on the same scale. However, if the situation does become sufficiently serious to worry the Communist Party leaders as the new generation moves in from next autumn, China will do whatever it needs to do – even if it is again left with unpalatable medium-term consequences.

We keep our moderate positive rating on Chinese equities this month. We think declining inflation and the first moves towards policy easing will prove positive for equities in the coming two-three months. Among sector allocations we retain moderate positive ratings for energy and consumer staples.

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

Taiwan

The slowdown of global economic growth already hit Taiwan’s exports in August and led to a sell-off in the country’s stock market that was followed by a second wave of selling in September. Compared with other EMs in our universe, however, the erosion of both equity and currency performance in Taiwan last month was less marked, partly because foreign investors had already been exiting the local market in August.

Given its dependence on exports, Taiwan is particularly vulnerable to a downturn in global growth. Both export orders and industrial production were sluggish in August. The growth of export orders, which is the leading indicator of export shipment in the next one-three months, fell to 5.3 per cent year on year in August, down from 11.1 per cent in July. Industrial production also slowed, recording 3.6 per cent year-on-year growth in August compared with 3.9 per cent the previous month. However, a breakdown of the export figures shows an interesting trend: exports of information and telecommunication products (e.g., smart phones and laptops) were still growing at 39 per cent year on year in August while the growth of electronics exports (e.g., manufactures of semiconductors, LEDs and LCDs) was only 3.6 per cent. The launching of new products associated with the boom of smart devices should continue to be strong despite the global slowdown.

The central bank (CBC) responded to the developing global economic crisis by deferring a hike in its policy rate while allowing a modest depreciation of the New Taiwan dollar (NT$). The CBC left the policy rate unchanged at 1.875 per cent after the board meeting on 30 September. The previous cycle of gradual interest rate hikes lasted for four years from Q3/04 to Q3/08 (the policy rate increased from 1.375 to 3.625 per cent). The current cycle had only lasted five quarters (the policy rate increased from 1.25 to 1.875) before the current pause. According to a statement issued by the CBC, this decision reflects caution regarding increased global economic uncertainties. Other factors supporting the suspension of rate hikes include: the fall in commodity prices; the low level of domestic inflation compared to other Asian EMs; and stagnation in the domestic housing market. Although rate hikes have been suspended we expect the CBC to use other policy instruments to ensure that M2 growth remains within its 2.5-6.5 per cent 2011 target range. In August M2 growth was 6.2 per cent.

The depreciation of the NT$ last month was 5 per cent, substantially less than the 12 per cent slide in the Korean won. Despite losing export competitiveness vs Korea, the CBC is primarily concerned to dampen volatility in the NT$ and to keep domestic inflation low. For these reasons we believe the NT$ will continue relatively stable – the CBC publicly stated that it will intervene in the FX market if there are “seasonal or irregular factors such as massive inflows and outflows of short-term capital leading to excess volatility and disorderly movements in the exchange rate”.

During the second wave of selling last month foreign investors accounted for net outflows of NT$78.7 billion (US$2.6 billion) down from NT$190.3 billion (US$6.2 billion) in outflows in the previous month. Among sectors, financials bore the brunt of the selling, largely reflecting a sharp deterioration in sentiment towards financial stocks globally. The telecom sector showed its defensive strength by outperforming other sectors while the IT sector was helped by positive news on currency depreciation and the launching of new smart devices.

We retain a modest positive outlook on Taiwan as we believe the country’s export mix will help its major exporting firms weather the coming downturn in global consumer demand. We downgrade financials to neutral because of the very negative sentiment likely to prevail as European banks move into an uncertain recapitalization exercise. We also believe the positive news associated with cross-Strait business opportunities has already been priced in and additional provisioning on loans to DRAM producers will likely rise in the near term.

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

Indonesia

Indonesian stocks and government bonds sold off substantially in September as foreign investors departed in significant numbers. The JCI index was down 14.6 per cent in dollar terms and the rupiah depreciated by 4.2 per cent. Foreign investors sold 13 per cent of their government bond holdings (but still account for 31 per cent of bonds outstanding). Foreign investment in Indonesian assets was a popular but crowded trade. The sharp decline in asset values was thus driven by market technicals; concerns about economic fundamentals played a minor role.

The economy shows no signs of slowing. The retail sales index jumped 33.5 per cent in August over the previous year, driven by Ramadan-related purchases, but this result is also indicative of the continued strength of domestic consumption. Retailers expect growth to remain high as lower inflation boosts purchasing power. Moreover, exports were still strong in August, growing 37 per cent at an annual rate. A sharp rise in palm oil exports was a significant contributor. Combined with robust investment, GDP growth is expected to reach 6.5 per cent this year.

A slowdown of developed markets affects Indonesia primarily through exports. Lower commodity prices would affect a major share of exports, although the price of coal and palm oil have stayed relatively strong and are expected to remain supported by demand from India and China. Also, the EU accounts for 30 per cent of Indonesia’s non-oil trade surplus, so major problems in that part of the world could hit particularly hard, but exports to Asia have gained significantly in importance over the past five years.

Even in a worst-case scenario where exports drop to a marked extent, Indonesia’s strong domestic drivers will ensure growth remains robust. Moreover, low inflation and a low fiscal deficit leave ample room for monetary and fiscal stimulus. Indonesia is therefore relatively well positioned to ride out a global recession. If there is no recession, the current scenario of strong growth with subdued inflation and low deficits will continue. Given these strong fundamentals, we expect markets to recover once global market volatility moderates.

September inflation was lower than expected at 4.6 per cent. This was caused by lower food prices as well as low administered price inflation due to base effects. Core inflation was relatively high at 4.9 per cent, close to the 5 per cent level the Bank of Indonesia (BI) has signalled in the past could trigger a rate hike. However, BI has changed its tone and is currently more focused on protecting growth than reducing inflation. A rate cut is therefore more likely, especially if the global economic outlook worsens further. But we expect the policy interest rate to be kept on hold at the next Board of Governors meeting on 11 October.

The energy sector was hit hardest in September as investors expected coal prices to drop as a result of lower global growth. However, the coal price has held up through the turmoil and we expect it to remain supported by strong demand from China and India. We therefore expect a correction in the market, and upgrade energy. We maintain our moderate positive outlook on the consumer and financial sectors.

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

Turkey

Our previous call that the Turkish economy would experience a soft landing rather than the hard landing expected by most analysts is being borne out by recent data. Industrial production and the capacity utilization ratio both rose moderately in July, reflecting underlying strength in demand. Thanks to substantial and early depreciation of the Turkish lira, exports rose well above expectations, up 40 per cent in September vs the previous year. From early April to early August the lira depreciated by 17 per cent against both the dollar and the euro at a time when most EM currencies were still strengthening.

Looking forward, a sharp slowdown in European growth will undoubtedly slow the growth in external demand with only a partial offset due to a weaker lira. Other data point to further slowing in final domestic demand as a lagged effect of earlier monetary tightening via substantial hikes in banks’ reserve requirements. Consumer loan growth declined to an annualized 10 per cent rate in September from 20 per cent in August. The demand for consumer durables, particularly cars, will continue to weaken because of the depreciation in the lira. We keep our sector rating outlook for industrials at minus 2 for the next three to six months.

The lira was less affected than other EM currencies by recent market turmoil since it had already depreciated by 25 per cent prior to the current crisis, i.e., between December 2010 and this August. The early downward adjustment of the lira also explains why Turkey outperformed other emerging markets during the recent turmoil – it had already underperformed these markets earlier this year. Besides this there was welcome news in the form of an S&P upgrade of Turkey’s local-currency credit rating to investment grade. There was also positive news on the political front after the pro-Kurdish BDP party ended its four-month boycott of the parliament when its elected MPs took their oath. This is positive for prospects for the constitutional reform process that is expected to get under way in the coming months.

Taking into account the six-nine month lag before currency depreciation feeds through to trade flows, we expect to see the country’s sky-high current account deficit fall steadily over the coming year. The current account balance in H1/11 recorded a record deficit of 11 per cent of GDP. As the effects of lira depreciation affect trade flows the deficit will gradually decline. Prospects for the expansion of exports to the Middle East and North Africa have improved markedly: the market share of these regions in Turkish exports is now 25 per cent vs 20 per cent in 2010; the share of the Eurozone in Turkish exports in the same period has declined to 38 per cent from 50 per cent. Import growth will slow in light of lower growth in domestic demand and the rise in import prices of consumer goods. We expect a current account deficit to GDP ratio of slightly more than 5 per cent for H2/11.

Concerning monetary policy, we expect the Central Bank of Turkey (CBT) to continue a proactive policy, reversing earlier tightening measures in response to the slowdown of European growth. In the next six months we expect the CBT to gradually cut banks’ reserve requirements. On Wednesday the CBT slashed banks’ reserve ratios for foreign currency-denominated deposits by 50 bps for maturities longer than 12 months and 250 bps for deposits longer than three years. This move added US$1.3 billion in dollar liquidity to the market and buoyed the lira. Similar measures for lira deposits followed on Thursday. These moves will have a positive impact on banks' profits. With these prospects we upgrade the outlook for the financial sector to neutral.

We do not think the CBT will cut its policy rate any time soon because inflation will remain above 6.5 per cent next year. Instead we anticipate other policy tools – primarily reductions in reserve requirements – to be used to stimulate the domestic economy. We expect GDP growth to ease to 3.5-4 per cent next year, substantially better than the market consensus that foresees growth of only 2 per cent.

Based on our positive projections on both political and financial developments we raise the overall rating of Turkish equities one notch to neutral.

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

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