EM Strategy Monthly

Portfolio strategy

Overview

Emerging equity markets were down slightly at the end of July and further losses were registered during the first week of August. Still their performance beat developed markets by a wide margin: about two per cent vs the US and seven per cent vs Europe. But the overall winner was commodities which managed a small gain driven mainly by precious metals. All of our charts use three-day moving averages so the impact of Thursday’s sharp declines in prices is less drastic that the one-day changes.

Among the emerging markets that we follow, one of our top picks – Indonesia – led the overall performance ranking by a large margin. Unlike other emerging equity markets Indonesia appears almost completely decoupled from any sort of global contagion. Russia and China, two of our other overweight recommendations, followed but both were adversely affected by the global equity market correction at the beginning of August as were Taiwan and India. Our underweight recommendations, Turkey and Brazil, fell to the bottom of the performance ranking.

Turning to the outlook, we have pared back our ratings on both Indonesia and China to moderate positive. In the case of Indonesia we think the very strong recent performance will lead to a period of more subdued inflows and some profit taking on the part of foreign investors because of concerns about the market’s valuation. We think the good news on inflation is now behind us and we are concerned that the market is vulnerable to a mild correction over the forecast period. In the case of China, we still think that a peak in the inflation cycle this month will drive outperformance in the coming three-six months but we are less sure about the timing in view of strong headwinds from a slowdown in global economic growth.

Our two underweight recommendations, Turkey and Brazil, remain unchanged. Both markets lagged substantially during July. We keep searching for reasons why these markets should touch bottom during the forecast period but so far we have failed to find any. We do think Turkey could move into a turnaround towards the end of the year if the Central Bank’s forecasts of a soft landing prove accurate. In Brazil the lack of a coherent economic policy to tackle inflation leaves us without a strong reason to change our negative outlook.

Note: The country ratings give preferences relative to our universe of emerging equity markets (i.e., not versus developed market performance). The sector ratings indicate our view of a given sector relative to each country’s overall index.

The performance of EM fixed income last month was outstanding, easily outdistancing every other asset class. Yields on 10-year sovereign dollar bonds fell 40-60 bps across the board, even for some of the EM black sheep such as Argentina and Venezuela. Our call to focus on Russian local markets also worked out well as yields on 10-year sovereign OFZs fell nearly 40 bps in response to signs of lower inflation. Yields on local debt in Indonesia and Turkey also fell by a similar amount.

Looking ahead, we believe investors should focus on local market bonds, especially in Russia. The declines in yields on EM sovereign dollar debt have been unprecedented and largely reflect the flight of capital out of eurozone bonds. We think this flight of capital will increasingly seek to diversify into equities, commodities and local markets for the simple reason that yields on dollar bonds have reached very low levels.

Note: Yields and rates as of 10 am BST 5 Auguest

Global themes for portfolio allocation

The flight of capital from debt-burdened developed economies has begun in earnest and will be accelerated by the recent global market selloff; well-managed emerging economies, hard commodities and gold will be the primary beneficiaries of new portfolio allocations.

Last month we wrote at length about the debt burdens of developed economies and why we thought that these problems would restrain their ability to grow in the future. Developments since then in both the eurozone and the US provide ample evidence that the dynamics of their debt problems are now acting to accelerate the outflow of investable capital from their markets.

While it is difficult to forecast with any accuracy how the recent declines in developed markets prices will play out we do sense a fundamental reassessment on the part of markets about the outlook. There is much less confidence that governments and central banks have the right policy answers to the crises or the courage to tackle needed structural changes. It is certainly true that company balance sheets in the developed world are mostly in good shape and underlying profit performance is still good. What has changed is the context – with top policymakers floundering to deal with obvious overindebtedness investors must question whether satisfactory growth can be sustained.

Our analysis last month was very much at the “big-picture” level. We expressed a conviction that the performance of EM equities would be a major beneficiary of a global reallocation of capital out of developed markets into well-managed emerging ones. This month we drill a bit deeper to focus on how this process is likely to play out, because it is clear that the impact of these outflows will differ among EM asset classes as regards both its force and its timing.

The striking development over the past month was the unprecedented rally in EM sovereign international bonds. Yields on EM debt have fallen anywhere from 40-50 bps to as much as 70-75 bps as investors’ search for “safe havens” for their nest eggs intensified. From our perspective the evidence that emerging markets have become the new “safe havens” is incontrovertible.

Investors are realizing that assets formerly thought safe might actually be rather risky. Foremost in investors’ minds is the need to avoid risk and move into safe havens: that is, gold and EM debt of countries with a strong ability to pay (whatever the rating agencies say). So the prices of EM debt from countries such as Brazil, Russia and Mexico skyrocketed. These are the first-round effects.

Today EM debt is the “safe haven” trade but a similar conclusion will likely be reached before long regarding EM equities. It is impossible to say how long this will take, perhaps three-six months, maybe even longer. Emerging economies will have to show that they can sustain growth even as the developed world goes into a slump and inflation will have to be controlled. Some countries are obviously further along in meeting these challenges and we hasten to recommend that investors differentiate among emerging economies (as we do in what follows below).

For now “risk off” means that EM equities are mostly not to be found on most investors’ asset reallocation menu (though the contrarian in us says it may be time to move more aggressively into EM equities). The economic slowdown developing in the US and Europe will adversely affect emerging markets at the margin. We think this risk is overrated. We do recognize that until it is clear that most emerging economies will be able to sustain relatively rapid growth despite an economic slowdown in the developed world “risk off” may continue to be the operative watchword for many investors.

Our conclusion is simply that the reallocation of capital from developed markets to EM equities will take time to develop, but emerge it will, because developed markets will be flooded with ever more desperate attempts by their monetary authorities to prevent the feared “double-dip” (now that fiscal stimulus is ruled out). All that liquidity has to go somewhere. Yes, all this monetary recklessness will eventually fuel the fires of inflation along with EM currency overvaluation. In the meantime investors should expect EM equities to gradually build up a head of steam as the disorder in the so-called developed world continues unabated.

Commodity prices will benefit from asset reallocations as investors look for alternatives to stagnant developed country markets.

Commodity prices rallied strongly in July before selling off in the last week as US debt limit negotiations went down to the wire, triggering a flight out of risk assets (see Chart 3 below). Even with that downturn factored in, the SPGS commodity index outperformed US and EU equities in the month of July. We expect that trend to continue. As the growth outlook in the US and Europe continues to deteriorate, investors will once again turn to commodities as they seek better returns than are available in euro and dollar securities.

Even though Thursday’s sell-off in global markets has erased the benchmark SPGS commodity index's price gain for the year, pushing it into negative territory (-1.1 per cent year-to-date), commodity market fundamentals remain broadly positive. Energy prices rallied strongly in the first three weeks of July, leading the overall rise in commodity prices during that period. This occurred despite the June decision of the International Energy Agency to release crude from member country strategic reserves, a move that it has since announced that it will not repeat for the time being. Continued, albeit slower, economic growth in emerging markets will counterbalance stagnating economic activity in the US, supporting energy prices at current levels in the near term.

In line with our expectations, agricultural commodity prices have found new support in recent weeks. Corn prices have led the sector higher over concerns about unseasonably hot weather affecting the US crop. High temperatures in corn-growing regions in central and northeastern China have also prompted speculation that this country may re-enter the international markets for imports. These factors, combined with strong emerging market demand and relatively tight markets, will help support prices for agricultural commodities in the near term.

As discussed in last month’s TS View, we continue to expect prices of key commodities to rebound in H2/11 as China stops drawing down raw material inventories and begins restocking via imports. Copper restocking may already have begun, with China’s copper imports ending a two-month slowdown with a rise of almost 10 per cent in June. 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. Iron ore will be the exception to this trend since China’s inventories remain relatively high and steel production growth in the country is likely to slow in H2/11. Overall, 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.

EM sovereign fixed income securities will continue to provide attractive returns as investors seek safe havens for their capital. The best opportunities in the coming months will be found in Russian local market bonds.

Last month saw impressive performance by EM sovereign dollar bonds driven by the reallocation of capital out of sovereign debt of a growing number of eurozone countries, including France, Italy and Belgium, investors having already fled the peripheral countries. The Thursday selloff in global markets had relatively little impact on EM sovereign debt yields, though because US Treasury yields fell, debt spreads did widen.

Investors’ search for “safe havens” drove EM 10-year bond yields down across the board, both for bellwether issuers such as Brazil (-40 bps), Russia (-40 bps) and Mexico (-60 bps) and for smaller countries – Colombia (-55 bps), Peru (-70 bps) and Indonesia (-50 bps). All of these issues should continue to attract funds by virtue of their implied “safe haven” status.

Investors’ capital will continue to be reallocated out of eurozone government bonds but prospects for further gains in EM sovereigns are limited by the relatively low yields on these issues. Several examples will illustrate this point: yields on French 10-year sovereign debt (in euros) are now about 3.2 per cent or 85 bps over German bunds (both rated AAA); yields on Brazilian dollar debt (rated BBB-, nine steps below France) are 3.6 per cent or 100 bps through Italian sovereign BTPs (rated A+, five steps above Brazil) and a whopping 1,130 bps through Cyprus (recently downgraded to two steps above Brazil). Investors should not be surprised that formal ratings of sovereigns have little relation to today’s market realities.

Because of these uncertainties, we believe the best opportunities over the next two to three months will be found in EM local market sovereign debt. Our recommendation last month to explore opportunities in Russian ruble bonds was timely: yields on the government’s 10-year domestic bond (OFZ) fell 35 bps. We think prospects for further declines in yields are very good because inflation is now falling rapidly: July inflation came in at 9 per cent, down from 9.4 in June and further rapid declines are certain due to the base effect (last year prices rose sharply from August because of drought). The combination of falling inflation and a modest appreciation in the ruble (because interest rates will lag the decline in inflation) should produce annualized percentage returns for investors in the mid-teens to low twenties.

EM themes – Investment ideas

Brazil

At a time when markets were waiting on the government for positive initiatives to resolve the country’s inflation dilemma President Dilma Rousseff decided last month to launch an anti-corruption crusade. Dilma targeted the Ministry of Transport, which has long been the fief of a small party in her coalition, the Party of the Republic. Officials in the Ministry were said to enjoy multimillion-dollar mansions thanks to widespread kickbacks on government contracts.

This initiative brought praise and consternation in equal measure. Dilma is sending a clear message that she will not tolerate corruption, unlike her predecessor Lula who was entangled in multiple scandals during his presidency. At the same time many worry that if she pushes her crusade too far she may threaten the governability of her unwieldy coalition. This would translate into legislative gridlock in the Congress where the passage of most legislation must be “greased” with liberal amounts of cash and favours. Already prospects that progress could be made on many pending initiatives, including bills to begin privatizing airports and continue road concessions, are fading fast. The next move is clearly Dilma’s but markets are uncertain how she will now deal with the repercussions of her anti-corruption crusade.

The other key development during the past month was the decision by the Banco Central (BC) to omit a reference in the minutes of its 20 July monetary policy committee meeting to its commitment to continue raising interest rates for an undetermined period. The BC did raise its Selic policy rate by 25 bps to 12.5 per cent at the meeting, but analysts now believe it will move to the sidelines of the inflation fight and some believe its next move will be to cut rates. This led to an initial selloff in bond markets and then a recovery. We see the BC as willing to accept more inflation so as not to harm the country’s growth prospects; this argues for a pause in tightening, not a move to cut rates.

While the BC moved to the sidelines the Finance Minister Guido Mantega stepped in to attempt another fix for the overvaluation of the Real exchange rate. The latest measures impose mandatory non-interest-bearing reserves on short dollar positions in FX derivatives that exceed a given limit. After an initial 1-2 per cent decline in the Real, rates returned to previous levels before weakening again in the recent global market selloff.

This measure was followed earlier this week by a new initiative to protect Brazil’s manufacturing from competition with foreign imports. The wide-ranging industrial policy entitled “Bigger Brazil” comprises a major expansion of trade investigators, tightened border inspections to prevent third party relabelling of imports via Mercosur trade partners (mainly Paraguay) and targeted tax exemptions for a list of consumer goods sectors such as textiles, footwear, furniture and software. These efforts were received with predictable scepticism by market analysts who pointed out that cheap imports actually help Brazil keep inflation down.

All these recent developments reinforce our judgment that Dilma’s government lacks a coherent economic strategy. Brazil’s piecemeal economic policy initiatives fail to add up to an effective plan to address continuing inflationary pressures. While we doubt that a policy of ever higher interest rates is the right way to address problems of structural inflation we do think that much more can and should be done in the fiscal arena. We are not optimistic, however, that the government will go down this path at all soon.

We retain our moderate negative outlook for Brazilian equities. Last month the performance of the Brazilian market came in at the bottom of our country sample, even below Turkey. Performance will likely bounce from current lows but we are not optimistic that a sustainable turnaround is in the works.

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

Russia

Our positive call on Russian equities that dates from the beginning of the year is based on two key elements, one economic and the other political. The economic call is that disinflation will reign during the second half of 2011; the political call is that political stability will characterize the pre- and post-election periods (Duma elections are scheduled for December and the presidential vote will take place next March).

The disinflation story remains firmly on track as we head into the second half of 2011. CPI inflation that peaked at 9.6 per cent early this year is likely to fall rapidly due to the base effect caused by last year’s drought which pushed up grain prices beginning last August. At the beginning of Q4/11 CPI inflation can be expected to fall well below 8 per cent and by the end of 2011 the year-on-year rate should be around 7 per cent, giving an average rate for the year of 7.5 per cent. This scenario assumes the inevitable pre-election boost to spending and rough stability in global oil prices (this will keep the fiscal deficit at around 1.5 per cent of GDP).

Our political call puts us more at variance with the consensus than does our economic scenario. Political pundits in Moscow are currently abuzz with speculation that we will see surprises in the run-up to the December Duma elections; the betting is very much that Putin will push out Medvedev and reclaim the presidency. This view is often accompanied with predictions that such a move would usher in a new Brezhnev-like era of political and economic stagnation. The implications of this scenario are obviously rather negative for prospects for Russian equities.

Our call is for a continuation of the current duumvirate, with Vladimir Putin remaining as Prime Minister and Dmitri Medvedev as President. Last month we predicted that Putin would dispel the uncertainties surrounding his plans at the pre-election congress of the party that he leads – United Russia – at the beginning of September. We are less certain today of the timing of such an announcement – Putin is a man who likes to keep his cards close to his chest and he may not feel there is sufficient need to dispel today’s political uncertainty until nearer the elections. We still believe that Russia’s elite will opt for stability sooner or later; stability in turn argues in favour of a continuation of the current political arrangements.

We retain our moderate positive rating on Russia with a strong overweight in financials. Although the Russian market has outperformed so far this year we do not think valuations are stretched especially following the recent selloff. Our top recommendation remains financial stocks. Last month financials lagged the overall index largely because of weakness in VTB as it cleaned up after the fraud at the Bank of Moscow which it had rushed to take over earlier in the year. With this embarrassment behind it, we continue with a strong overweight recommendation in financial stocks. Second quarter data show total bank loans rising at a 24 per cent annual rate accompanied by a strong deposit inflow. Prospects for earnings gains later this year therefore appear solid.

We continue to rate energy stocks at neutral. Given their heavy weighting in the index, we are counting on strong performance from financials and materials stocks, especially the steel sector, to generate modest outperformance. Disinflation should eventually prove positive for the utility sector. Because regulation plays a major role in the performance of such stocks we think a positive move in this sector will probably be delayed until early next year, i.e., after inflation has come down to much lower levels.

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

India

Earlier this year we highlighted the likelihood that Indian growth and inflation would disappoint this year. In January we said that GDP growth this fiscal year (FY11/12) would fall to around 7 per cent at a time when the government and most market analysts were forecasting 8-9 per cent. Our view is now the emerging consensus as analysts mark down their estimates.

On inflation we emphasized that structural factors would keep prices relatively high and that investors should expect an extended period of interest rate tightening by the Reserve Bank (RBI). We see no reason to alter this outlook despite the surprise hike of 50 bps in the RBI’s policy rate last month. Our India research director Shumita Sharma Deveshwar returned to the issue of structural inflation last week (see here), arguing that rising rural wages are an important factor behind persistently high food inflation. This is why we disagree with those who argue that we are at a turning point in the RBI’s tightening cycle. We think it is too early to expect a pause in the RBI’s anti-inflation efforts – at a minimum we think there are still one or two more rate hikes in the pipeline. Even after these moves we think the solution to persistent inflation will involve structural reforms: rate hikes alone cannot solve India’s inflation problem.

The opening of the so-called “monsoon session” of the Indian parliament on 1 August soon degenerated into the usual free-for-all shouting match on the part of the opposition. We expect these antics to die down in early September and only then will we be in a position to judge whether the government will make any progress in passing some of the pending bills and in implementing a series of executive decisions, especially the opening to foreign investment in multi-brand retail and the partial and full privatization of various state-owned firms.

We still expect progress on the reform front, albeit too slow and too limited to bring about major advances in economic performance. Expectations about the reforms have turned more pessimistic in recent months, reflecting the lingering influence of corruption scandals and the markets’ uncertainty as to whether Prime Minister Manmohan Singh has the necessary support and energy to push the reforms ahead. The Prime Minister’s Economic Advisory Council recently joined the chorus urging the government to be more active in pushing through reforms. National elections are still three years in the future but politicians are already gearing up for the crucial vote in the first half of next year in Uttar Pradesh. So political expediency may continue to overrule economic logic as the window for reform closes.

The performance of Indian equities last month largely met our expectations: consumer staples outperformed (our only outperform call) while financial stocks (rated moderate negative) fell about 4 per cent roughly in line with the overall index. For August we keep India at neutral and reduce materials to moderate negative. Materials stocks fell sharply at the end of July as a result of corruption allegations in various mining ventures in Karnataka; we do not expect a quick turnaround in these stocks.

We keep consumer staples at moderately positive even though we are increasingly concerned about potential overvaluation. Consumer staples stocks have risen nearly 30 per cent over the past 12 months compared with a flat trend in the MSCI India composite index. On valuation grounds these stocks are rich but underlying earnings performance continues impressive. We have postponed a downgrade for another month.

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

China

China’s economy continues to perform marginally better than consensus. The August manufacturing PMI came in at 50.7, down slightly from June but above market expectations. Details of the index show that inventories of finished goods fell sharply, suggesting that underlying domestic demand remains relatively resilient. A further implication is that manufacturing will likely recover once the inventory cycle turns up again at the end of the summer.

All is not well across every sector, however. There is continuing evidence that the credit squeeze is hurting SMEs especially. Nonetheless the widespread view that the US and European debt crises will prove a drag on global manufacturing does not find confirmation in Asia: the measure of new export orders in China’s PMI recorded the biggest gain among all sub-indexes, rising by 2.9 points to 56.5 in July. Meanwhile Korea’s July exports set a new monthly record, rising nearly 30 per cent on a year-on-year basis. Global manufacturing may be slowing but Asia looks relatively well positioned to outperform other regions.

We expect the next batch of monthly economic data on 9-10 August to confirm that inflation peaked in this cycle at 6.4 per cent; prospects of a gradual decline in inflation in the coming months are good now that pork prices appear on a downward trend. The lifting of price controls on edible oils suggests the government believes this as well. We will have to wait a bit longer for evidence that property prices are on course for a soft landing. We do not think the sector is heading for a crash in prices and sales volumes but it will likely be early September before the hard landing scenario can definitely be ruled out. Even so, property price declines ranging up to 10 per cent should be expected in some regions.

Our bullish call on Chinese equities has been based on an imminent downturn in the inflation cycle. Once inflation is on a downward course we expect to see investor sentiment improve in anticipation of the beginning of an easing cycle. Our reading of the data suggests that this is still the most likely scenario.

Other developments have caused us to downgrade our rating of Chinese equities to moderate positive, however. The high-speed rail crash on 23 July will undoubtedly slow the breakneck pace of fixed asset investment in the coming six to 12 months. This will probably be felt more next year than in the next two or three months and lead to a slowing of growth next year to 8-8.5 per cent. But the knock-on effect of the tragedy on investor sentiment is now being felt, with the result that markets will likely remain subdued over the coming two or three months.

Pessimism about slowing growth in developed economies is also weighing on market performance. Fears of a major negative effect on Chinese growth from lacklustre growth in developed economies are overblown in our view. The growth in export volumes is moderating but China is still on course to achieve a US$150 billion trade surplus, not far below last year’s US$183 billion figure. With about 50 per cent of China’s total trade turnover concentrated in processing, a downturn in external demand affects both import and export volumes; Chinese value added in such activities is rather small.

Among sectors we downgrade industrials to neutral. The railway tragedy has obviously hurt all associated sectors, but we would note that the downturn in industrials last month predated it by several weeks. This suggests that there are other factors at play in the sector’s underperformance; expectations of a significant easing in growth are probably playing a role in this regard. Consumer stocks in both staples and discretionary sectors continue to perform well despite lofty valuations; media, internet and car firms are definite favourites at the moment.

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

Taiwan

We retain our moderate positive rating on Taiwan, based on the island’s low inflation, currency stability and steady growth. Prospects for continued deepening of cross-Strait economic cooperation with the Mainland are an additional positive factor in the outlook. The normalization of economic relations with the Mainland should over time improve business opportunities for Taiwanese firms and banks.

Following a salary hike for public servants of 3 per cent in July, the government announced further wage adjustments comprising a 5 per cent hike in the minimum monthly wage. The decision which disappointed both labour and business groups will be effective next January. President Ma Ying-jeou is expected to introduce additional spending initiatives ahead of elections next January in order to boost his re-election prospects. These will likely include increased subsidies for farmers and other consumption-boosting outlays. Regarding cross-Strait negotiations, the third round of talks within the Economic Cooperation Framework Agreement began on 1 August; we are optimistic that these regular talks will lead to benefits for Taiwanese firms in the long term.

Taiwan’s macroeconomic environment and exchange rate will stay relatively more stable than its major Asian competitors’. The Central Bank is firmly – some would say obsessively – committed to maintaining economic stability by controlling the volatility of the Taiwan dollar. The latest CPI data show inflation dropped to 1.3 per cent due to slower food, transport and communications cost rises. Although inflation will trend up slightly in H2/11 due to seasonal factors and the base effect we expect price increases to remain around 2-2.5 per cent, one of the lowest rates anywhere.

The major uncertainty in the outlook is associated with weakening demand in developed markets. This could have a significant impact on exports of the IT sector. Recent data on export orders show a decline to single-digit growth of 9.2 per cent year on year. The latest HSBC PMI figure also pointed to a weaker outlook, registering 46.1, the lowest reading since January 2009. The slowdown in the important IT sector can be seen in Q2 results for TSMC, the world's largest semiconductor foundry manufacturer: faced by declining profits, senior management announced cuts in capex investment for 2011. Electronic equipment firms are still enjoying rapid growth, but other developments have clouded the outlook for this subsector: HTC, one of the leading Asian smartphone makers, is facing a patent war with Apple that could have major implications for its profit outlook. We downgrade our call on IT to moderate negative as we expect weak equity performance in the near term.

With export growth likely to moderate, we look to consumption-related sectors to sustain growth in H2/11 and 2012. Last month consumer staples and consumer discretionary sectors easily outperformed the index. We overweight these sectors for the pre-election period based on faster growth in disposable incomes and improved prospects for market expansion into China.

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

Indonesia

Our strong overweight call on Indonesia has worked out well. The stock market was up 10 per cent in July, taking the total increase over the past year to 30 per cent. Thursday’s global market correction did bring a correction of about 5 per cent on Friday in Jakarta, but market prospects continue positive for the remainder of the year. Much of the recent strength was caused by a slowing of inflation from 7 per cent in January to 4.6 per cent in July. Moreover, analysts are increasingly highlighting the strengths of Indonesia compared to developed (and some emerging) countries: strong domestically driven growth, healthy balance sheets and low fiscal deficits and government debt. All these factors are analysed in detail in our 5 May report, “Why investors should turn to Indonesia”. Wellian Wiranto of HSBC even argues that Indonesia has become a safe haven: “as dark clouds gather once more over the global economy, look to Indonesia for a port in the storm.”

Although we still believe in the strength and stability of the Indonesian economy, some commentators are overly optimistic. We worry that a wake-up call to the realities of the problems still present in the economy could lead to a correction of the current high valuations. This correction is probably still a few months away – or it may not occur until 2012 when inflation begins rising in earnest – but the rally is likely to lose some of its steam after the recent strong run. We remain positive on the outlook but less so than we were in the past few months.

The main trigger for a tempering of optimistic expectations will be the return of inflation. The continued decline of inflation since January was caused almost entirely by base effects as food prices were extraordinarily high in 2010 due to extreme weather. As base effects wear off (but temporarily come back in November and December) food inflation will begin increasing again. In the medium term, we expect food inflation of around 10 per cent on average, driving headline inflation back up to 6-7 per cent.

In addition core inflation will increase because demand remains very robust. Credit growth is high (23.4 per cent in June), exports continue strong (59.3 per cent growth in June) and consumers are very confident. This explains the impressive second quarter profits reported in the past weeks – especially for banks and consumer companies – and points to continued strong growth, potentially above 6.5 per cent.

Meanwhile, Bank Indonesia’s (BI) tone has become even more dovish, stating in its June inflation report (issued before the latest inflation numbers) that “the current BI Rate level is still in line with the effort to maintain stronger economic activities supported by stability”. Given that the government has decided not to increase the fuel price this year, BI is unlikely to raise rates before 2012. It might instead introduce further macroprudential measures to deal with “excess liquidity”. For example, BI has already announced it is considering limiting bank lending for property and autos. Additionally, it is likely to continue to allow appreciation “in line with that in the Asian region” to reduce imported inflation. Overall, these measures will have limited effect, so the monetary stance will remain accommodative.

There is some danger that the government will push for this accommodative stance to persist even as inflation picks up. While it has raised its growth targets, progress on policies to improve the production capacity of the economy is slow. The Ministry of Finance announced that spending on infrastructure for the first half of the year reached only 16.8 per cent of the target for 2011. This points to continued problems in budget disbursement and does not bode well for the execution of the Master Plan for Economic Growth Acceleration. Lacking the ability to spend the money itself, the government may well push for continued cheap credit to get private companies to contribute.

We reduce our country rating to moderate positive after the recent strong growth in equity prices.

Last month consumer stocks continued to outperform, both consumer discretionary and staples. We retain a positive outlook for these sectors but downgrade consumer staples to moderate positive after recent strong gains. Banks also continue to outperform despite relatively rich valuations. Prospects for continued outperformance are good, given strong underlying earnings growth.

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

Turkey

Even though the June parliamentary elections brought another sweeping victory for the Justice and Development Party (AKP) Turkey’s political life suffered a dramatic escalation in tension in their wake. A boycott of parliament by 29 Kurdish independent MPs was started after seven of their colleagues were barred by the Supreme Election Board from being seated on the grounds that they had been charged with making speeches deemed to be propagandistic.

Prime Minister Recep Erdogan responded in a strongly confrontational and non-conciliatory manner to the boycott, further exacerbating tensions between the Kurdish minority and the new government that he leads. He further unsettled the political environment with provocative comments on Cyprus and his relations with the military. In our view, Erdogan’s overconfidence after the election led to such behaviour. Nevertheless, our judgment is that Erdogan will adopt a more conciliatory approach before political debates reach extremes. Erdogan needs to forge a political consensus in favour of constitutional reforms and he cannot do this if he fails to lessen tensions with the Kurds and other opposition forces.

As political debates heat up ahead of the start of the next parliamentary session in October, sentiment in the financial markets will undoubtedly suffer. This comes on top of widespread market opinions that the economy is heading for a hard landing unless the Central Bank of Turkey (CBT) moves to tighten interest rates soon. We do not subscribe to such views. The CBT can be criticized for failing to move faster to introduce additional measures to dampen loan demand after its initial unorthodox policies failed to produce the desired results. But there are finally signs that the sharp reserve requirement increases and restrictions on consumer loans are acting to rein in loan demand. The recent move by the CBT to lower the policy rate 50 bps to 5.75 per cent reflects their confidence that a hard landing for the economy is not on the cards. We expect to see a sharp slowdown in loan and GDP growth later this quarter.

The combination of heightened political tensions and the still uncertain extent of the coming economic slowdown make us pessimistic on the near-term outlook for equities and the lira. The Turkish index was among the worst performer among the emerging economies that we cover. We retain a strong negative rating on the market. We do think a soft landing for the economy is more probable than the hard landing that the consensus now predicts. If we are correct, then equities should rebound once this scenario begins to play out towards the end of the year.

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

Sector and country insights

EM leaders and laggards in consumer goods sectors

Which EM markets have delivered the best returns to investors who are following the “rising middle-class consumption” theme? For the month of July in any case it is clear that Indonesia and Taiwan are the winners.

Chart 12 provides a picture of the performance of MSCI consumer staples stocks in the EM markets that we monitor. Two smaller Asian economies led the pack: Indonesia and Taiwan generated returns of over 10 per cent on the month. The other EM markets lag far behind. The performance of consumer staples stocks in China, India and Turkey was flat over the period while Brazil and Russia registered sizeable losses.

The story for consumer discretionary stocks was not much different. Indonesia and Taiwan lead the crowd, followed by China and India. Turkey and Brazil bring up the rear. (An MSCI sub-index for Russia is not available.)