EM Strategy Monthly

September 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, 1 September.

Our next Strategy Monthly will appear on 7 October.

Overview of August performance

August was notable for extreme volatility and herd behaviour. After strong outperformance in July EM equities were buffeted by the Eurozone debt crisis and the ensuing market panic in early August. EM markets recovered strongly during the last week of August (with the exception of Indonesia and Turkey, which were closed for religious holidays). The performance of EM equities closed the gap with US equities after the 22nd but still lagged the US MSCI index. Commodities, however, were the best performers overall, helped by substantial increases in soft commodity prices triggered by growing pessimism about this year’s harvests.

Indonesia and Brazil were the top performers among the emerging markets that we follow. (When the Indonesian market reopens on 5 September following the week-long holiday we expect to see further substantial gains.) Over the past year Indonesian equities have outperformed other EM markets by a wide margin: in dollar terms the Indonesian market is up 21.8 per cent compared to the second-ranked market, Russia, which has managed a 16.8 per cent gain.

Turning to the outlook, Russia is our strong conviction call for September (upgraded). As we explain in detail below, markets have overreacted to potential risks associated with the coming European economic slowdown. Russia’s growth at the current time is predominantly driven by domestic factors that are little affected by turmoil in Europe. We expect to see a positive political cycle take shape in the coming month as the country heads towards parliamentary elections in December and a presidential contest next March.

At the other end of the spectrum we have raised the outlook for both Brazil (to neutral) and Turkey (to moderate negative). Both countries have moved into a period of monetary loosening and slower growth. Although our previous negative views have played out as expected, we think the worst is now behind us, at least for the next three months.

The performance of EM fixed income last month was strong though some of the local market returns have been eroded by short-term currency weakness, especially in Russia. Looking ahead, we have a positive outlook for both external and local EM debt. Our top pick is Turkish local debt following the sharp decline in the lira over the past two months. We think downside risks on the currency are limited from existing levels.

Portfolio strategy

Global themes

The decoupling of EM markets is coming but investors should first prepare for a full-blown Eurozone financial crisis.

Last month we argued that the much debated “decoupling” of emerging from developed markets must be viewed as a sequential process. (The interested reader may wish to refer to the details of our argument here.) In short we think the decoupling of equity performance will take time and it will be preceded by the decoupling of fixed income.

Although there is mounting evidence that EM debt is increasingly viewed as a “safe haven” trade, last month’s experiences should remind us that any emerging market security will be sold in the midst of a market panic such as occurred during the second week of August. That was when the correlation of the S&P 500 stocks hit 80 per cent, higher even than the 73 per cent peak reached at the climax of the Lehman crisis in 2008. So even to raise the issue of decoupling one has to assume that certain minimum conditions are met, namely that markets are not characterized by extreme volatility and panic.

This is another way of saying that for decoupling to happen we need to find ourselves in markets in which fundamentals matter for valuations: i.e., where stock pickers and economic forecasters pursue worthy endeavours that rest on facts, not emotion or psychology. Unfortunately there are reasons to think that we are still far from this desirable state.

The Eurozone debt crisis is the primary reason why we are likely to find ourselves back in panic-driven markets before long. The Eurozone authorities have responded to their crisis by kicking the can down the road, dribbling out rescue packages in the hope that markets will somehow ignore the rot that lies behind the past accumulation of debt. As one of our friends put it, the French and Germans want to keep the patient (i.e., Greece, Portugal, etc.) in the intensive care unit but without providing the resources needed to restore its health.

The dilemma today is that conditions have deteriorated to such an extent that there appear to be only two ways out if the euro is to be saved:

1. The rich countries (read Germany) provide a bailout in the form of a joint and several guaranteed Eurobond to the struggling peripheral countries.
2. A massive write-down of the debt triggers a recapitalization of Eurozone banks.

The first option looks politically impossible while the second looks unaffordable. Some other escape may be found but for now the crisis goes on getting both worse and more expensive for all involved.

Despite this depressing outlook we think it is still important to spell out the arguments why decoupling is likely, even if this is still in the future. We highlight two primary reasons.

First, if one approaches the investment process from a bottom-up perspective then the challenge is to find good companies that generate strong cash flows and pay dividends. If major emerging markets are able to sustain expansion when developed economies enter a period of subdued growth then the number of such companies located in the emerging economies will inevitably grow over time. In fact we think this is the most likely scenario for the medium-term future. But a critical assumption of this argument is that fundamentals matter for valuations: i.e., we do not find ourselves in a panic-driven market environment.

The second argument is that markets will be forced to revise their perceptions of what are considered safe investments. The Eurozone crisis happened because lenders, especially banks, considered lending to peripheral countries “safe”. It turned out that they were wrong. The US subprime debacle was caused by massive investments in securities that most thought were safe (because of dubious financial engineering and pliant rating agencies). These investors were also wrong and the losses are still being counted.

Today most investors are attuned to the obvious market risks but they have misconceptions of what is safe. Ari Bergmann of Penso Advisors illustrates this point with reference to Hurricane Irene in the US:

"Everyone knew that the risk in low-lying areas in the path of the storm was extremely high and everyone was ordered to evacuate. This was based on the assumption that somewhere else was safer. But in the end the low-lying areas did not get hit that hard but the areas where many went (upstate New York, Vermont) suffered terrible damage."

The parallel with the current market environment can easily be drawn: every investor knows that the risks of the debts of the peripheral Eurozone countries are high. But where are the safe alternatives? Are US Treasuries safe? Are German bunds safe? How about gold? The answer is that nothing is really intrinsically safe − there is only relative safety. And protecting yourself against the potential “black swan” that is lurking around the corner may eat up all your potential return. So finding a balance between risk and reward is essential.

The moral of this parable is that investments in emerging market securities are not risk-free but many can provide attractive risk/reward characteristics. But, again, for this argument to hold we need to be in an environment in which fundamentals matter for valuations and the risks associated with such investments are sufficiently transparent to be realistically priced. We are not there yet but the turmoil that lies ahead will likely force some major re-evaluations of the positive relative attractiveness of EM investing.

EM sovereign fixed-income securities will continue to provide investors with attractive risk/reward opportunities as Eurozone finances head into deeper crisis.

Last month was marked by unprecedented volatility in EM fixed-income securities, both external debt and local markets. We think the Eurozone economic crisis will remain “on the boil” with a high probability of another crisis followed by a “panic attack” in markets not dissimilar to the one that we recently experienced.

Given these prospects, we recommend that investors add fixed-income exposure to sovereigns that possess the following characteristics: stable growth prospects, low fiscal deficits and low debt-to-GDP ratios. Among the countries that we monitor, the best investment opportunities will be found in securities from Brazil, Russia, Indonesia and Turkey. Our top pick today would be Turkey, followed by Russia.

Investors who take on such exposures should expect security prices and currencies to exhibit extreme volatility during panic periods such as the recent one but they should also expect valuations to regain previous levels after the markets settle down. An alternative strategy would be to wait for periods of high volatility before adding to investment positions. In the latter case investors should do their homework well in advance so as to discover where to find longer-term value when the market lemmings head off the cliff.

Last month 10-year fixed-income securities (highlighted in the above table) all recorded lower yields (i.e., higher prices) with the sole exception of Chinese local 10-year debt (whose yield rose 17 bps). The biggest reductions in yields were found in local currency debt: Brazilian and Turkish yields fell the most (which we did not anticipate), followed by Indonesian and Russian yields (which we did get right). At the current time we think the best investment opportunities can be found in Turkish local debt now that the Turkish lira has bottomed out.

Yields on EM sovereign dollar debt fell across the board but by more than we predicted. All four countries in our sample with actively traded dollar debt saw their yields drop by 45-55 bps, although prices yoyoed during the month before recovering. If we are correct in predicting a worsening financial crisis in the Eurozone then further price gains are likely in the next three-six months though local market debt will outperform external debt.

Agricultural commodities are poised to outperform over the near term as hopes of a robust supply response are dashed

Commodity prices fell sharply in early August before recovering to end slightly down for the month as the flight out of risk assets continued (see Chart 4 below). The deteriorating growth outlook for the US and Europe, combined with expectations of slowing growth in emerging markets (China in particular) has prompted investors to sharply reduce their exposure to commodities. Industrial metals such as copper have led the decline, with the S&P GSCI Industrial Metals Index falling almost 6 per cent in the last month. Despite investor risk aversion, commodities overall continued to outperform US and EU equities throughout August.

That outperformance has been due in part to the strength in agricultural commodity prices: the S&P GSCI Agriculture Index was up more than 6 per cent over the last month, after having fallen 16 per cent between March and June. Investors had been anticipating a strong supply response when prices began ratcheting up in June 2010, but the expectations that record harvests would drive down prices are rapidly evaporating as unseasonable weather in key growing areas, including the US, have adversely affected projected yields.

We believe that agricultural commodities, led by corn and soybeans, will continue to outperform over the next three to six months as harvests come in and the extent of the damage becomes apparent. Corn prices were up 15 per cent in August (for a 36 per cent year-to-date gain), while soybean prices have increased 7 per cent. Hot and dry weather in the US has led the USDA to steadily downgrade its forecasts for corn, wheat and soybean crops, pointing to worse-than-expected harvests this year. The USDA on 29 August said 54 per cent of the corn crop was in good to excellent condition, down from 57 per cent one week ago and 70 per cent one year ago. Meanwhile, 57 per cent of the soybean crop was in good to excellent condition, down from 59 per cent one week ago and 64 per cent one year ago.

The worsening situation in the US comes as harvest yields in other major producing countries are also looking uncertain and global stocks of wheat, corn and rice remain near historical lows. Dry weather is affecting corn production in central China, setting the stage for a further increase in corn imports this year. China, the world’s second-largest corn consumer, imported 1.6 million tonnes of corn in 2010 and has imported 200,000 tonnes in the first seven months of 2011, according to Customs statistics. Meanwhile, Australia is heading for a below-average wheat harvest, and concerns are mounting that the formation of a La Nina weather pattern will affect wheat, corn and soy crops in Argentina and Brazil. Rice prices are also expected to rise as Thailand, the world’s biggest exporter, begins buying rice from farmers at prices set above the prevailing market in October.

The continued and rising uncertainty about crop yields and harvests will drive up prices in the near term as investors adjust to the reality of a worse-than-expected supply situation for agricultural commodities. This near-term tightness will be compounded by continued strong demand for soft commodities from emerging economies – as we discuss in detail below, growth in emerging markets will moderate but still continue at relatively high levels. Looking to the medium term, we remain bullish on agricultural commodities: demand growth will continue to be strong as incomes rise and emerging markets struggle to boost production significantly. Low stocks-to-use ratios mean that weather disruptions will make for volatile prices and even with bumper harvests next year there is still a long way to go to restore normal inventories. The growing imbalance in supply and demand suggests that the overall direction of prices will be up with a potential correction not in sight until well into next year’s crop cycle.

Country strategy and portfolio allocation

• Brazil – Prospects for a more coherent economic policy are improving. We raise our outlook to neutral.
• Russia – Markets have overreacted to the European crisis. We move to a strong conviction positive outlook.
• India – We do not see reasons to raise the outlook; stay neutral.
• China – We retain a moderately positive outlook in view of falling inflation and continued robust growth.
• Taiwan – We remain optimistic on the markets in the run-up to the January presidential elections.
• Indonesia – Performance continues to be the best among the emerging markets. Stay overweight.
• Turkey – We upgrade the outlook to moderate negative as the economy slows and monetary policy continues in an easing mode.

Sector and country insights

• EM decoupling: Fact or fiction?

Brazil

Prospects for Brazilian markets have improved with the recent initiative of President Dilma Rousseff to increase the targeted nominal fiscal surplus this year. Even though the increase is relatively small − amounting to 0.25 per cent of GDP − we sense that Dilma is now committed to introducing tough fiscal discipline throughout the government over the coming six-12 months.

Investors should view this new initiative as an inflection point in economic policy. We find it unsurprising that the Banco Central (BC) followed Dilma’s lead on Wednesday with a 50 bps cut in the Selic rate to 12 per cent. It is clear that Dilma wants to lead a coordinated economic policy effort with the emphasis on more fiscal and less monetary tightening. We think this is the right way to go, but much will depend on effective implementation.

In her comments to the press Dilma pointed to the worsening global economic environment as the reason for taking this step. This was a convenient excuse for her unpopular medicine, but the real reason behind the initiative was that ever higher interest rates were simply not reining in inflation. This was clear in comments from Finance Minister Guido Mantega who said the action “makes it viable in the medium or long term to cut interest rates”.

The implication is that we are at an inflection point in monetary policy – interest rates have now moved onto a declining trend. The statement on Wednesday night from the BC’s monetary policy committee (COPOM) provided an extended comment on the potential impact for Brazil of worsening global economic conditions and implied that this development was the primary rationale for its action.

Our interpretation of these developments is that Banco Central President Alexandre Tombini has convinced Dilma that continuing to raise interest rates would harm economic growth without bringing significant benefits in terms of lowering inflation. To her credit, Dilma took the decision to tighten fiscal policy despite the predictable uproar that the move would create in her coalition and in the left wing of her own Workers’ Party (PT). The COPOM’s rate cut confirms that the BC is in agreement with these decisions.

Having criticized the government in past issues of our EM Strategy Monthly for the lack of a coherent economic strategy, we have been impressed with the leadership Dilma has exhibited in taking this initiative. At a time when ex-President Lula is still maintaining an unwelcome presence at the fringes of the PT we sense that Dilma is now forcefully putting her stamp on policy and taking much firmer control of the levers of power.

The big unknown is whether this new policy direction will be successfully implemented. Next year federal spending is expected to expand rapidly on the back of a scheduled 13.6 per cent rise in the minimum wage and additional essential infrastructure spending related to the upcoming World Cup and Olympics. Given these prospects, we think it highly likely that the government will try to boost tax revenues even more through a pressure on potential contributors. Among those likely to feel the heat from this fiscal effort are retail businesses which routinely evade sales taxes, mineral exporters such as Vale (which face higher export taxes) and state corporations (which will be asked to increase their contributions to the federal receipts or to cut investment plans).

We think Dilma will run into a number of problems in imposing her new-found fiscal stringency on her unruly coalition. Equity markets will welcome the declining trend in interest rates that is now being established but will remain sceptical on how effectively the new programme will be implemented. A rebound in equity prices is unlikely in the next two-three months not only because of concerns about the new policies but also because of worries about the global economic environment. If Dilma is able to push her new initiative forward we expect to see improved market performance on a three-six-month horizon.

We raise our outlook to neutral and shift the equity allocation away from defensive sectors such as consumer staples and utilities; the outlook for both has been reduced to moderate negative. We think the banks will be the primary winners in this new scenario, and so we raise our outlook on them to moderate positive. Falling interest rates should also benefit consumer discretionary stocks; we have raised our outlook to moderate positive.

The MSCI Brazil index performed relatively well in August, rebounding strongly at the end of the month. Sector performance was led by consumer staples and consumer discretionary. Energy and materials were the major laggards.

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

Russia

Equity market performance in August was strongly affected by the global panic because many investors expect Russia’s economic prospects to be adversely affected by the crisis in Europe and by oil price weakness. We disagree. We think the most important factors for the near-term performance of the Russian market are the sustained growth in retail sales, falling inflation, strong positive growth in domestic credit and positive news on the upcoming political transition. These are all domestic factors that are little affected by developments in Europe or the price of oil.

The latest data show an impressive rebound in domestic credit, up 2.2 per cent month on month with corporate loans up 1.7 per cent and consumer loans up 3.7 per cent. These figures point to strong showings for both industrial production and retail sales in the run-up to the Duma elections in early December. Even more important, however, the recovery of the domestic cycle suggests the domestic-led economic recovery will be sustained into 2012.

Inflation is falling rapidly due to the base effect from last year’s spike in grain prices associated with the drought. We expect the August CPI to be 8.2 per cent, down from 9 per cent in July; by year end we expect inflation to fall to 7 per cent or even lower. This decline in inflation will be positive for consumer confidence and retail demand. Retail sales growth in July came in at 5.6 per cent. We see little reason to think the expansion of retail sales will fall in the pre-election period since there will likely be various politically motivated initiatives to increase income transfers and subsidies to the voters. We doubt that consumer confidence will be adversely affected by the coming economic slowdown in Europe.

As for oil, the recently concluded deal between Exxon Mobil and Rosneft to extract oil and gas from the Russian Arctic is a major vote of confidence by the world’s largest oil company in Russia’s energy sector and in the prospects for FDI. Industry analysts estimate that the tie-up could translate into US$30-40 billion of new investment over the next two decades. More than any immediate boost to spending – which anyway is small – the agreement signals the willingness of the Russian government to enter into joint ventures to open up sensitive areas for foreign investment. The areas targeted for development are described as the last unconquered drilling frontiers. In a novel twist Rosneft secured the right to invest in some of Exxon’s US projects.

An additional lesson that investors should draw from the August turmoil is that the Central Bank (CBR) is taking a much more “hands-off” approach to the ruble exchange rate. During the month Russia’s gross international reserves grew by US$7.9 billion; most of this growth was caused by CBR intervention since the euro/dollar cross rate changed little during the period. Thus despite the turmoil the CBR was content to allow the ruble to fluctuate and wound up purchasing dollars rather than selling them as has often happened in similar periods in the past. This is a major reason to think that last month’s volatility could give way to a stronger ruble in the months before the December elections.

A final consideration for investors concerns the political cycle. We remain of the view that the political cycle will play out in a positive way and give a short-term boost to market confidence. We explained our views in detail last month but in short we expect the current political tandem (President Medvedev and Prime Minister Putin) to continue without change.

This month we move Russia to a high-conviction positive outlook in the wake of the substantial sell-off over the past month. We think market participants have got Russia wrong – the short-term growth drivers are predominantly domestic in nature and not dependent on the oil price or on European developments. Our top sector call remains financials: recently released earnings from both Sberbank and VTB highlight the strong earnings momentum of both institutions. The strong upturn in the domestic credit cycle that is now under way will sustain future earnings growth. We also upgrade energy to a moderate positive outlook.

Last month basic materials led the overall market: we retain our moderate positive outlook for this sector. We were disappointed with the performance of consumer staples, which lagged the overall index. We think prospects for retail are improving, so we retain our moderate positive outlook for the upcoming period.

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

India

Recent economic data releases have confirmed our earlier calls that growth would moderate and inflation remain relatively high. In the quarter to end-June GDP rose 7.7 per cent in line with analysts’ forecasts but well short of government expectations. Meanwhile inflation has inched up to over 9 per cent, all but assuring that the Reserve Bank (RBI) will remain in tightening mode for the next three-six months.

On the policy front there were few positive developments. Anna Hazare, a well-known social activist, succeeded in capturing media and popular attention and hijacking the political and legislative agenda with a very high-profile 13-day anti-corruption fast. The government initially took a hard line against Hazare by briefly arresting him; this strategy backfired, however, and galvanized public support for Hazare. The government was eventually forced to call a special Saturday session of parliament to debate and pass a resolution meeting some of Hazare’s demands. Prime Minister Manmohan Singh was reduced to heaping praise on the 74-year-old activist.

None of this will have much longer-term influence on corruption but it did distract the government from its day-to-day business and it did create further delays on the reform front. The best that might be hoped at this time with regard to implementing many of the government’s policy initiatives is that the slowdown in developed economies might give the government an excuse to push forward some of its more contentious reforms. Nevertheless there is still a widespread belief in many influential circles in India that the country is much less exposed to the vicissitudes of the global economy than other emerging countries.

Although the peak in India’s inflation cycle is coming closer, we think there are still one or two more rate hikes in the pipeline. We expect the RBI to tighten a further 25 bps at its 16 September meeting and the inflation rate could rise to over 10 per cent in the coming six-eight weeks before falling back. We do not think the peak in the interest rate cycle will be reached before early next year. Over the current fiscal year we expect growth to moderate but remain relatively strong at 7-7.5 per cent.

For the moment we do not see reasons to raise the outlook for Indian equities – we retain a neutral rating. With slow progress on reforms, a rerating of Indian equities depends on improving macro fundamentals. We think the soonest this can happen is early next year after the interest rate cycle peaks.

Last month Indian equity performance was led by consumer staples and energy. We keep consumer staples at a modest positive rating despite concerns about their expensive valuations. Recent GDP figures confirm that consumer spending remains a major growth driver but we do not expect a sustained spending boom. We upgrade financials to neutral from modest negative. We expect financial stocks to track the index but it is too soon to expect relative outperformance.

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

China

At a time when global growth prospects are weakening many analysts are revising their growth forecasts downwards to fit the gloomy mood of the markets. We are joining this crowd but we think the inevitable slowdown in exports will not come over the next three-four months but in 2012. We think the strength of economic growth will surprise on the upside in the coming months as the domestic inventory cycle ends and restocking boosts domestic demand. We see confirmation of this mild rebound in growth in this month’s HSBC PMI figure, which came in slightly stronger at 49.9, up from 49.3 in July. We project Q3 and Q4 growth at 9-9.5 per cent with a slowdown to 8-8.5 per cent next year.

We think near-term prospects for Chinese equities will be boosted by evidence that growth is holding up better than anticipated and by a declining trend in inflation that should be confirmed later this month when the August figures are released. We maintain our moderately positive outlook for the overall market.

We think inflation will decline to 6.2 per cent in August and then fall to 4.5-5 per cent within six months. Food inflation, which has been running close to 15 per cent in recent months, should drop substantially as the peak in the hog cycle is reached and pork prices turn down sharply. Pork prices rose 12 per cent in June but fell 0.2 per cent in August; sharp declines are probable beginning in September. Next year we think inflation will remain over 4 per cent due to continuing wage pressures on unit costs and an upturn in food prices after the Lunar New Year.

We do not anticipate a significant change in the stance of monetary policy in the next three months. The recent decision by the People’s Bank of China (PBoC) to extend reserve requirements to the banks’ off-balance sheet exposure is not likely to have a significant impact on overall liquidity. Our interpretation of this move is that the PBoC wants to discourage off-balance sheet lending by banks, not to tighten overall monetary conditions. So liquidity that is absorbed by the gradual implementation of these new requirements is likely to be replaced by reduced rollover of maturing PBoC bills.

We believe that a marked weakening of external demand would trigger a loosening of monetary policies and the introduction of targeted subsidies for consumption, not infrastructure spending as happened in 2008-09. However, since nearly half of China’s exports to developed markets represent processing trade, weaker foreign sales would be roughly matched by lower imports of components. For the next quarter we do not see signs of a sharp drop in exports – the HSBC September PMI reported a rise in export orders to 49.6 from 48.4 in July and 46.7 in June. The global economic slowdown will hit export growth next year when we project the contribution of net export to GDP growth will fall from one percentage point this year to zero. This will account for most of the reduction in GDP growth that we are forecasting.

We see no evidence of any imminent slowdown in property construction. Figures for floor space started and sold remain buoyant despite continuing efforts by the authorities to dampen property price inflation. A large-scale correction in the property market is undoubtedly coming but it is not probable now or next year in view of the leadership transition scheduled for late 2012 and early 2013.

Our recommended sector allocations remain unchanged from last month. We keep financials at neutral, based on the record earnings recently turned in by the country’s top banks and current low stock valuations. These institutions are in a position to build adequate reserves against potential non-performing loans and to manage gradual write-offs over a three-five-year period. Although still relatively small, China’s shadow banking sector has been a source of rapid and uncontrolled growth. Recent developments suggest that the authorities are now aiming to bring the sector under tighter regulatory control. Some innovative players will undoubtedly keep a few steps ahead of the authorities, but expansion will likely slow.

Sectors with a moderate positive outlook include energy, basic materials and consumer staples. Evidence of sporadic power shortages over the summer suggests that energy demand remains relatively strong. We see basic materials as a short-term valuation play: we think the recent weakness in valuations of stocks in the sector is an overreaction based on misplaced expectations of a sharp slowdown in growth, a scenario we think is unlikely. Finally we remain positive on the outlook for consumer demand. Declining inflation should boost consumer confidence, which should buoy stocks in consumer staples. We are less convinced that consumer discretionary stocks will outperform, especially the auto sector.

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

Taiwan

Taiwan's economic expansion will slow down further in H2/11 due to the effects of a weaker global outlook, lower inventory investment and domestic supply disruptions affecting petrochemicals exports. During August Taiwan's statistics bureau downgraded its overall growth forecast for 2011 from 5 per cent to 4.8 per cent and cut the inflation forecast from 1.9 per cent to 1.6 per cent due to the limited impact of this year’s typhoon season on food prices.

The Japanese earthquake and tsunami will also distort the pattern of growth. Inventories rose strongly in Q2/11 following the earthquake in March but this is being followed by destocking in Q3/11. An additional special factor affecting growth is the temporary suspension of operations at the Formosa Plastics Group's sixth naphtha cracking complex. The complex and associated businesses that depend on its output or supply it with inputs accounted for 10.6 per cent of Taiwan's GDP in 2010. Uncertainties about the timetable of suspension of the complex’s operation make it impossible to predict the final impact on GDP. Taking these factors into account, we cut our growth forecast to 4.5 per cent for 2011 but remain positive on the consumption sectors in H2/11.

In the coming quarter an overriding issue for investors in Taiwan is whether the presidential and legislative elections on 14 January 2012 will lead to another four-year "peace dividend" from the strengthening of cross-Strait economic ties. The election will be the first occasion for the electorate as a whole to deliver a judgment on the Economic Cooperation Framework Agreement signed last year. Whatever the outcome of the election, we expect the trade agreement negotiated between Beijing and Taipei under President Ma to continue to form the basis for the expansion of economic links. One of the largest beneficiaries will be Taiwan’s banking sector as it profits from relaxation of regulations on its Mainland operations. The machinery sector will also benefit as a preferred supplier to help meet China’s goals of “going up the value chain” that are set out in the new Five-Year Plan. A full discussion of these issues can be found in our publication Economic interests will trump politics in Taiwan’s presidential election.

Equity market performance last month was dominated by foreign investors: there was foreign net selling of NT$198.5 billion (US$6.8 billion). Selling was concentrated in the first three weeks and was followed by modest inflows in the last week of the month. The telecommunication sector, which enjoys stable cash flows and strong growth from value-added services associated with the use of various smart-phone devices, and consumer staples outperformed due to their defensive strengths. The IT sector was heavily sold off by foreign investors due to fears that the strategic retreat of HP from its PC business would adversely affect Taiwanese firms who play a major role as components suppliers to HP. Although uncertainties remain, we move IT from moderate negative to neutral as we believe the market sell-off fully reflects the bad news associated with these developments: Taiwan’s IT sector remains globally very competitive and we believe that it is capable of rebounding from these recent setbacks.

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

Indonesia

The sell-off of Indonesian equities in August was relatively mild; the stock market outperformed the US, the EU and other emerging markets. The Indonesian economy is relatively sheltered from a slowdown in developed markets thanks to strong domestic growth drivers and the fact that only a quarter of exports go to the US and the EU. Bank Indonesia (BI) is confident that the economy will grow 6.6 per cent this year despite the slower growth in developed economies.

That said, Indonesia remains vulnerable to a weakening of investor sentiment because foreign investors play an important role in the stock market and own more than one-third of the government’s rupiah bonds. The government is aware of this risk and has set up the Bond Stabilization Framework to offset a sudden reversal of foreign investment flows. And BI has signalled that it stands ready to use its FX reserves to stabilize the rupiah if necessary. Although Indonesia is not isolated from problems elsewhere, it is likely to be relatively robust compared to the muddle-through scenario in the developed markets.

August was a quiet month in Indonesia due to Ramadan. The stock market was closed this week and inflation data will not come out until 5 September (we expect a small increase in inflation). The most important piece of economic news was the announcement of the draft budget for 2012, which shows the government to be very optimistic about the economic outlook, committed to maintaining fiscal conservatism but unwilling to take unpopular decisions, especially on the reduction of fuel subsidies.

The budget document projects growth at 6.7 per cent and inflation of 5.3 per cent in 2012. We believe this is overly optimistic – growth of 6.7 per cent would drive core inflation up; combined with higher food prices, this would almost certainly cause inflation to be in the 6-7 per cent range, if not higher. Although BI might be slow to increase interest rates, if core inflation increases to over 5 per cent it is likely to act to cool the economy down.

The 2012 budget deficit is targeted at a conservative 1.5 per cent of GDP, lower than the projected 2.1 per cent for 2011. This will be achieved mostly by lowering subsidies and raising non-tax receipts. After plans to raise fuel prices earlier this year were postponed, the government had to raise the budgeted 2011 subsidies by 30 per cent (due to the higher oil price) and vowed to reduce fuel subsidies in 2012. In a turnaround the government is now planning to increase them by 2 per cent in 2012. Instead, it is “considering” raising electricity prices by 10 per cent – if the House of Representatives does not block the proposal again – to reduce the bill for electricity subsidies.

A sharp reduction of fuel subsidies is one of the major risks for high inflation in 2012, so inaction in this area is positive in that respect. However, it also shows that the government lacks the courage to make needed changes in policy and confirms our view that major reforms are unlikely to be pushed through before the 2014 elections. This means progress on infrastructure projects, which are critical for Indonesia’s longer-term economic growth, will be slow.

Last month energy was the main underperformer, due to lower expectations on the coal price as the result of a global slowdown. We are less negative than the market: thermal coal prices have been remarkably resilient in recent months and we expect them to remain supported in view of continued strong demand from India and China and an increase in imports by Japan in Q4/11. We therefore keep our moderate positive outlook on energy. Consumer staples continued to lead the overall market. We remain positive on the consumer sector although valuations look rich. The same can be said about financials: we retain a moderate positive outlook for the sector but remain concerned about overvaluation. Last month financials closely tracked the index.

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

Turkey

After the Central Bank’s (TCB) surprise rate cut last month the market has revised expectations in line with our earlier out-of-consensus view that a sharp slowdown in loan and GDP growth was in the works. Recent data confirm a slowdown in industrial production and loan demand while inflation remains within the TCB’s targeting band at 6.3 per cent.

It is still too early to draw any definitive judgments about a possible hard landing for the economy next year. The recent surge in imports is likely to be reversed very soon but prospects for the economy are far from encouraging. Turkey is more exposed to the EU economic slowdown than most other emerging economies. The rapid downgrading of European growth prospects will have a significant impact on exports of Turkish manufacturing firms during the next 12 months. This explains our downgrading of the outlook for industrial stocks (see below).

The banks will be the major beneficiaries of the TCB’s easing policies. After the Central Bank's monetary policy committee left interest rates unchanged last week TCB Governor Erdem Basci announced that monetary policy would be eased in response to slowing external demand. We expect further relaxation in the banks’ reserve requirements before any further rate cuts take place. These moves will help banking profitability but with a worsening economic environment banks will also face rising non-performing loans. These factors do not argue for an overweight call on the overall market but we have upgraded our outlook for financial stocks. Given the mix of positive and negative developments, we move to a moderate negative rating for this sector.

With this change we also raise the overall rating of Turkish equities one notch to moderate negative (to reflect the large weight of financials in the index). A further consideration is that much of the bad news is already reflected in today’s prices following the market’s weak performance over the past year – Turkey is the worst-performing market among the seven that we monitor. We do expect the TCB to ease monetary policy proactively if signs of economic weakening do develop. Therefore we think an outright recession is unlikely but the developing economic environment is likely to continue to be negative for equity performance.

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

Sector and country insights

EM decoupling: Fact or fiction?

The topic of the decoupling of EM markets from developed markets generates strong views among analysts: some vehemently deny that decoupling is possible while others are just as adamant that it is inevitable.

We decided to look for empirical evidence on decoupling with a focus on fixed-income securities. We chose fixed income because it is nothing short of a mug’s game to look for decoupling in equity prices when even the S&P 500 stocks showed an 80 per cent correlation, higher even than during the panic in 2008 (for details see this).

In order to test for decoupling we compared the iShares Emerging Market Sovereign Debt ETF (Bloomberg ticker EMB) and a similarly rated US corporate bond ETF. Since the EMB average bond rating is BBB-, we selected an ETF bond fund with a similar rating, the PIA BBB Bond Fund (Bloomberg ticker PBBBX). PBBBX invests in BBB-rated debt, mostly US corporates but also a few foreign issues such as Petrobras bonds. As a final point of reference we include on Chart 12 below the performance of the iShares High-Yield Bond ETF (Bloomberg ticker HYG); the average rating of the HYG ETF is B+. This fund represents what EM debt used to be, i.e., low-rated securities.

The chart shows that EM debt performed roughly in line with comparably rated US debt as the European crisis gathered momentum in its initial stages in July and early August, rising over 2 per cent. When the second phase of the crisis erupted in the second week of August (“the panic”) EM debt fell sharply. This is when the market cared little that EM debt was just as good (in a credit sense) as the BBB bond fund. So it is clear that EM debt will still carry a bit of the legacy of the bad old days when a panic hits.

This snapshot tells us that EM debt can decouple from lesser-rated securities but only in conditions short of overall panic. At a crisis point it becomes tarred with the brush of its past legacy of debt defaults. The more positive lesson of this episode is that EM debt ended the two-month period only slightly below the BBB bond fund. Traders take note!