EM Strategy Monthly

December Strategy Roadmap

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

Note: Yields and rates are as of 10am GMT 1 December.

Our next Strategy Monthly will appear on 6 January.

Overview of November performance

November was a risk-on/risk-off month as sharp declines in equities gave way to a strong rally at the end of the month. EM performance fell between the US (which did relatively better) and the EU (which did slightly worse). The best performance, however, came from commodities, thanks to the strong performance of energy. Although analysts have been working overtime to reduce their growth forecasts for next year, oil markets have run counter to the general pessimism as a result of Libya’s outage and the prospect of a European boycott of Iranian oil (for details see our Global Themes section below).

Markets remain believers in an eventual Eurozone bailout and coordinated policy actions by major central banks to avert a market meltdown. This flies in the face of the well-established track record of Eurozone leaders over the past year to over-promise and under-deliver. But we are long past the time when fundamentals as opposed to sentiment rule the roost. Risk-on/risk-off will continue to be the main driver of equity performance in the approach to the EU summit on 9 December when the latest “solution” to the current crisis will be duly announced.

Individual country performance was hardly encouraging as all the countries we monitor turned in negative numbers, ranging from -1.4 per cent in Russia to over -14 per cent in India. We were gratified nonetheless that our country calls were very much on target, led by our positive-rated markets − Russia, Indonesia and China − while our underweight – India – brought up the rear.

We see a breakup of the Eurozone ahead

For reasons that we detail in the following Global Themes section, we believe the Eurozone is heading towards breakup. We have much less confidence in predicting the path of such a breakup. We simply do not know how the short-term dynamics will play out. We do anticipate extraordinary efforts by Eurozone policymakers, the IMF and others to find a viable resolution to the crisis. In our view the breakup is likely to be long and drawn out, punctuated by periodic acute crises as the best-laid plans of Eurozone leaders are dealt a death blow.

As long as Germany – and by implication German taxpayers – refuse to bail out the laggards, the scope of the adjustment that faces countries such as Greece, Italy and probably Spain to remain in the Eurozone under the latest “fiscal compact” is simply unachievable. There is little doubt in our minds therefore that markets will continue to be volatile for the foreseeable future, rallying on hopes of a solution to the crisis only to fall back when the realisation sinks in that the latest solution cannot work. Our recommendation to clients is unchanged – use coming periods of extreme volatility to take positions in top-rated stocks with a focus on Russia, China and Indonesia.

Portfolio strategy

Global themes

A breakup of the Eurozone is unavoidable

We think the Eurozone crisis has passed the point of no return; we no longer believe the Eurozone can be preserved in its present makeup. We have little confidence that today’s behind-the-scenes activity by all the players in this drama to craft a “fiscal compact” will find a formula to restore growth. Make no mistake: without growth, the peripheral countries cannot make the economic and social adjustments that will be required to avoid a breakup.

Greece is obviously the prime candidate for exiting the Eurozone in the next three-six months. Prospects for Italy and Spain are less clear. Both countries will likely be offered the option of targeted support for efforts to meet criteria for a new “fiscal compact” along with a strict timetable for progress towards this goal, but longer-term prospects must be judged as daunting, for both political and social reasons. This is not a path to restored growth but an invitation to social strife and economic depression. Euro exit and devaluation remain the most feasible options for these countries to regain economic growth. We think Eurozone policymakers will choose instead to go down a path that will prolong but not alter the final outcome.

Back in 1988-89 I was the chairman of the economic committee advising creditor banks in the Mexican debt rescheduling that eventually led to the creation of Brady bonds, which granted Mexico substantial debt relief. The lessons of that exercise are relevant to an assessment of prospects for the peripheral Eurozone countries today. By August 1988 when the negotiations got under way, Mexico had been struggling for six years after the initial debt default to restore economic growth with no success. Fiscal reforms that had been imposed in the midst of a prolonged recession did bring an impressive primary budget surplus (i.e., the budget surplus before interest) of over 7 per cent of GDP. But the key to stimulating growth was still missing. By securing a Brady debt restructuring, Mexico was able to substantially eliminate its debt overhang and thus restore confidence by stretching out debt maturities and reducing interest rates. A strong economic recovery followed.

If I were to take Italy and impose the Mexican time line from the outbreak of the crisis to eventual restoration of economic growth, then I judge that Italy is barely one or two years into an adjustment period that could easily stretch another 6-8 years into the future. The question is whether the “fiscal compact” that Chancellor Merkel is holding out to the peripheral Eurozone countries is any different from all the failed reform and rescheduling efforts that I participated in as an intrepid bank economist back in the 1980s. I would suggest that it is not, except for the straitjacket that Eurozone membership imposes on any future efforts to achieve the needed economic and social adjustments. It will be exceedingly difficult to restore growth if Italy remains in the euro.

We are not facing a “Lehman Brothers moment". Back in September 2008 the US could have bailed Lehman out, but chose not to. The problem today is that Italy is too big to save, even for Germany plus the IMF thrown in for extra measure. Of course, it is theoretically possible that Italy could adopt the reforms necessary to get back on a positive growth path. But in the context of a world faced with recession, accelerating bank deleveraging and rising social tensions, such efforts at adjustment are bound to fail.

What is more important is that Germany’s leaders have accepted that the Eurozone will have to be restructured. The political calculus for Chancellor Merkel is that it is good politics to prevent the European Central Bank (ECB) from stepping in to buy up Italian or Greek debt unless draconian economic adjustments are imposed. This is why she has laid out a path to fiscal union that none of the peripheral countries will be able to travel. The inevitable result will be a Eurozone breakup – no matter how much Eurozone leaders may deny it.

EM banks and sovereign fixed-income securities offer attractive ways to play the coming Eurozone breakup

If we are correct in anticipating a breakup rather than a bailout of the Eurozone, then we would suggest two ways for investors to play this outcome.

The first is to buy EM banks in the midst of the coming turmoil that is likely to accompany a euro breakup. Chart 3 below shows that EM financials have closely tracked EU financial stocks throughout 2011 even though the majority of these banks have little direct involvement in the Eurozone. The only exceptions are the handful of independent East European banks (the majority of banks in the region are owned by European banks). In a post-breakup environment EM banks would decouple from European and US banks that have direct exposure to the breakup.

A second way to play a breakup is via EM sovereign debt. After a Eurozone breakup spreads on Eurobonds of the survivors will likely fall sharply, reflecting a severe demand-supply imbalance; i.e., the demand for top-quality sovereign paper will far exceed the supply from Germany, France and the other probable members that would constitute the new Euro area. In any of the many possible scenarios that could lead to such a result, the “smart” money would already have sold the problem sovereigns’ paper, leaving the ECB, the IMF and local banks holding the remaining questionable debts.

In this scenario France would probably offer investors in the new Euro-area sovereigns the best total returns. The reason is because spreads on French sovereigns to Bunds are the widest among the countries with a high probability of meeting Chancellor Merkel’s fiscal compact. The exit of Greece and possibly several other peripheral countries from the euro would thus drive a strong convergence trade.

For reasons already discussed above, the ability of Italy and Spain to implement the adjustments necessary for membership of such a newly reconstituted union is less certain, though it cannot be ruled out. Both countries may be able to “buy time” and gain support for efforts to meet such criteria under a strict timetable, but longer-term prospects must be judged as unachievable for both political and social reasons. Euro exit and devaluation remain the most feasible options for these countries to regain economic growth. A second-best option would be to launch a pre-emptive rescheduling of their debt by reducing interest rates and stretching maturities, while rejecting “haircuts” on debt holders. We think this option is unlikely to be accepted in the near term but would become unavoidable in several years’ time after a failure to meet the terms of the new fiscal compact.

In a post-breakup world yields on German and French sovereign paper would likely fall to record lows, probably close to 1 per cent (cf. Japan, whose 10-year paper yields 1.05 per cent). In this environment yields on investment-grade EM sovereigns such as Brazil and Russia would offer investors attractive relative value, given current yields of 3.4 per cent and 4.5 per cent respectively on their 10-year benchmarks.

We believe that investors would win either way by buying top Euro or EM sovereigns. The post breakup euro world will look very much like Japan today. The difference is that none of the EM sovereigns will be burdened with the legacy of the defaulted debt that will have piled up in the ECB prior to breakup. This is why the EM debt option should be preferred.

The Eurozone crisis will have a varying impact on commodities: metals will remain vulnerable to financial market volatility while oil, agriculture and bulks will be driven by underlying supply and demand fundamentals

Commodity prices overall continued to be whipsawed last month by changes in investor sentiment. After their brief rally in October, commodities resumed their slump in November as fears of a hard landing for China resurfaced and markets started to price in the probability of a Eurozone breakup. The diminished expectation that European policymakers will find a lasting solution to the crisis in the near future and the growing likelihood of a severe economic contraction in Europe have added to investor caution and prompted investors to once more cut their exposure to risk assets (see Chart 5 below).

Energy and industrial metals such as copper, which are the commodities that have been heavily traded by financial investors, declined the most last month. Prices of agricultural commodities fell very sharply, led by wheat due to a glut of Black Sea exports that resulted in a collapse in global prices. In contrast, energy remained supported due to continued tightness in the global oil market resulting from Libya’s outage and the prospect of a European boycott of Iranian oil.

The question now facing investors is: How will an extended period of financial turmoil in developed markets, in conjunction with slower growth in the developed world and China, affect commodity markets in the coming six-12 months? The short answer is that it will have varying impacts for different commodities, with those that are more financialized experiencing more volatility and others being driven relatively more by underlying fundamentals.

In this regard, it is useful to compare the year-to-date performance of different classes of commodities with that of emerging market and developed market equity indices (see Chart 6 below). The first thing to note here is that, overall, commodities have been surprisingly resilient despite market turmoil; a good part of this result can be attributed to continued strong emerging market demand growth. Standard & Poor’s GSCI Total Return Index, which tracks 24 commodities, is up 0.4 per cent year to date. That compares with a fall of more than 10 per cent in the MSCI World Index (which includes only developed country equities) and an almost 25 per cent drop in the MSCI Emerging Markets equity index.

Turning to the performance of commodity sub-indices, it is evident that they diverge sharply with respect to one another and relative to the EM and DM equity indices. The price performance of industrial metals has very closely tracked that of EM equities, with both asset classes falling by almost the same amount year to date. This is not surprising considering that industrial metals such as copper are among the most financialized of commodities and therefore the most subject to swings in investor sentiment; in addition, EM equities are considered "risky" assets and are likewise vulnerable to the back and forth of risk-on/risk-off trades.

At the other extreme, precious metals have outperformed all other commodity classes and equities. However, like industrial metals, gold and silver are much financialized and remain tied to market sentiment, though in an inverse way. Given these characteristics, we believe that the outlook for base metals and for precious metals is one of continued extreme volatility as long as the uncertainty regarding the Eurozone crisis and Chinese growth continues. In the meantime, we expect China to continue to opportunistically restock raw materials. For example, Chinese copper imports hit a 16-month high in October and are expected to rise again in November.

By contrast, energy, agriculture and bulk commodities (such as coal and iron ore) have been driven more, on a relative basis, by supply and demand fundamentals. Energy is up for the year, as the oil market has had to deal with supply disruptions in Libya, Syria and the North Sea amid still relatively strong demand. We expect oil prices to remain supported over the next year on continued supply tightness, including a possible embargo on Iranian oil and the stoppage of oil exports from Southern Sudan.

Agricultural commodities have been the second-worst performing subclass after industrial metals, falling almost 20 per cent year to date. However, much of this decline has been driven by fundamentals, in particular a glut of wheat on the back of strong harvests in the Black Sea region and the return of cheap Russian and Ukrainian wheat to the export markets after last year’s export ban. The increase in Black Sea cargoes has hurt exports of relatively more expensive US and West European wheat, which has resulted in CBOT wheat prices falling more than 20 per cent this year. That compares with a decline in corn prices of just over 4 per cent over the same period, with supplies in that market remaining tight relative to demand. Overall, however, the drivers of the agricultural bull market remain in place, with grain stockpiles still relatively low – next year corn stocks are expected to be the lowest since 2006-07, according to the USDA – and demand from emerging markets continuing to grow.

We expect coal and iron ore, both of which are not easy for financial investors to invest in, to continue to trade on fundamentals. After largely holding steady in Q2 and Q3, prices of thermal coal have fallen 9 per cent since October on the back of higher inventories at Chinese power plants and lower imports of Indonesian coal to India after an increase in Indonesian coal export prices. We believe that demand from India and China will support higher prices going into next year – India is suffering from a domestic coal production crisis and depends on imports, and China will continue to import coal when international prices fall below domestic prices.

Similarly, iron ore prices are being driven more by fundamentals than by market sentiment. Prices have swung dramatically in recent weeks, falling more than 30 per cent in October as Chinese steel mills went on a buyers’ strike (see the November strategy monthly) before recovering 25 per cent in the first half of November and then falling off again. Chinese iron ore inventories are at a record high, but we believe that import demand will recover as China begins easing policy and that this will support prices in an environment in which global supply remains constrained.

Country strategy and portfolio allocation

• Brazil – We raise the outlook to neutral in response to the authorities’ proactive efforts to boost growth. We remain negative, however, on the outlook for inflation and the economy in H2/12.

• Russia – We retain a moderate positive outlook with a strong conviction on Russian oil stocks. We think Russian growth will be relatively immune to a Eurozone breakup scenario.

• India – Slowing growth amid high inflation and deteriorating sentiment leave no reasons to become more positive on the outlook. We retain a moderate negative rating.

• China – Declining inflation, expectations of policy easing and cheap valuations make Chinese equities look attractive. We retain a moderate positive outlook.

• Taiwan – We rate Taiwan’s prospects as neutral due to a deteriorating external environment.

• Indonesia – We expect Indonesia to remain a top performer in view of a sustained domestic consumer boom and strong demand for the country’s coal exports in China and India. We keep a moderate positive outlook.

• Turkey – We retain a neutral rating on Turkey even though we do not believe it will suffer greatly from the fallout of a Eurozone breakup. The contagion effect will likely keep investors on the sidelines for now, however.

Brazil

Brazil’s near-term outlook has become clearer over the past month even if the longer-term picture appears murkier. Monetary policy is firmly on the path to continued easing as evidenced by the statement issued earlier this week when the Banco Central (BC) reduced its SELIC policy rate by another 50 bps to 11 per cent. Meanwhile, fiscal and trade performance continues to be relatively strong though substantial deterioration is on the cards for 2012. The government’s decision this week to reduce taxes on appliances and portfolio investment inflows highlights a policy activism that is uncharacteristic for Brazil.

The BC’s proactive role in responding to the developing global recession reflects the bank’s priority under the leadership of Alexandre Tombini to sustain growth over reducing inflation. This marks a fundamental shift in policy in comparison with earlier BC presidents, such as Arminio Fraga and Henrique Meirelles, who elevated the fight against inflation to the top of the BC’s priorities. We think Tombini’s initiative is moving policy into a blind alley that will result in higher future rates of inflation.

The reason why inflation has in the past been the top priority of the BC is that Brazil’s politicians have shown little ability or inclination to rein in spending. Investors have no reason to believe that they have turned over a new leaf. For now, however, Tombini’s new focus has been received positively by the markets because there is as yet no evidence against a critical assumption of this policy – that global recession will dampen domestic inflation.

We take a more sceptical view than the consensus on the inflation outlook. We think inflation will come down but only marginally, to around 6-6.5 per cent in six months’ time. This limited improvement will partly reflect the impact of supply-side bottlenecks, especially labour shortages. But it will also be influenced by a weak Real and a significant fiscal stimulus that is in the pipeline. The Rousseff administration has already outlined a series of fiscal measures to boost aggregate demand next year via tax breaks for labour-intensive industries and a sizeable 14.3 per cent hike in the minimum wage. The minimum wage acts as a reference for 30 million workers and 20 million pensioners, so it has a very broad impact on consumer demand. The recent tax reductions will cost the Treasury an estimated R$7.5 billion (US$4.2 billion) over the coming year.

We expect the BC’s SELIC policy rate to be below 10 per cent and heading towards 9 per cent by Q2/12 but inflation will still be over 6 per cent, close to the bank’s upper inflation targeting band of 6.5 per cent. If growth is weak and below the government’s 3 per cent target we think the BC will continue easing, reflecting a view that action to boost growth is more important than fighting inflation. However, if growth is above 3 per cent we think the BC will put its easing policies on hold. Where policy goes from here is unclear. We do not think the BC will be inclined to tighten monetary policy either by pushing rates back up or by re-imposing macroprudential policies on the banks because inflation would be at the upper inflation targeting band (even though well above the announced 4.5 per cent goal). One thing that can be predicted with some confidence is that a tightening of fiscal policy is quite unlikely. With local elections scheduled for October 2012, Dilma’s government will look for ways to boost spending, not to cut it.

What is important for investors over the next six months is that inflation will remain relatively high and the government and BC will lean towards stimulus at the cost of future inflation and fiscal erosion. We have raised our outlook for Brazilian equities to neutral from moderate negative because we think markets will ignore medium-term inflation risks in the context of a gloomy global economic environment. In six months’ time, however, we anticipate that sentiment will turn negative in reaction to evidence that inflation remains high. This means equity markets will hold their own in the near term, but that the necessity to tighten policy to cap inflation will limit longer-term performance.

Among sectors, we implement a more defensive allocation, raising consumer staples and utilities to moderate positive. We continue consumer discretionary at neutral because prospects for home builders (which represent a significant weighting in the sub-index) will benefit from government support programmes for housing. A weak near-term outlook for hard commodities will adversely affect materials stocks; we keep a moderate negative outlook.

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

Russia

Although Russia is often lumped in with the economies on the European periphery most exposed to the Eurozone crisis we believe this is a misreading of its economic vulnerabilities via trade and finance.

One reason why many investors shun Russian equities is a perceived vulnerability of the economy to volatile oil markets. Some degree of vulnerability exists (even if frequently overrated), but as we explain below Russia’s oil resources are a major plus for both fiscal performance and the balance of payments in current market conditions. A second “fear factor” on the part of some investors is the apparent financial dependency of Russian borrowers on European capital markets that was on prominent display during the 2008-09 crisis, dragging the economy into recession. There are compelling reasons to think this dependency is substantially less today than during the previous crisis.

To be sure, Russia exports a large share of its oil output to Europe. But despite expectations of a weakening oil market crude prices have remained firm. In Russia’s case other factors have pushed up the price of Urals. These have led to the disappearance of the traditional pricing discount of Urals to Brent crudes. In part this is explained by technical factors such as the greater suitability of Urals for the needs of European refineries that are today short distillates – Urals provides a much higher yield of fuel oil than traditional Brent mixes. Support for Urals has also come from political developments inasmuch as Urals competes in the Mediterranean region with Iraqi crudes that have experienced supply disruptions and with Iranian crude that is threatened by sanctions.

Financial linkages between Russia and Europe are strong but a repeat of what happened in the previous crisis is unlikely. In 2008 Russian banks and companies were hard hit by the crisis due to outsized maturity exposures in Eurobonds and syndicated loans that proved difficult, even impossible, to refinance. This time around the crisis has been widely anticipated and exposures hedged. Russian borrowers have built up high levels of foreign assets (at around US$40 billion compared with US$57 billion in external debt repayments due in the period December 2011 – June 2012). In addition many obligors have already hedged prospective FX exposures via derivative transactions. This has been reflected in the unexpectedly high levels of private capital outflows during Q3/11. An additional reason to think that the European crisis will have a limited impact on Russian growth is that the government stands ready to provide funding via state banks such as Sberbank and VTB for any firms that encounter difficulties accessing financing.

Our base case for the economy foresees stable growth at around 4 per cent this year and next with a strong current account surplus and small fiscal surplus of 0.5-1 per cent of GDP this year and a similar-sized deficit in 2012. Inflation that came down rapidly this year will level off around 6.5 per cent. Monetary policy will continue to be tight with modest but positive real interest rates, limited intervention in FX markets and ample liquidity provided by the Central Bank and the Ministry of Finance. A stable oil price will provide sufficient fiscal revenues to limit erosion in the budget balance while relatively low inflation should lead to greater upward flexibility in administered prices, especially for electric utilities.

Our strong conviction positive call for the forecast period is Russian oil stocks. The combination of a stable oil price along with a cheaper ruble will translate next year into strong earnings momentum for the sector. In addition, a number of the oil majors have implemented improved dividend policies that should help buoy valuations. We remain positive on financials although we have trimmed the outlook to moderate positive because of the European crisis. The banks are vulnerable to negative sentiment coming from Europe even though there is limited dependence on external funding. Recent earnings releases illustrate the positive case for the large state banks. For example, this week Sberbank reported a 76 per cent rise in third quarter earnings, which reflected a return on equity in the first nine months of 2011 of 31.6 per cent and Tier 1 capital of 13.2 per cent. Few banks anywhere come close to these achievements.

In other sectors we initiate a call on utilities with a moderate positive outlook. This call is driven by our judgment that the sharp fall in inflation will substantially reduce administrative interference in setting electricity tariffs. The profitability of the sector should benefit materially. Last month utilities along with telecoms were the major outperformers. We reduce consumer staples to neutral; due to the deceleration in revenue growth we view the sector as overvalued after earlier outperformance. We reduce materials to moderate negative after disappointing earnings performance and less bullish prospects for prices of hard commodities.

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

India

India is currently experiencing a marked slowing of economic growth amid continuing high inflation and deteriorating sentiment about the outlook. GDP growth for the quarter ending in September fell to 6.9 per cent, the slowest pace in over two years. Meanwhile inflation has remained high at 9.7 per cent with little sign that the Reserve Bank rate hikes have reduced inflationary pressures.

Although the Indian economy is less dependent on exports than either China or Russia this has not acted to boost confidence that policy actions will be able to steer the economy away from further declines. There is widespread pessimism about Prime Minister Manmohan Singh’s efforts to restore confidence after a string of corruption scandals and evident inability to push his reform agenda. The recent decision to allow 51 per cent FDI in multi-brand retail came after many years of policy paralysis. Opposition parties disrupted the sitting of parliament more as a demonstration of the weakness of the government than as a protest against the measures themselves. After the high expectations of recent years the surge of negative economic sentiment is felt particularly acutely even though India still enjoys a relatively rapid GDP growth rate in comparison with other emerging economies.

The contrast with 2008-09 provides partial answers to some of the policy problems faced by the Singh government. The previous crisis hit when the economy was coming out of a boom in which high tax receipts were creating space for fiscal stimulus. The situation today is that the fiscal deficit is quite high at a time when the economy is slowing. The room for fiscal stimulus is severely restricted, reflecting the legacy of past populist policies enacted by Congress Party-led coalitions. Another major difference is the emergence of structural inflation due to supply-side bottlenecks rather than excess aggregate demand. The policy response to inflation has been driven by monetary tightening, which has negatively affected investment but with little impact on inflation. The country today finds itself in a much worse position than in 2008-09 because there is virtually no room for monetary or fiscal stimulus.

The policy prescription is clearly to begin addressing supply-side bottlenecks by pushing reforms and dismantling the many subsidies − i.e., by fiscal consolidation. But this appears to be unfeasible for political reasons. Using monetary policy to fix structural inflation merely undermines overall growth with little benefit in reducing inflation. The bottom line is that there is no quick fix to India’s inflation problems or to slowing growth unless structural reforms are pursued with a vigour that the current government sadly appears to lack.

While there is a case to be made that economic sentiment is unduly bearish – India does after all rank near the top of the EM growth league – it is hard to find reasons other than short-term technical ones why Indian equities should outperform other EM markets. Last month the Indian market was the worst performer among the countries that we monitor. There may be room for a technical bounce from last month’s dismal performance, but the longer-term prospects are still uninspiring. We retain a moderate negative outlook on the overall market.

Among sectors, consumer staples continued to outperform and we retain a moderate positive outlook. Over the past 12 months consumer staples have outperformed the overall MSCI India Index by approximately 25 per cent. No other sector comes close.

We keep a moderate negative outlook for both financials and basic materials. With slowing growth, bank NPLs will continue to rise, depressing bank profitability. We expect materials also to lag due to slower growth.

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

China

Debates about risks of a hard landing for China revolve primarily around exports and property. We are definitely in the soft landing camp, though we have trimmed our 2012 GDP growth forecast to 7.5-8 per cent to reflect a more pessimistic view of prospects for European growth in 2012 (-1 per cent for the EU27).

In comparison with 2008 when Chinese GDP growth fell precipitously in the final quarter of the year, the dependence of the growth rate on external demand has been cut in half – before the 2008 crisis net exports contributed about 20 per cent of total GDP growth; currently net exports account for only 10 per cent. For 2012 we forecast that net exports will subtract as much as 1.5 percentage points from the overall GDP growth rate, roughly 40 per cent of the negative impact of net exports on GDP growth in 2009. The main difference this time around is that the US is expected to sustain modest positive growth of about 1.5 per cent; the crisis will affect growth primarily in Europe. Another major difference is that the inventory cycle will be less severe than in 2008 when many firms went out of their way to inflate inventories ahead of the August Beijing Olympic Games.

As they did in 2008-09, we anticipate that Chinese policymakers will move proactively on signs of slowing demand and waning economic sentiment. The decision to cut banks’ reserve requirements by 50 bps this week provides evidence of this. The cut was accompanied by action by five central banks, led by the Federal Reserve, to reduce the cost of dollar funding for European banks. This highlights the willingness of China’s monetary authorities to join globally coordinated policy initiatives, though there is undoubtedly still a reluctance to take unilateral action to help bail out Eurozone banks, as many have urged.

One difference this time around is that the authorities have much less room for manoeuvre than during the last crisis. Chinese policymakers are acutely aware of all the economic imbalances caused by the massive expansion of bank credit in 2009. We anticipate that a new stimulus will be targeted on the social housing, water supply and irrigation, consumption and high-tech sectors. In the case of social housing the aim is to provide central funding to the many local authorities that are strapped for funds. Such initiatives can be expected to have a quick payoff in view of the availability of resources due to the slowdown in commercial property development.

There is little doubt that the commercial property sector has entered a broad-based slowdown, but this does not imply that the government will step in to bail out the many private developers that have their backs to the wall. Our expectation is that restrictions on the commercial market will remain in place in order to stop the escalation of property prices, to force a consolidation among developers and to dampen speculation. While the evidence of a growing weakness in housing starts and sales is widespread, only two out of 70 medium and large cities have so far shown year-on-year declines in prices. Government policy easing will be targeted, with a likely focus on helping first-time buyers; restrictions on the purchase and financing of second and third dwellings will remain in place. We anticipate that property prices will decline up to 20 per cent in first-tier cities and up to 10 per cent in second- and third-tier cities.

The annual Work Conference that takes place in early December will set out the guidelines for monetary policy for the coming year. We anticipate that the annual target for bank lending will be raised to Rmb8-8.5 trillion, up about 10-15 per cent compared with this year’s level. We also expect to see further gradual reductions in reserve requirements, but no changes in interest rates (deposit rates are still negative in real terms).

We retain a moderate positive outlook on Chinese equities based on declining inflation, expectations of further policy easing and cheap valuations. Among sectors, we retain a moderate positive outlook for energy that will benefit from recent hikes in energy tariffs. We also keep our positive outlook for consumer staples, the top-performing sector last month. We reduce consumer discretionary to neutral in expectation of slowing car sales. Financials will benefit from the initiation of monetary policy easing; further reserve requirement reductions should follow at periodic intervals. We keep our moderate positive outlook.

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

Taiwan

With every investment bank analyst revising down forecasts for developed economies, the key question for the outlook is how Taiwan will weather the global slowdown. Export orders increased 4.4 per cent year on year in October, which was higher than September's 2.7 per cent. Markets responded positively to these data, believing that export momentum will be stronger than earlier expected. We disagree. We think that underlying external demand is still fragile due to global uncertainties and risk aversion.

We believe that the recent rebound of export orders is driven mainly by a rise in US demand associated with the rebuilding of inventories from low levels. US retail consumption has grown 8-12 per cent since January, but importers have kept inventories low, indicating caution and lack of confidence in the outlook for consumer demand. As a result there has been an increase in last-minute orders driven by short-term changes in sales volumes. This new pattern of ordering has put Taiwanese manufacturers at a disadvantage because it hinders the optimization of their labour and capital resources, with adverse implications for profits. Seasonally driven demand may help Taiwan's exports in the near term but the longer-term outlook remains uncertain, which discourages new investment.

In labour markets the weakness in the current situation has depressed consumer confidence because of worries about potential layoffs and reduced-time work. The unemployment rate remained stable at 4.3 per cent in September-October and regular income (excluding any bonuses) is still growing (up 1.9 per cent, the 23th consecutive month of positive growth). But concerns about the future are rising. Monthly working hours are declining, highlighting the fragility of labour markets – hours worked in September were 11.5 hours less than in August, though this figure is only down 1.1 hours compared to the same month last year.

As we highlighted last month, the emergence of mandatory unpaid leave has raised concerns whether consumption in 2012 will be sustained at current levels. According to the Council of Labour Affairs, 85 companies imposed mandatory time off as of 30 November though the figures are viewed by the market as significantly underestimated. The response of the administration has been to announce a plan to provide an additional 20,000 temporary jobs to cushion the deteriorating labour market and boost consumer sentiment.

These measures address short-term issues but do not tackle longer-term structural problems that prevent many manufacturers from moving up the value chain via investments in new technologies and innovation. The economy remains vulnerable to the volatility in external demand and competition with other Asian exporters such as China and Korea. There is little prospect that this situation will change next year. The manufacturing sector will remain dependent on short-notice, urgent export orders until growth in Taiwan’s major external markets stabilizes.

Given poor growth prospects for developed markets, we retain a neutral outlook for Taiwan’s equity market during the forecast period. We expect the government to respond to weak external demand by expanding the current programme of providing short-term employment and training to upgrade skills. This should help sustain retail consumption. Foreign investors continue reducing exposures in Taiwan, though the overall scale of net selling in October was less than in August and September. The Financial Supervisory Commission, under guidance from President Ma’s office to reduce market volatility, on 22 November announced a cap on short-selling (to be limited to 20 per cent of the previous 30-day trading average volume). This measure may have a short-term impact on the market but it is not likely to have a lasting effect on equity market performance – where recovery will depend on global economic recovery.

Turning to our sector calls, we retain a moderate positive outlook for telecommunication services, consumer staples and consumer discretionary. IT and financials remain at neutral.

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

Indonesia

Indonesia was the top performer in a weak November market in line with our expectations. We expect this outperformance to continue for the forecast period because Indonesia is relatively well positioned for a global slowdown: its domestic growth drivers remain strong, inflation remains subdued and Bank Indonesia (BI) continues its monetary easing.

BI surprised markets by cutting its rate by 50 bps on 10 November (we expected a 25 bps cut). We believe BI is easing aggressively because it thinks inflation is on a downward trend as a result of the economy’s improved growth potential and it expects a slowdown of external demand (see our 18 November note).The global outlook has worsened substantially since last month. As a result, BI has lowered its 2012 growth forecast to 6.3 per cent from 6.5 per cent.

The effects of the global slowdown appeared for the first time in the October export numbers, which showed non-oil export growth slowing to 20.3 per cent year on year from 46.3 per cent in September and 35.9 per cent in August. Imports are still robust, growing at 29.1 per cent year on year, down from 46.3 in September (but up from 23.9 per cent in August).

At the same time, November inflation declined further: the headline number fell to 4.2 per cent from 4.4 per cent in October. We believe that the more negative growth outlook and lower inflation will drive BI to cut its rate further. Its only concern will be the effect a lower interest rate will have on the currency and capital inflows. However, for now, BI is confident that it will be able to intervene effectively to stabilize the currency and sovereign bond prices. We therefore expect a 25 bps cut at BI’s 8 December meeting and, unless the currency depreciates substantially, a further 25-50 bps reduction before March 2012.

This aggressive monetary easing spells trouble for inflation in H2/12 (see our note), but in the short term inflation is likely to remain subdued (partly due to base effects) and lower interest rates help to sustain domestic demand amid slowing external demand. Domestic growth drivers are active – retail sales, credit and investment growth are strong and consumer confidence is at a record high. Consumption should be further boosted by a 20 per cent wage increase for public sector workers as well as an 18.5 per cent minimum wage hike in Jakarta. We therefore expect growth to remain at 6-6.5 per cent in 2012, unless the global slowdown is worse than our already pessimistic expectations.

Although we remain positive on Indonesia’s short-term growth outlook, the prospects for reforms to move it onto a higher growth path (in line with BI’s assumption on the growth potential) continue to be grim. The government’s capital spending continues to lag, with only 32 per cent of the meagre budget spent by September. The draft Land Acquisition Bill is now ready to be submitted to the President for his approval and then will be sent to parliament in mid-December. Even though the bill is supposedly a priority for both the parliament and the President it could take another six-12 months to become law. Meanwhile there are more signs of a worsening investment climate and increasing protectionism and cronyism, particularly in the mining and energy sector. The government announced plans in November to add a clause to the oil and gas law that will give Indonesian firms priority in taking over the expired contracts of foreign firms.

Energy was the strong underperformer this month. We had not anticipated the decline of coal prices that began in October but think it is overdone in view of continuing strong Indian demand. We therefore maintain our overweight on energy. We continue to be bullish on the consumption sector given the recent boost to purchasing power by wage hikes and low inflation. Financials should continue to benefit from buoyant loan growth and high interest rate margins. Overall we rate Indonesia moderate positive.

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

Turkey

Investors’ concerns about the Turkish economy largely centre on the current account and interest rate policy. For example, Fitch downgraded the Turkish country rating outlook from positive to neutral, citing worries that the financing of the country’s large current account deficit may lead to a sudden credit stop. We think this is the wrong question to ask; after all, if financing dries up there would not even be a current account deficit. The relevant issue is Turkey’s capital account and the source of capital inflows. In this regard we are impressed with the breadth and depth of capital inflows. In the wake of the Arab Spring Turkey received significant inflows of private wealth; some of these inflows were recorded in the standard balance of payments lines but many wound up in “errors and omissions”, i.e., unrecorded capital inflows. Turkey’s current account deficit in Q3/11 was US$16.3 billion while errors and omissions were a positive US$3.7 billion, or 23 per cent of the deficit.

Turkish banks also are in a secure position with regard to funding. In part this reflects the legacy of the 2001 crisis that led to the imposition of tough regulations on the banks (for details on the banks see our report). As a result, Turkish banks have capital levels far in excess of banks in most other countries, whether emerging or developed. Paradoxically Turkish banks stand to benefit from the current crisis both through flight capital inflows from Eurozone depositors and from the diversion of Arab deposits out of Eurozone banks. Of course none of this means that Turkish banks are immune from potential losses if they make bad loans to domestic consumers, but claims that the large current account deficit could precipitate a banking crisis are far fetched.

The Central Bank of Turkey (CBT) expects the current account deficit to improve beginning in Q1/12 from a record 10 per cent of GDP. The bank bases this assessment on an evident slowdown in the growth of domestic credit. The CBT is now tracking what it calls “the tendency” in credit growth; these are simply shorter-term moving averages. The latest measure of this indicator shows a decline in total credit growth to 20 per cent on a four-week average basis or 10 per cent on a 10-day moving average basis (both at annual rates). These data point to a sharp decline in credit growth that will likely be confirmed when the official end-year figures are released.

A recent government decision to hike excise taxes and selective VAT rates, together with lira depreciation and higher food prices, has put upward pressure on consumer prices. The administered price hikes associated with the special consumption taxes pushed inflation up by an estimated 1.35 percentage points in October. We expect another above-trend increase in November’s inflation rate. On the positive side, the government announced its commitment to consider VAT reductions, mainly on food prices. The government has already cut VAT on meat and wheat prices to 1 per cent from 8 per cent in an attempt to counter trade in the underground economy. We believe consumer price inflation in December will reach 9 per cent, slightly above the 8.8 per cent upper end of the CBT’s forecast band. Next year we forecast inflation at 7.5 per cent.

Our view is that the CBT is confident that bank credit growth is now approaching acceptable levels. Rather than abandon its controversial monetary policies, the bank is attempting to increase the transparency of its market-related actions. For example, the CBT is now pre-announcing its FX and weekly repo auctions. Another sign that the CBT is sticking to its unorthodox policies can be seen in the renaming of its inflation targeting regime to “IT++”, meaning that the monetary policy regime incorporates both an inflation targeting band and a goal of financial stability. We think this means that the CBT will target a policy rate (5.75 per cent currently) as well as a macroprudential policy mix encompassing required reserve ratios and other liquidity management tools. The focus of the new regime covers both credit and currency conditions.

At its November MPC meeting the bank did not change its one-week repo and overnight lending rates but did indicate that unexpected liquidity conditions will now be controlled by alterations in weekly funding amounts, i.e., not by interest rates. This policy targets volatility in the FX market. The planned lower limit of the one-week repo funding amount will be announced bi-weekly. By pre-announcing details of its auctions the CBT is aiming to rebuild market confidence. The bank will now announce the upper limit for the volume of FX selling auctions two days in advance to increase predictability.

How all these measures will affect the exchange rate is unclear. In a surprising comment Governor Basci said that the Turkish FX market is not overly volatile. He based this on comparisons with other emerging markets, namely South Africa, Brazil and Hungary. Basci said that the critical level for FX market volatility is 1 per cent per day and that daily volatility of the Turkish lira is currently below this level, unlike the situation in the aforementioned countries. The implication is that the CBT may tolerate further depreciation of the lira provided it is gradual and not volatile.

We retain a neutral outlook on Turkish equities. We do not think the Turkish economy will suffer substantially from the continuing turmoil in the Eurozone. We forecast GDP growth next year of 3.5-4 per cent, a figure that is in line with government expectations though above market consensus. Among sectors, we see positive prospects for energy and electricity in 2012 associated with prospective privatization initiatives for Gediz Electricity and Baskent Gas. Moreover, Russia’s Gazprom has expressed an interest in investing in the Turkish electricity market. We upgrade industrials to moderate negative based on expectations of expanding export sales in the Middle East.

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

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