EM Strategy Monthly

January 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 5 January.

Our next Strategy Monthly will appear on 3 February.

Overview of 2011 performance

In a year that was marked by the upheavals of the Eurozone crisis it was emerging market equities that took it on the chin in terms of performance. Any uninformed person viewing the picture conveyed by Chart 1 would immediately conclude that an even worse calamity than the Eurozone debacle must have hit the emerging markets as a group. But this is demonstrably untrue.

Although some EM economies performed better than others, overall EM economic performance was better than in developed economies on almost every conceivable creditworthiness measure: economic growth was higher, fiscal deficits were lower and public debt burdens (measured by public debt to GDP) ended the year as a fraction of those in developed countries. True, inflation was generally higher in the emerging world but EM central banks from China to India and Russia have responded with tightening measures to dampen inflationary pressures.

Looking into the future we think the interaction of demographic and economic factors will heighten the divergence of growth drivers in developed and emerging economies. As Arjun Divecha of GMO Emerging Markets has noted in a recent op-ed, a record number of people are moving into their earning years in emerging markets at the same time that developed market baby boomers are starting to retire. He concludes that “the world is in the middle of a massive shift in demand from the developed world to emerging markets”.

We would hasten to add that it still makes a great difference which emerging markets those who accept Divecha’s argument go into. Equity performance last year in individual countries may be divided into three broad groups (all returns are measured in dollar terms). Indonesia’s 2.8 per cent total return puts it in a class by itself. In effect Indonesia has decoupled from troubles caused by the current crisis. The next group of countries includes three of the BRICs plus Taiwan. Their total returns range from minus 21 per cent in Russia and China to minus 25 per cent in Brazil. The third group of laggards includes Turkey and India, where declines of over 37 per cent in equity returns for the year were recorded.

Source: Bloomberg.

Cynics will immediately suggest that investors in EM equities may count on being fleeced no matter how compelling the investment case for this or that market may be. Others are likely to counter that market valuations became “temporarily” detached from underlying fundamentals last year as a result of the “risk-on”-“risk-off” mentality that gripped markets. This of course is an ex-post facto rationalization and begs the question of when markets will again begin paying attention to the fundamental valuation drivers that we all learned about in Investing 101.

A final group of incurable optimists, which includes us, would nonetheless offer the observation that last year’s dismal results mean that equity valuations in emerging markets are now unusually compelling. Burton Malkiel, the well-known author of “A Random Walk Down Wall Street”, noted in a recent “Wall Street Journal” op-ed that price-earnings multiples of emerging market equities have gone from 20 per cent premiums to developed equities to similar sized discounts. He also pointed out the EM debt carries significantly higher yields than do developed sovereign bonds. We would add that the fundamentals underlying the creditworthiness of most EM sovereigns are substantially stronger than for most developed countries.

Portfolio strategy

Global themes

The roadmap for EM investors contains more that its usual share of potholes in 2012

Less than one week into the new year and all the good cheer that seemed to accompany the holidays has already dissipated. The “feel-good” rally lasted all of one day before news hit the wires that Spain had botched its forecast for last year’s fiscal deficit by a whopping 2 per cent of GDP. This greased the skids under the markets and pushed equity prices down sharply and bond yields up. Markets earlier appeared confident that Spain was different than Greece; now they are not so sure.

In Greece Prime Minister Lucas Papademos threatened the unions that if they do not agree to cut annual pay by as much as the equivalent of two months’ earnings the country could end up in a disorderly default by March. To lighten the mood an unnamed IMF official was quoted as saying that the 50 per cent private sector debt reduction deal under negotiation, which Papademos described as “exceptionally crucial”, may not be enough to meet the Fund’s target for debt sustainability (i.e., the limit of 120 per cent of GDP by 2020). The implication was that the Fund may go back to the drawing board before making a decision on its next disbursement. To cap this week of surprises the head of Greece’s central bank raised for the first time the possibility of leaving the Eurozone and returning to the drachma. Even though this possibility was advanced as a threat to recalcitrant labour and employer organizations to get their agreement on new austerity measures, the topic has until now been taboo.

In what we may soon be calling the “nordeurozone”, policymakers appear bent on their version of seppuku also known as the renewed “Stability and Growth Pact” that was approved at the EU summit held on 9-10 December. For his part in this celebration of austerity France’s President Nicolas Sarkozy announced that his government would accelerate the adoption of a financial transactions (Tobin) tax before the presidential elections in April. In his new year address Sarkozy said the financial sector “must be made to participate in the repair of the damage it caused”. Going ahead with such a tax on a unilateral basis would not only undermine the earning ability of French banks but also accelerate the exit of banking activity from France to abroad, especially to the City of London. This looks very much like an own goal in favour of the UK’s David Cameron, who vetoed the December communiqué.

I have already spelled out my views on prospects for the Eurozone in detail in the last two Monthly Strategy reports in November and December, so here I offer only a brief summary:

1. Austerity by itself will not restore growth to overindebted countries such as Greece and Italy. Without growth such countries will not be able to eliminate their debt overhangs. The option of debt restructuring with longer maturities and lower interest rates will be rejected, unwisely in our view, everywhere except Greece.
2. Greece’s efforts at austerity will sooner or later collapse, resulting in a decision to leave the euro. On present trends this will happen by midyear.
3. Restoration of economic growth in other periphery countries requires far-ranging structural reforms, including bank recapitalizations and the elimination of restrictive labour market practices. Whether such reforms can be implemented is uncertain owing to strong opposition from entrenched interest groups such as labour unions and public employees.
4. This means the present crisis will be protracted, possibly for another 4-6 years, until a resolution of the crisis one way or another is reached. The Eurozone (minus Greece) will continue to exist but it will experience a low-level permanent crisis because of the lack of a fundamental resolution of the region’s debt overhang.
5. The single-minded pursuit of greater austerity with the goal of ultimate fiscal union will lead Europe into a prolonged recession. Bank deleveraging will amplify these recessionary trends as the interbank market shrinks and the ECB is forced to step in to recycle internal liquidity within the Eurozone.

We draw several implications from these points for investors in EM securities. One is unsurprising: markets will suffer abrupt swings in sentiment during the coming 3-4 months as a result of uncertainty about how the crisis will play out. The second is that non-Eurozone markets will gradually be able to decouple from events in Europe provided that:

1. The costs of the crisis are imposed and borne by the various participants, whether the national governments (i.e., the taxpayers), the banks, the ECB or various separate interest groups (labour unions, public sector employees, savers).
2. Countries are able to demonstrate their ability to grow notwithstanding continuing turmoil in the Eurozone.

If we are correct in our call that Greece will eventually leave the Eurozone, for example, then when that happens the costs of failure will have been imposed (unfortunately most haphazardly and mostly on the country’s citizens) and we will then learn how widespread the contagion to other countries will be. Uncertainty about both events is already present as is widespread market scepticism that both events can be avoided by adhering to the current austerity strategy.

These events, if they do occur may of course lead to new uncertainties, but failure may also force the adoption of new policies that actually improve the outlook, such as debt restructurings involving longer maturities and lower interest rates that distribute the inherent “losses” in a more equitable way and over a longer time. The present Eurozone strategy to deal with the current crisis appears in our judgment incapable of avoiding significant losses via the imposition of Teutonic-style austerity in the peripheral countries. But as long as Eurozone policymakers remain in denial about the potential losses associated with the region’s debt overhang, a relatively painless resolution to the crisis will remain out of reach.

My second point is perhaps more controversial. There has been no evidence during the recent crisis of any financial market decoupling – indeed markets have become even more correlated. My argument is that this state of affairs cannot persist if individual economies are able to demonstrate their ability to grow and prosper amid continuing Eurozone turmoil. The fact that the US market has outperformed most other markets recently is largely due to market perceptions that the US economy will muddle through the coming year with steady, albeit moderate growth despite the lack of progress in addressing the country’s large fiscal deficits and rising debt burden.

If this is true for the US – and I am only claiming a partial decoupling – then it can also happen for those emerging markets that can demonstrate sustained growth over the coming months. At the moment there is little conviction among investors that the emerging economies will in fact be able to avoid being caught up in a spreading global economic crisis. That risk is clearly a major worry, which is why caution is appropriate during the coming 3-6 months. It will obviously take time, but by H2/12 we should be in a position to know whether the current crisis has turned into a global economic meltdown or whether it is largely confined to Europe with limited fallout elsewhere. That will be the time when emerging markets may have an opportunity to return to outperformance.

Our judgment is that most emerging economies will be able to sustain growth based on domestic growth drivers or (in the words of Arjun Divecha that I quoted earlier) that we are in the middle of a massive shift in demand from the developed world to emerging markets. Investors will need to have patience but they will be rewarded in the end.

The year ahead for commodities: Geopolitical risks, China demand shifts, supply disruptions and other factors to watch

After a 12-month period of extreme volatility across all raw material markets, which were without exception buffeted by rapidly shifting risk appetites and waves of pessimism and optimism over the Eurozone crisis and China’s growth prospects, 2012 began with markets slowly starting to come round to our view that China would achieve a soft landing later this year. The more constructive view about growth in China, which has been the key driver of demand for hard commodities, and stronger oil prices on the back of heightened tensions over Iran helped the benchmark S&P GSCI Total Return Index, which tracks 24 commodities, end the year up by almost 4 per cent (see Table 2).

As measured by the S&P GSCI Index, commodities had a seesaw year. After being up by more than 15 per cent year-to-date in April, commodities then fell to a negative 10 per cent return in October as fears of a global slowdown and of a hard landing for China peaked; they finished the year having outperformed both developed and emerging equity markets. Among the commodity sub-indices, industrial metals and agriculture have underperformed while precious metals outperformed, as has energy, which has the largest weighting in the overall index.

Source: Bloomberg.

Looking forward to 2012, we expect commodity markets to continue to be volatile as sentiment overrides fundamentals even though we believe that supply remains constrained for key commodities, including oil and copper. We believe that although Europe will fall into recession, the US economy will muddle through, China will achieve a soft landing (as we spell out in the China section below) and other emerging markets will continue to grow relatively strongly. Against that backdrop we will be looking particularly closely at the following drivers of commodity markets over the next 12 months:

Geopolitical risk: This heads the list in a year when escalating tensions in the Gulf could result in sharp swings in oil prices. This risk is heightened now that Europe has agreed to impose a ban on imported Iranian oil and Iran has retaliated with a threat to close the Strait of Hormuz, through which approximately a third of seaborne oil trade flows. The prospect of instability in the Middle East will support prices of oil, especially since developed country inventories are lower than normal, and could have spillover effects on other commodities, including fertilizers or oil substitutes such as thermal coal and natural gas.

China’s changing commodity demand patterns: Even though we expect China to achieve a soft landing – a view supported by the recent stronger-than-expected Chinese PMI manufacturing data – the structure of the Chinese economy is changing. Investment growth in infrastructure and housing, hitherto the main drivers of China’s demand for raw materials, is falling while the emphasis shifts to boosting domestic consumption and higher-value-added manufacturing. This will impact demand for copper, iron ore and steel even though the country’s programme to build social housing and to continue building out urban infrastructure will cushion some of the decline.

Resource nationalism and other supply disruptions: Countries that are dependent on natural resources exports are acting increasingly aggressively to hike taxes and royalties or to take other measures to both increase their share of the profits and ensure adequate supply for domestic use. The most recent case is India’s decision to boost export duties on iron ore to 30 per cent in support of the country’s steel industry. The Indian action will help to support prices of iron ore even as global steel demand growth slows down. When taken together, such moves, along with the rising number of supply disruptions resulting from labour disputes or protests by local communities against mining operations will bolster hard commodities prices at the margin.

La Nina and extreme weather events: Another type of supply disruption that can severely affect commodity prices is weather-related. La Nina is back again. In 2011 extreme weather resulted in floods in Southeast Asia and Australia, shutting down Australia’s coal production and wiping out Thailand’s rice crop and undermining its position in the global auto supply chain. At issue is whether the countries (and supply chains) affected the last time round are in a better position to weather similar disruptions again.

Commodity trade finance: Overall the global trade in commodities is likely to be impacted by a shortage of trade finance, as European banks, which have traditionally dominated the market, cut back their exposure while they deleverage in order to build up their capital ratios. The speed at which US and Asian banks can pick up the slack will be the key determinant of whether commodity trade flows will be as severely hit as they were during the 2008 crisis. The evidence today indicates that commodity-financing bottlenecks are indeed emerging, but so far the overall impact is limited.

Country strategy and portfolio allocation

• Brazil – We are impressed by President Dilma Rousseff’s growing popularity and the authority that she has gained in her fight against corruption. However we keep our rating at neutral in view of concerns about persistent high inflation.

• Russia – Solid underlying economic trends are confronting rising political risk. We keep our moderate positive rating, judging that current equity valuations already reflect a sizeable political risk discount.

• India – The market has cheapened markedly in recent months and may be in for a short-term technical rebound. We retain a moderate negative rating owing to the lack of a clear programme of policy change over the next three months.

• China – Falling inflation and policy easing should outweigh concern about slowing growth. We believe in a soft landing for the economy and retain our moderate positive outlook.

• Taiwan – We find ourselves less negative on the outlook than market consensus. We think exports will hold up better than market expectations thanks to sustained demand from the US. We keep a neutral rating.

• Indonesia – We retain a moderate positive outlook but believe economic trends will turn less favourable in H2/12 as inflation rises from current low levels.

• Turkey – We think the market will lag behind other EM equities in the next three months but we foresee a better performance beginning in Q2/12. We keep our neutral rating.

Brazil

Brazil’s near-term outlook has changed little over the past month. We expect that the Banco Central (BC) will stick to its easing policy in order to sustain domestic economic growth in the face of a worsening global economic environment. We expect a reduction of 50 bps in the BC’s SELIC policy rate on 18 January; and further reductions will follow, bringing the reference rate to 9-9.5 per cent by Q2.

At the same time we remain pessimistic on inflation. The IPCA inflation index has remained above the 6.5 per cent upper target band ever since Q2/11 and we expect it will remain at 6-6.5 per cent during our 3-6 month forecast horizon. The December IPCA result just announced came in at 6.5 per cent, meeting the upper bound of the target. Although inflation will slow down a bit in the coming months and stay within the target band, we believe Tombini’s credibility will continue to erode as the market increasingly comes to believe that his policy target of 4.5 per cent is hopelessly out of reach.

Even though a reversal of policy and a move to tightening policies appears unlikely, we expect the BC will put its easing policies on hold towards the end of Q2 in the face of persistent high inflation, particularly if growth manages to stabilize at around 3 per cent. A worst-case scenario cannot be ruled out, however, one in which the BC continues cutting rates below 9 per cent in reaction to very weak economic growth. In effect this would represent the abandonment by the BC of its inflation targeting regime and would deliver a blow to market confidence.

A deteriorating fiscal position is the main factor that poses inflation risks over the course of the coming year. The government is hiking the minimum wage starting this month by over 14 per cent and public spending on major infrastructure projects is being stepped up. And there are further risks from a pending Supreme Court judgment that may rule in favour of providing full pension benefits for early retirees who return to work; this could add an estimated additional US$40bn (1.6 per cent of GDP) to budget outlays. A final spur to increase government spending will come later in the year ahead of October local elections. As a result of these various fiscal stimulus initiatives, we doubt the primary fiscal surplus will reach the 3.1 per cent of GDP target; an outcome closer to 2-2.5 per cent is more likely.

With monetary policy fixed on easing, the government will focus on sustaining growth. Its policy target will be to maintain growth at between 3 and 3.5 per cent. Q3/11 growth slowed down noticeably, to 2.1 per cent on a year-on-year measure and to zero on a quarter-on-quarter basis. Wary of the threat that the global economic slowdown may bring, the government will seek to channel increased spending through state-controlled banks, especially the country’s development bank BNDES. Such public loans are typically offered at preferential rates – 6 per cent in the case of BNDES; this further burdens the country’s fiscal accounts.

The most positive development in recent months has been the huge popularity that President Dilma Rousseff has won through her fight against corruption. We must admit that we were sceptical of the wisdom of her decision to take on corrupt politicians in the cabinet that she inherited from former President Lula. But her successes have turned into a major asset for the government. She was able to maintain tight control on expenses last year and she appears very determined to impose her authority on the fiscal initiatives that are under way this year. This has been demonstrated by her rejection of further wage and pension increases in the budget bill and her pushing for additional budget cuts and by prompt inquiries on alleged embezzlements by her ministers. Further light on Dilma’s growing authority will come when she reshuffles her cabinet in the coming weeks. The step that is still lacking is turning this enhanced authority into progress in implementing needed policy reforms to spur new infrastructure initiatives.

We retain our neutral rating on the overall market. Although we are turning more positive on the political environment, we are still worried that persistent high inflation will serve to undermine investors’ confidence because of worries about a potential hard landing in 12-24 months. Among sectors we retain a moderate positive rating on financials, utilities and consumer staples; all three sectors were outperformers last month. We were disappointed that consumer discretionary stocks lagged substantially last month but we retain a neutral rating, as we expect home builders will benefit substantially from government fiscal stimulus over the coming year.

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

Russia

Russia’s solid economic prospects have been brought into question by evidence of blatant voting fraud in the 4 December Duma elections. This led to mass protests, with growing numbers of participants at successive public demonstrations in Moscow and several other cities. The initial number of participants in the 4-5 December protests was only several thousand but the latest gathering, on 24 December, was estimated at over 75,000. Further protests can be expected.

Until these events the Russian equity market had rallied impressively, up by nearly 20 per cent during October and November. In the two weeks following the election Russian equities lost over 10 per cent and ended the month the worst-performing market among the seven markets that we monitor. Future prospects for Russian equities will now be burdened by a “political discount” associated with these new risks. The evident arrogance of self-perpetuating ruling elites that have failed to respond to the aspirations of a growing middle class of younger, well-educated citizens has re-introduced political risks that will confront investors for some time to come. The challenge facing investors is to judge whether current valuations adequately reflect the inherent dangers posed by these risks.

We do not think the current protests will turn into a Russian version of the “Arab Spring” with a lurch of society into near-term economic destabilization. Nonetheless these events point to a longer-term decline in the viability of the present system of political management based on mild authoritarianism legitimized by popular consent that is derived from the stability and economic advancement delivered by the regime.

The new political risks can probably be effectively managed if the top leadership (in the person of Vladimir Putin) applies the lessons the Chinese Communist Party drew two decades ago from the collapse of the Soviet Union: impose a rotation of the top leadership, crack down on corruption and free economic initiative from oppressive bureaucratic controls. Put another way, the weakening of the ruling establishment’s legitimacy is not yet fatal but its future viability is now in question. At the moment there is no evidence that Putin is prepared to follow this path of reform; instead he appears bent on returning to the presidency for another 12 years. Lacking such reforms, however, the present system cannot ensure stability beyond the new political cycle that is getting under way.

Amid these growing political concerns the performance of the economy has consistently outperformed consensus expectations. Preliminary data indicate that consumer price inflation fell to 6.1 per cent in December, the lowest outcome since the collapse of the Soviet Union 20 years ago. GDP last year rose by 4-4.5 per cent, led by domestic activity: retail sales were up by about 7 per cent and investment by 6 per cent. Despite the worry of some analysts that oil prices would weaken in response to a slowdown in European economic activity, this did not occur. The price for Russian crude averaged US$109/bbl last year. This helped to produce a modest fiscal surplus of about 1 per cent of GDP and a healthy current account surplus estimated at US$120 billion (6.6 per cent of GDP).

Economic prospects for this year point to a continuation of current trends: modest growth of around 4 per cent and a stabilization of inflation in the 5.5-6.5 per cent range. We expect that the Central Bank of Russia will keep monetary conditions relatively tight so as to dampen both inflationary pressures and capital outflows. Last year capital outflows reached an estimated US$85 billion, up from US$34 billion in 2010. Outflows will probably persist this year on a more modest level as firms repay debt and European banks restrict new lending. Despite significant outflows, the economy has successfully sustained steady, moderate growth rates. This is why we do not expect that recession in Europe will dampen Russia’s growth prospects this year. Tight monetary policies should translate into a stronger ruble.

In the next 2-3 months Russian equities will remain vulnerable to swings in market sentiment associated with the upcoming presidential election on 4 March and to continued Eurozone volatility. We expect Putin to easily win the election: despite the protests, he still remains the most popular politician in Russia. This assumes that Putin is elected without evidence of major fraud, albeit with reduced support compared to previous elections. Putin has gone out of his way in public comments to mock the protestors but we believe the post-election period will lead to a less confrontational posture on his part towards the public opposition. This should be positive for equity performance in the 3-6 month window following the March election. For this reason we retain a moderate positive call on Russian equities – today’s valuations already incorporate a sizeable political risk discount based on their low relative valuations.

We retain a strong-conviction positive call on Russian oil stocks because we do not think global oil prices will weaken significantly in view of the likely continuation of current tensions in the Gulf. The combination of stable oil prices and a cheaper ruble will translate into strong earnings momentum for firms in this sector. Many Russian oil stocks also offer attractive dividends. We also retain a moderate positive call on financials. The sector will remain vulnerable to Eurozone developments but the sector’s strong earnings momentum and strong capital position should over the year translate into outperformance.

Our call last month that utility stocks would benefit from tariff hikes now that inflation has fallen to record low levels was clearly wrong. These stocks were punished last month, falling by nearly 20 per cent. Hikes in utility tariffs have been postponed until midyear, i.e. after the election. We think the market reaction was overdone: the tariff hikes will come; just the timing has been deferred. From current levels we view utilities as a candidate for a rebound – we retain a moderate positive rating.

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

India

India earned the dubious distinction last year as the worst-performing equity market among the seven emerging markets that we monitor. With a dollar-adjusted decline of 37.5 per cent it edged out Turkey for last place (see Table 1).

In view of this performance we do not see reasons to expect a substantially better performance in the coming year. While some analysts argue for a bottoming out of the current bearish cycle, we think the negative factors in the outlook point to a less optimistic judgment about market trends in the coming 3-6 months.

The dominant positive factor in the outlook is that the country’s interest rate cycle is at a turning point. The Reserve Bank (RBI) has publicly announced that its tightening cycle is at an end. The timing of future interest rate reductions, however, is not clear. Some analysts are looking for cuts in rates following the RBI’s 24 January meeting. We agree that the RBI has shifted its main policy focus to growth over inflation but we think reductions in interest rates will be delayed for several months, perhaps longer. Although inflation has fallen in recent months, the decline has been driven by falling food prices. Core inflation, the key inflation measure the RBI focuses on, is still rising. It moved up to 8 per cent in the most recent November data (December inflation figures will be released next week). In support of our view we cite comments by Subir Gokarn, the RBI’s deputy governor, in a conference presentation this week in Singapore. According to Bloomberg he said that the monetary cycle has peaked but he added that it “does not necessarily say that a quick reversal is in order because inflation risks are still visible, still high”.

A second factor that some see as a positive is the recent depreciation of the rupee: over the past three months the rupee fell vs the dollar by 8 per cent. This currency move has clearly been positive for India’s IT sector, which has substantially outperformed the overall market in recent months (see Chart 7). The depreciation should also be positive for other exporting sectors. But elsewhere in the economy depreciation has created problems, especially regarding prices of imports such as crude oil. The rupee’s depreciation has translated into a sizeable increase in the government’s subsidy bill inasmuch as most hydrocarbons remain heavily subsidized. On balance we do not view the rupee’s depreciation as a positive factor for the outlook for equities over the 3-6 month forecast period.

A factor arguing for caution in the outlook is the consolidated fiscal deficit (central government plus states). It is running close to 9 per cent this fiscal year, well over the government’s target. With six state elections scheduled for February and March we doubt there will be any new policy decisions to rein in the deficit until after the election results are known, i.e. towards the end of the fiscal year on 31 March. The new budget for FY2012/13 should be submitted to the parliament by early March, but delays appear unavoidable.

A credible performance by the Congress Party in these state elections would create room for new initiatives to raise revenues via subsidy reductions but it is too soon to be sure this will occur. Easing the burden of subsidies must come from fuel price hikes, especially for diesel, but this is a very politically charged move that may be deferred if the Congress Party leadership is not happy with the election results.

There is a strong likelihood that no substantive policy changes will come until after the elections, and even then needed reforms will depend on the election outcomes, which are impossible to call now. We doubt this uncertain outlook will translate into outperformance for the Indian market over the coming three months. We think it makes sense for investors to wait on the sidelines until greater clarity is forthcoming on the reform agenda of the current government. For these reasons we retain a moderate negative rating for the overall market.

Among sectors we retain our long-standing moderate positive rating for consumer staples. These stocks have consistently outperformed the overall market despite their rich valuations. The time when consumer staples fail to outperform the market will be when prospects for other sectors improve markedly. We are not yet at that point.

Among other sectors we retain a moderate negative rating for financials. We think the market is getting ahead of itself in anticipating that declining interest rates will be positive for banks. We think the RBI will not start to cut rates until March. In the meantime banks will face rising NPLs that will eat into loan margins and profitability. With growth stuck in the 6.5-7 per cent range for the next year, we think loan write-offs will be the dominant worry for investors in bank stocks, not potential gains from falling interest rates.

Finally, we retain a neutral rating on energy stocks. We believe the government will have to adjust fuel prices but we see this happening no sooner than midyear. Any adjustment will be positive for the sector but there are so many imponderables associated with such a move that we cannot recommend an overweight position to investors at this time.

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

China

We remain firmly in the soft landing camp vs those analysts who argue for a hard landing for the Chinese economy over the coming 12 months. There is little doubt that Q1/12 will be “relatively difficult” for business, as Prime Minister Wen Jiabao recently noted. For the current quarter growth is likely to fall to a 7.5 per cent annualized rate, compared to 8.5 per cent likely to be announced for Q4/11. For the year as a whole we project growth of 7.5-8 per cent, with a modest pickup in the pace of growth during the second half.

Exports have held up relatively well into the end of the year – up by about 14 per cent in Q4/11 – but further weakness is unavoidable during the next 12 months. For 2012 as a whole we expect exports to record much slower growth, in the range 0-5 per cent, with negative rates at midyear before recovering towards yearend. This weakness contrasts with Q4/08, when exports collapsed overnight, falling from a 20 per cent plus positive rate of growth to a similarly sized negative figure. The fact that the US economy is muddling through with 1.5-2 per cent growth this year means that the slowdown in exports will be modest despite renewed recession in Europe.

A second important factor in the outlook is that recent declines in inflation mean the government is in a position (in Premier Wen’s words) “to fine tune monetary policy as needed”. The annual December economic work conference elevated growth to the first rank in its listing of the priorities for monetary policy; fighting inflation was demoted from first to third place while economic restructuring remained in second place. What this new policy mix means in practice is still unknown. We anticipate that monetary easing will aim for loan growth of Rmb8-8.5 trillion (US$1.25-1.35 trillion), a rise of 25-30 per cent from last year’s actual new lending. Cuts in minimum reserve requirements will emerge in the coming weeks and months, with a total of at least 150 bps likely before midyear.

There will not be a repeat of the huge 2008-09 monetary and fiscal stimulus package. Instead we expect to see targeted programmes on sectors such as social housing, water supply and irrigation and priority industries identified in the current Five-Year Plan running to 2015. Activity in the property sector will reflect diverging official priorities: social housing will be pushed aggressively, but existing restrictions on private property investments will probably continue in force at least until midyear.

Despite the broad-based slowdown in the commercial residential property sector, we doubt the government will step in to bail out private developers. Instead we think policy will aim to force far-reaching restructuring within the sector and produce a substantial reduction in the number of surviving property firms. It is certain that widespread bankruptcies among smaller developers will result from these policies. Our reading of official policy is that the ultimate aim of these policies is social in nature – to damp down speculation, stabilize property prices and provide affordable housing to those unable to afford getting on the property ladder.

The highlight of the year will be the five-yearly congress of the Communist Party in October-November (the date is not yet fixed). The congress will formally elect six new members of the nine-member Standing Committee of the Politburo, with Xi Jinping assuming the post of General Secretary. The process of leadership change will culminate in March 2013 with Xi’s move into the role of state president, succeeding Hu Jintao, and Hu’s protégé Li Keqiang most likely taking over from Wen as prime minister.

We retain our moderate positive outlook on Chinese equities based on declining inflation and expectations of further policy easing. But near-term prospects for equities will be clouded by distortions associated with the early date of the Spring Festival (New Year’s holiday), which begins on 23 January vs last year, when it fell on 3 February. Because the holiday falls in a different month than last year, monthly economic data will be very difficult to interpret. For these reasons we think outperformance is likely to be concentrated in the 3-6 month window than in the next few months.

We retain a moderate positive outlook for financials, which should benefit from policy easing and continued record profits despite increasing write-offs of NPLs. We also keep our moderate positive view on the energy sector, which will benefit from price reforms and hikes in energy tariffs. Consumer staples should enjoy improved profitability thanks to declining inflation. We keep the sector at moderate positive.

We upgrade industrials to moderate positive. Industrials have been the worst performing sector over the past 12 months; policy easing should provide a major boost for the sector and make up some of the ground lost over the past year. Other changes include downgrades for basic materials and consumer discretionary.

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

Taiwan

Taiwan is particularly vulnerable to a global slowdown because exports are an important growth driver. Exports are equivalent to 74 per cent of GDP and are concentrated in the technology sector, which is highly cyclical and dependent mostly on final demand from developed markets.

The slowdown of global economic activity during 2012 has already had a significant impact on Taiwan. GDP growth has slowed from 6.6 per cent in Q1 to 3.4 per cent in Q3 (we expect 4.5 per cent overall for 2011). Export growth has come down from around 20 per cent year-on-year in H1 to around 10 per cent in H2 and was only 2.4 per cent in November. The unexpectedly low November number is partly due to supply-chain disruptions after the recent Thailand flooding, but a sharp drop of exports to Europe, which fell by 22 per cent year on year, also was to blame for the poor outcome.

We expect exports to slow down further in 2012. The continuing crisis in Europe will keep global demand weak. However we are more optimistic than some on Taiwan’s growth outlook. Only 15 per cent of exports go to Europe (directly or indirectly). About the same amount goes to the US and a third goes to China. If the US muddles through and China avoids a hard landing, as we forecast, the slowdown of exports will be limited and in no way comparable to the sharp drop that was seen in 2008. But China’s near-term lower growth outlook means that exports are likely to remain weak until growth picks up again on the mainland starting in Q3.

So far consumption, which accounts for 60 per cent of GDP, has held up well. The unemployment rate has been stable since March at 4.3-4.4 per cent. Yet a number of companies are putting employees on temporary leave, to cope with falling orders. The government has been taking measures to provide short-term employment, but a lasting solution will await a recovery in export demand. There are now signs that consumer sentiment has been hurt by slower growth and bad equity performance. Consumer confidence fell across the board in November and retail sales growth appears to be slowing down (it was 4 per cent year on year in November compared to around 5.5 per cent in Q2 and Q3). We expect consumption to stay relatively weak in H1/12 until exports recover.

Weak demand, lower commodity prices and a relatively strong currency have kept inflation very low. The November figure was 1 per cent year-on-year but a sharp hike in food prices pushed the index up to 2 per cent in December. The rate is likely to fall back in several months as food prices normalize. This will open some room for monetary easing and fiscal measures after Q1 if the economy slows down more than currently expected.

According to the latest polls, the presidential elections on 14 January are likely to be won by President Ma. This is positive for cross-strait relations, although we believe that the Economic Cooperation Framework Agreement (ECFA) with China will stay in place no matter who wins, as explained in our August note. Closer ties with China will benefit Taiwan’s banking sector as it profits from relaxation of regulation.

Moreover there are opportunities for Taiwanese consumer companies in China. Many catering and clothing companies are rapidly expanding into China, which provides an excellent opportunity for longer-term brand-building in the Asian and wider world markets. Another positive development is the expansion of Japanese machinery companies into Taiwan driven by a desire to diversify risk in the wake of the 2010 earthquake, the strong yen and Taiwan’s ECFA with China. Lastly we expect suppliers of key components in the IT sector to outperform because of limited availability and substitutability in the market.

Taiwan’s equity performance in 2012 was mostly in line with other emerging markets. The MSCI index moved sideways up to August and then decreased sharply as the Eurozone crisis intensified. We retain a neutral rating on the 3-6 month prospects, as we believe consensus expectations are unduly bearish on export demand. Among our sector calls we reduce consumer discretionary to neutral in view of slowing consumer demand.

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

Indonesia

Indonesia was the big winner in 2011: equities outperformed the MSCI emerging markets index by 23.6 percentage points. And while many other EM currencies depreciated strongly in the second half of the year, the rupiah remained relatively stable, ending the year flat vs the US dollar.

The main drivers of this outperformance were the ones we pointed out in our 5 May report: strong domestic growth drivers make Indonesia less vulnerable to external conditions and stable macroeconomic policies ensure contained inflation and low debt. Growth last year was strong and stable, at 6.5 per cent in each of the first three quarters. At the same time a dramatic reduction of inflation has been achieved, from 7 per cent in January to 3.8 per cent in December, mostly through lower food inflation. In addition the Indonesian parliament in December passed a long-delayed land acquisition bill, removing some obstacles to improving the country’s woefully underdeveloped infrastructure. These developments drove Fitch to upgrade Indonesia to investment grade on 15 December – a move likely to be followed by Moody’s and S&P later this year.

In consequence the outlook for 2012 remains bright, although growth is likely to slow down modestly to around 6 per cent. Export growth has decreased significantly, from around 40 per cent year-on-year in mid 2011 to 8.3 per cent in November. We expect export growth to remain weak but to be stronger than during the 2008 financial crisis. Coal and palm oil prices will remain relatively strong and only a small share of total exports goes to Europe.

Unlike in 2008, domestic confidence is very strong. Bank Indonesia’s (BI) consumer confidence index reached an all-time high in December. Lower inflation and wage growth are boosting purchasing power and, as a result, retail sales continue strong. Consumption is therefore likely to remain a major growth driver in 2012. Although investment is typically more sensitive to slowing exports, other factors are likely to keep investment robust in 2012. Looser monetary policy is decreasing the cost of financing, foreign direct investment is still strong and the passage of the land acquisition bill is likely to kick-start several large construction projects.

In addition the government stands ready to act if the economic slowdown is stronger than expected. The 2012 budget contains contingency provisions to provide fiscal stimulus if necessary. Additionally the low level of inflation gives the BI room to cut rates further. In fact we expect it to cut rates by 25 bps on January 12 and possibly by another 25 bps in February or March.

Indonesia has many things going for it: inflation is low, domestic growth drivers are strong and some progress is being made on structural reforms. However we believe some observers are too optimistic. Because valuations are high and foreign participation is large, disappointing news could have a disproportionate effect on asset prices. We believe disappointment is likely to come on two fronts: a lack of progress on structural reforms and infrastructure, and a return of inflation.

Although the passage of the land acquisition bill in December was a positive, it is not a panacea. An inefficient and corrupt bureaucracy and an opaque regulatory environment combined with a lack of planning and coordination among the various ministries that will be pursuing their own projects will continue to be a drag on infrastructure. Moreover we expect continued slow progress on structural reform and budget disbursement, and project execution will remain inefficient and slow. As of November 2011, the government had only spent 60 per cent of its annual capital expenditure budget.

A lack of supply-side reforms combined with buoyant demand is likely to lead to increased inflationary pressures (see Bank Indonesia’s rate cuts expose the economy to serious inflation risks). Moreover, once the base effects wear off, food inflation is likely to increase significantly, though the extent depends on the harvest. Combined with planned increases of administered prices, inflation will probably start increasing in March and move up to around 6 per cent. We believe the BI will be slow to respond to higher inflation, creating worries that it may fall behind the curve.

We retain our moderate positive rating in the 3-6 month horizon. We are concerned that Indonesia’s outperformance could lose steam at midyear when inflation starts increasing and it becomes clear that infrastructure progress remains slow.

The materials sector got a big boost from the passage of the land acquisition bill, as cement companies are expected to benefit from increased construction. We believe this rally is overdone and expect some correction as it becomes clear that the near term impact of the bill will be limited. We keep our positive outlook on the consumer sectors, as we expect confidence and purchasing power to remain high. We see coal prices remaining weak in the next 3-6 months until Chinese growth starts to pick up again. We therefore downgrade energy to +1.

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

Turkey

The Central Bank of Turkey (CBT) has been battling the country’s economic imbalances ever since November 2010, when it decided to introduce its unique mix of non-orthodox policies. It has achieved some of its objectives but has not succeeded in convincing many in the markets that it is on top of the economy’s problems. This has left many with a concern that more aggressive policy tightening may be unavoidable along with risks of a hard landing. The market’s worries last year focused initially on the country’s large current account deficit and overly rapid expansion of bank credit. More recently market sentiment has been preoccupied by a sharp rise in inflation and weakness in the Turkish lira.

The latest data reveal a sizeable correction in the external balances. In November exports rose by 14.6 per cent month-on-month and imports fell by 4.5 per cent, both seasonally adjusted. Depreciation of the lira, tax hikes on specific imports (textiles and meat) and slower expansion of consumer credit helped to achieve these results. There is also evidence that the structure of Turkish exports is changing in favour of Middle/Far East countries and away from Europe. The share of the EU in total Turkish exports declined from 56 per cent in 2007 to 45 per cent by end-2011. A continuing shift in the trade structure to alternative markets will serve as a partial buffer from European recession, though Turkish exports will obviously be hit by the slowdown.

Although there is evident progress in reducing the current account deficit, a recent surge in inflation has served to divide the market into two blocs, one pro-CBT and the other anti-CBT. Inflation ended up the year at 10.5 per cent, nearly double the official target of 5.5 per cent. Those in the anti-CBT bloc argue that monetary policy has been ineffective by pointing to the current high inflation rate and sharp depreciation of the Turkish lira, which fell 22.6 per cent vs the US dollar during 2011.

At present the CBT retains a low policy rate (5.75 per cent) but it forces a variable portion of market access to central bank credit at a much higher 12.5 per cent rate. In effect it utilizes this interest rate corridor to implement a flexible strategy by varying the quantity of credit that it offers at the lower preferential rate. Once the amount on offer at the 5.75 per cent rate is taken up, there is a discrete hike in the cost of overnight credit to the higher 12.5 per cent rate. Whether such an interest rate corridor makes sense or not ultimately will depend on the CBT’s success in reducing inflation. In this regard the CBT’s policies will be particularly tested in Q1/12. Inflation is likely to stay high in the first few months of 2012 owing to the pass-through of lira depreciation into domestic prices, the lingering effects of administered price hikes and rising food prices. In addition to its actions on domestic markets, the CBT typically will also intervene in foreign exchange markets, selling dollars in order to dampen volatility in the lira by soaking up lira liquidity.

We expect CBT policy will begin to show positive results by end-Q2/12 as slower growth dampens import demand and inflation fall back below 10 per cent as the pass through from one-off administered excise tax hikes on consumer goods wanes. We expect inflation to fall to 8.5 per cent by midyear and to 7.5 per cent by December. Although the CBT has said it intervenes in FX markets only to dampen the volatility of the lira, we believe the level of TRY1.90/US$ has become a de facto intervention point for the CBT. We presume the CBT’s rationale for choosing this level is that it thinks last year’s 22 per cent depreciation is enough to correct the country’s trade imbalance. The risk in defending such a level for the currency is that it may take some time for the needed trade adjustment to actually occur. Despite these risks we anticipate the CBT will manage to keep the lira within a TRY1.82-1.92/US$ range during the next 3 months.

We believe that growth this year will come in above consensus, at 3.5 per cent thanks to continuing strong investment associated with industrial productivity enhancements. We also see positive prospects for privatizations in 2012. Although the privatization of the electric power generator and distributor Akenerji was annulled recently due to the lack of the bidders, there are good prospects for the privatization of 9 electric producers and another 9 electric distributors. The energy sector outperformed last year, which is to say that it declined less than any other major sectors. The overall market was down 37.4 per cent in dollar terms, marginally ahead of India the worst performer. In addition to these offers there are ten more projects to be privatized in the road transport infrastructure sector, both toll roads and bridges. Tenders are expected to be announced by May.

We retain a neutral rating on Turkish equities and anticipate that markets will remain weak in the coming three months before strengthening in the three to six month window. With this in mind we recommend that investors stay on the sidelines for now while looking for opportunities to pick up top-quality stocks during periods of market weakness.

We keep our moderate positive rating for financials. Turkish banks are strongly capitalized but valuations have suffered because of fears about potential fallout from the Eurozone crisis. We anticipate that the CBT will further reduce the banks’ reserve requirements during H1/12 if the growth of loans falls below 25 per cent (on an FX adjusted basis). We believe the CBT will act to ensure strong profitability for the sector given its concerns about the spillover of the Eurozone crisis into the sector. Consequently, we expect improved profitability of the banking sector during 2012. We also retain a moderate positive rating on energy, which has been the top performing sector over the past three months with a positive 3 per cent return at a time the overall market fell over 15 per cent.

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

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