Global Emerging Markets Equity Research 25 July 2014
The Underdog is Back The case for an Emerging Equities Bull Market This report makes the bull case for emerging market equities. The asset class’s underperformance from late 2010 to 1Q14 was, in our view, primarily cyclical. Both monetary and fiscal policy was too accommodative in 2009/10. This led to inflation, and then EM central banks tightened, reducing growth and earnings. The growth tourist left EM. We believe this will change with EM forward EPS outperforming DM into 2015. The growth tourist will return, in our view. The near term case for emerging market equities: 1. Compression of excessive risk premiums 2. Accelerating global economic growth 3. Stabilization of Chinese growth combined with ‘extending and pretending’ in the financial sector, avoiding a credit event (for now) 4. Discounting an acceleration in EPS growth in 2015 5. Global funds underweight EM equities 6. Valuations low for this point of the cycle 7. Valuation attractive relative to fixed income and DM equity 8. Mandates for better economies; Indian election 9. EM joining the ‘axis of easing’
Emerging Markets Equity Strategy Adrian Mowat
AC
(852) 2800-8599
[email protected] Bloomberg JPMA MOWAT
J.P. Morgan Securities (Asia Pacific) Limited
Pedro Martins Junior, CFA (55-11) 4950-4121 [email protected] Banco J.P. Morgan S.A.
David Aserkoff, CFA (44-20) 7134-5887 [email protected] J.P. Morgan Securities plc
Rajiv Batra (91-22) 6157-3568 [email protected] J.P. Morgan India Private Limited
Sanaya Tavaria (1-212) 622-5469 [email protected]
J.P. Morgan Securities LLC The long term case for emerging market equities: Kevyn H Kadakia 1. Median potential real GDP growth 4% vs. 1.8% in DM (91-22) 6157-3250 2. Median potential nominal GDP growth 7.8% vs. 3.8% in DM [email protected] 3. Higher potential EPS J.P. Morgan India Private Limited 4. Median debt/GDP 146% vs. 270% in DM 5. Median public sector debt/GDP 53% vs. 84% in DM 6. 34% of global GDP… forecast to increase to 50% by 2025 7. Demographics of India, Indonesia, the Philippines, Mexico, Turkey and Brazil.
Figure 1: EM must deliver premium EPS growth to outperform 450
12M Fwd. EPS EM rel DM
EM rel to DM (RHS)
400
Figure 2: EM bull market as US rates normalize 400
6
350
5
300
4
250
3
200
2
150
1
100
0
FDTR
MSCI EM (RHS)
EM rel DM (RHS)
350
450
350
300 250 200 150 100 50 88 90 92 94 96 98 00 02 04 06 08 10 12 14 Source: MSCI, IBES, Datastream, Bloomberg, 18 July 2014.
250
150
50 02
03
04
05
06
07
Source: Bloomberg, J.P. Morgan
See page 19 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. www.jpmorganmarkets.com
Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
The case for Emerging Market equities The near term Compression of excessive risk premiums Accelerating global economic growth Stabilization of Chinese growth combined with ‘extending and pretending’ in the financial sector avoiding a credit event (for now)
Figure 3: Contracting risk premiums: EMBI and CEMBI spreads still higher than US HY EMBI Global CEMBI Broad US HY (RHS)
500 450
900 800
400
700
Discounting an acceleration in EPS growth in 2015
350
600
Global funds underweight EM equities
300
500
Valuations low for this point of the cycle
250 May-11
Valuation attractive relative to fixed income and DM equity
Source: Bloomberg, 18 July 2014.
Mandates for better economies; Indian election
Figure 4: EM Fx rebound from 2013 lows
EM joining the ‘axis of easing’
The long term
Nov-11
May-12
Nov-12
May-13
Nov-13
101 100 99
Median potential real GDP growth 4% vs. 1.8% in DM (Figure 14)
98
Median potential nominal GDP growth 7.8% vs. 3.8% in DM (Figure 15)
96
Higher potential EPS (see ‘High GDP = High Equity Returns, A reminder of EM outperformance trend’, Mowat et al, 3 January 2012)
93
97 95 94 92 Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Median debt/GDP 146% vs. 270% in DM (Figure 16)
Source: Bloomberg, 23 July 2014
Median public sector debt/GDP 53% vs. 84% in DM (Figure 17)
Figure 5: EM’s large underperformance relative to DM
34% of global GDP… forecast to increase to 50% by 2025 (Figure 18) Demographics of India, Indonesia, the Philippines, Mexico, Turkey and Brazil; rapid growth in working age population (see Table 2)
Our current strategy Our monthly emerging markets equity strategy report is Key Trades and Risk (click here for the latest edition). The weekly reports are Herd Instinct (click here for the latest edition) and Dashboards (click here for the latest edition).
2
400 May-14
Jun-14
120 110 100 90 80 70 Jul-09
Jul-10
Jul-11
Jul-12
Jul-13
Jul-14
Source: Bloomberg, 23 July 2014. Note: Chart shows performance of MSCI EM vs World.
Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
Compression of risk premiums Faced with tapering, investors exited EM risk assets in 2H13. EM equities, fixed income, and currencies all declined. We entered 2014 with excessive risk premiums. Tapering proved to be a non-event. US bond yields declined. Contrary to popular fears, demand for EM debt is strong. EMBI and CEMBI spreads are contracting. EM currencies rallied hard from their 12-month lows. The compression of risk premiums was stage one of the rally.
Figure 6: Recovery in EM currencies INR KRW TRY BRL PLN AUD ZAR IDR MYR EUR
Accelerating growth EM growth was below potential in 2013 and 1Q14. Our forecast is acceleration above potential. PMI and export data are consistent with this forecast. Please see Figure 7 for our detailed forecasts.
PHP RUB MXN HUF THB SGD JPY
China stabilization with extending and pretending Economic risk is lower with 2Q14 growth meeting target. The PMIs, auto sales, retail sales, exports and IP are consistent with stabilization in growth. Investors left our China Summit reassured that growth is slowing rather than stalling. The large volume of maturing trusts have either been rolled or refinanced by banks. Extending (roll loans and capitalizing interest) and pretending (not recognizing the risk to repayment) avoid crystallizing a credit event. This occurred for more than a decade in Japan. We see no reason why the regulator would wish to generate a credit event, and thus we expect ‘extending and pretending’ to continue. Total social financing in June accelerated as policy eased to achieve the 7.5%oya growth target. At a local level property price control measures are being eased. The reduction in perceived risk is helping the largest and second-cheapest EM reduce its significant YTD underperformance. Our view is China will follow rather than lead EM higher. The key risk is the China property market. Our China economist Haibin Zhu believes that housing booms and busts have significant implications on economic growth (see China’s housing problem: looking from a crosscountry perspective and China's property market: a major macro risk). Japan’s and Taiwan’s late ’80s bubbles are good analogies. Both countries had excess savings (large current account surplus), momentum in equity and property markets plus demographic challenges (see China challenged: Lessons from other Asian bubbles). The correction in their property prices was slow and protracted. The impact on activity was more marked.
TWD CLP CNY HKD CZK 0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Source: Bloomberg, 23 July 2014. Note: Chart shows FX returns from the low since January 2013.
Figure 7: Global GDP growth proxies (% change, annual rate; monthly data) 6 Nowcaster
PMI
Potential GDP (2.7%)
5 4 3 2 1 10
11
12
13
14
Source: J.P. Morgan
Figure 8: China residential construction starts (advanced 12 months) vs. sales 150
sqm mn
Residential construction starts, 3mmva
Residential Sales, 3mmva
130 110 90 70 50 30 Jan-06 Dec-07 Oct-09 Aug-11 Jul- 13 May-15 Source: CEIC, J.P. Morgan calculations, June 2014. Note: The numbers are seasonally adjusted
3
Global Emerging Markets Equity Research 25 July 2014
Discounting an acceleration in EPS growth in 2015 Premium growth attracts investors to EM. It is growth in EPS, not GDP that matters. EM equities failed to offer this from late 2010. In our view this was a cyclical, rather than secular, issue. In 2009/10 debt to GDP and fiscal deficits expanded across EMs. This aggressive progrowth policy resulted in inflation. The majority of EM central banks tightened policy in 2011. Weaker demand combined with new capacity led to a profit recession. We believe we are exiting this earnings recession. Companies are more focused on margins. Corporate capex is weak. Accelerating growth adds top-line leverage to improving margins. The result should be that markets discount strong 2015 EPS in 2H14. Remember that markets turn six months before analyst earnings revisions. Today revisions are negative. This should change in 2H14. Figure 9: Premium EPS growth key to outperformance
-0.05
06
07
08
10
11
12
13
14
Figure 11: Global emerging markets funds, weekly net flows (US$mn) 1120
5,500 2,500
1040 1000
(500)
960
(2,000)
920
(3,500) (5,000) May-12
Oct-12
88 90 92 94 96 98 00 02 04 06 08 10 12 14
Aug-13
WeeklyNet Flows (L)
Jan-14
880 Jun-14
MSCI EMF Index (R)
Source: MSCI, Datastream, EPFR Global, J.P. Morgan
Valuations low for this point of the cycle Please see the scatter charts from pages 8 to 9. Valuations attractive relative to fixed income Earnings yields spread to bond yields average 3%.
Source: Bloomberg, IBES.
India
Brazil
South Africa
Korea
China
12.0 10.0 8.0 6.0 4.0 2.0 0.0 (2.0) (4.0)
Turkey
Figure 12: Current EY minus BY
Russia
Global funds underweight EM equities This view is based on client feedback, tracking mutual fund flows, and our global asset allocation team’s EM positioning proxy. The majority of clients we meet are more comfortable with US and European equity risk than EM. Views on Japan are mixed. The proxy calculates the 41-business-day rolling beta of the average daily returns of the 20 biggest US-domiciled active equity funds against the daily relative return of emerging markets vs. US equities. The betas are based on multiple regressions of the relative performance of MSCI EM vs. the S&P500. The average beta in the past year is 0.05. It has increased in the past three months from 0 to 0.10. This suggests that positioning in EM equities is still light.
Mar-13
Indonesia
100
1,000
Mexico
150
Source: MSCI, IBES, Datastream, Bloomberg, 18 July 2014.
4
09
Source: Bloomberg, J.P. Morgan.
300
150 50
0.00
1080
200
100
0.05
4,000
250
200
0.10
Chile
250
0.15
350
350 300
0.20
Malaysia
400
400
0.25
Poland
EM rel to DM (RHS)
0.30
Philippines
12M Fwd. EPS EM rel DM
0.35
Thailand
450
Figure 10: Equity mutual fund beta to EM vs. US equities relative performance
Taiwan
Adrian Mowat (852) 2800-8599 [email protected]
Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
Mandates for better economies The Indian electorate voted for better governance. They were frustrated by poor economic performance. The new government majority is the largest in 30 years. The second largest democracy in EM; Indonesia also voted for better governance. It is easy for EM to beat a skeptical consensus. The next test is the Brazilian election. EM joining the ‘axis of easing’ Surprise rate cuts have come from Turkey and Mexico recently. Further cuts are coming from Chile, Hungary, and Russia, while others—such as Peru—may join. We also now see a cut from Poland in 3Q14. At the same time, expected hikes are delayed until later this year (India and South Africa). Some caution should be taken here, however. The shift to more easing in many EM countries will likely intensify the inflows as many local yield curves keep pricing hikes instead of cuts. This should make these markets more vulnerable to an eventual correction if UST yields back up sharply again. The signals from next week’s Fed meeting will be key to watch. In some cases, the shift to an easing (or least away from a hiking) bias among EM central banks has an added political motive. Despite Turkey’s GDP surprising far to the upside last quarter along with improving sentiment, falling lending rates, and still very elevated inflation, the CBRT is likely to deliver more easing in response to harsh criticism from the government. In India, the RBI appears willing to give the incoming government some space to implement reforms and has put its hiking cycle on hold despite inflation still running at target with upside risk given the likelihood of a deficient monsoon in 3Q14—our call for a 4Q14 hike is close. In Brazil, where the BCB is under political pressure to ease as growth decelerates, COPOM still seems reluctant to cut given persistent inflation pressures. At the same time, we do not see hikes starting back up until early 2015. For more, see ‘Global Data Watch’, Kasman, 13 June 2014. EM and higher US rates Does this conflict with the ‘axis of easing’ point? A more benign monetary policy in EM is a near-term positive. But growth, rather than cheap money, is more important for a growth-asset class such as EM equities, in our view. EM equities absolute and relative returns were strong during the last period of normalization in US rates. During the 2003 to 2006 period the Fed fund target rate increased from 1% to 5.25%. Ahead of the first rate increase markets were weak, then rallied hard once normalization started.
Table 1: Official interest rate forecasts Country Global Excluding US Developed Emerging Latin America EMEA EM Asia The Americas United States Canada Brazil Mexico Chile Colombia Peru Europe/Africa Euro area United Kingdom Norway Sweden Czech Republic Hungary Israel Poland Romania Russia South Africa Turkey Asia/Pacific Australia New Zealand Japan Hong Kong China Korea Indonesia India Malaysia Philippines Thailand Taiwan
Current rate (%) 2.32 3.09 0.29 6.00 7.39 5.90 5.60 1.58 0.13 1.00 11.00 3.00 3.75 4.00 3.75 1.53 0.15 0.50 1.50 0.25 0.05 2.30 0.75 2.50 3.50 7.50 5.75 8.25 3.81 2.50 3.25 0.05 0.50 6.00 2.50 7.50 8.00 3.25 3.50 2.00 1.88
Jun-15 forecast 2.31 3.07 0.35 6.03 7.45 5.76 5.66 1.55 0.13 1.25 11.00 3.00 3.25 5.00 4.00 1.43 0.15 1.00 1.50 0.25 0.05 2.00 1.25 2.00 2.75 6.50 6.25 8.00 3.86 2.50 4.25 0.05 0.50 6.00 2.50 7.50 8.25 3.50 4.00 2.50 2.00
Change since (bp) 05-07 avg Trough* -200 53 -116 66 -320 0 -101 111 -336 158 -33 193 -19 112 -350 49 -438 0 -273 75 -425 375 -487 0 -94 325 -331 100 -31 250 -221 20 -283 0 -444 0 -169 25 -231 0 -235 0 -483 0 -350 25 -202 0 -469 0 N/A N/A -254 75 -741 324 14 91 -344 0 -413 75 -17 0 -548 0 -14 69 -165 50 -237 175 113 325 1 125 -356 0 -183 75 -71 62.5
Source: J.P. Morgan estimates, * refers to trough end-quarter rate from 2009-present, Effective rate can be adjusted on a daily basis, ** BoJ targets Yen 60-70tn/year expansion in monetary base. Aggregates are GDP-weighted averages, For more, see ‘Global Data Watch’, Kasman, 18 July 2014.
Figure 13: EM bull market as US rates normalize 6
FDTR
MSCI EM (RHS)
EM rel DM (RHS)
450
5 350 4 3
250
2 150 1 0
50 02
03
04
05
06
07
Source: Bloomberg, J.P. Morgan
5
Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
The longer term: Higher growth with lower leverage Median potential real GDP growth 4% vs. 1.8% in DM (Figure 14) Median potential nominal GDP growth 7.8% vs. 3.8% in DM (Figure 15) Higher potential EPS (see ‘High GDP = High Equity Returns, A reminder of EM outperformance trend’, Mowat et al, 3 January 2012) Median debt/GDP 146% vs. 270% in DM (Figure 16) Median public sector debt/GDP 53% vs. 84% in DM (Figure 17) 34% of global GDP…forecast to increase to 50% by 2025 (Figure 18)
Table 2: Change in working age population 2005-2025 Country India Pakistan Nigeria Bangladesh Indonesia Congo Ethiopia Philippines Brazil Egypt Mexico Sudan Turkey Others Total
Absolute change (millions) 250 57 43 38 35 28 25 23 19 19 17 16 8 204 782
Contribution to growth in working age population (%) 32.0 7.3 5.6 4.8 4.5 3.5 3.2 2.9 2.5 2.4 2.1 2.1 1.1 26.0 100
Source: J.P. Morgan economics.
Demographics of India, Indonesia, the Philippines, Mexico, Turkey and Brazil; rapid growth in working age population (see Table 2) Figure 14: Higher growth: Potential real GDP growth for EM and DM countries (%) 8.0
Median: EM 4%; DM 1.8%
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Source: J.P. Morgan economics. Note: DMs in red, EMs in blue
Figure 15: Higher growth that drives the top line: Potential nominal GDP growth for EM and DM countries (%) 12.0
Median: EM 7.8%; DM 3.8%
10.0 8.0 6.0 4.0 2.0 0.0
Source: J.P. Morgan economics, Bloomberg. Note: DMs in red, EMs in blue. Potential nominal GDP calculated using potential real GDP and central bank inflation target. HK and Singapore do not have an official central bank target. The 10 year realized deflator in Singapore and Hong Kong is 2%. This is used in calculating potential nominal GDP’ 6
Global Emerging Markets Equity Research 25 July 2014
Adrian Mowat (852) 2800-8599 [email protected]
Figure 16: Lower debt burden: Total debt to GDP (%) for EM and DM countries (2013E) 450
Median: EM 146%; DM 270%
400 350 300 250 200 150 100 50 0
Source: J.P. Morgan economics, BIS, IMF, World Bank. Total debt = Private debt + Public debt. For China, we add change in TSF to BIS private sector credit (till June 2013) to get December 2013 data. Note, we exclude cross border flows into banks while calculating private sector external debt. DMs in red, EMs in blue.
Figure 17: Notably lower public sector debt burden: Public debt to GDP (%) for EM and DM countries (2013E) Median: EM 53%; DM 84%
250
200
150
100
50
0
Source: J.P. Morgan economics, BIS, IMF, World Bank. Note: DMs in red, EMs in blue.
Figure 18: Share of key EM and Developed regions as a percentage of global nominal GDP 100%
Others (8%) LatAm (7% to 9%)
90%
CEEMEA (7% to 10%)
80% 70%
Rest of EM Asia (8% to 12%)
60% 50%
China (13% to 19%)
Japan (7% to 4%)
40%
Developed Europe (24% to 18%) 30% 20%
North America (26% to 20%)
10% 0% 2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
Source: J.P. Morgan economics, IMF. Note: Regions follow MSCI country definitions. The projections assume nominal GDP growth at potential real GDP growth and central banks inflation target. To compute FX for periods beyond 2014, we assume the normalization of REER over the forecasted period. 7
Global Emerging Markets Equity Research 25 July 2014
Adrian Mowat (852) 2800-8599 [email protected]
EM valuations mid-range Figure 19 Cheap cyclicals plus expensive internet and staples: Forward P/E versus trailing P/BV for key EM country sectors 25.0
Mexico CS S Africa CD
China CS 20.0 Mexico
Taiwan Materials
Brazil CS
Forward PE
Philippines
15.0
India
Malaysia
Taiwan S Africa Materials
Korea Industrials
India IT
India Fin
Colombia Chile
Taiwan IT
Indonesia
S Africa
S Africa Telecom
Poland India Fin ex HDFC Taiwan Fin Czech Peru Thailand Korea Materials China Telecom China Industrials S Africa Fin India Energy China CD Brazil EM Turkey Hungary Korea IT China Energy Korea Fin India PSU Banks Turkey Fin Brazil Fin Korea China Brazil Energy
10.0
Korea CD
Brazil Materials 5.0
Mexico Telecom
China Fin
Russia Russia Fin Russia Energy
0.0 0.0
1.0
2.0
3.0
4.0
5.0
6.0
Trailing PB
Source: IBES, MSCI, Datastream, 21 July 2014. Note: The outliers Mexican materials (P/E 28x, P/BV 2x), Greece (P/E 26x, P/BV 1.1x) and China IT (P/E 27x, P/BV 7.6x) are excluded from the chart.
Figure 20: EM cheap versus history….but this hides a wide spread (Number of standard deviations from 10-year average forward P/E and P/BV for key EM country sectors) 2.5
S Africa Mexico Materials Mexico
2.0
1.5
Thailand S Africa Fin
Korea Industrials
Korea Materials
China IT China CS
No. of std dev from 10yr avg fwd PE
India PSU Banks
Korea Fin Brazil
0.5
S Africa Materials Hungary Peru Korea
Poland India
Taiwan India Fin
EM
Czech
Brazil CS
Turkey
Turkey Fin
China Telecom India Fin ex HDFC Colombia Korea IT India Energy India IT Brazil Energy Chile Brazil Fin China Industrials Taiwan Fin Korea CD Russia Energy China CD Russia Russia Fin China
Brazil Materials China Energy
(1.0)
Malaysia
Indonesia
1.0
(0.5)
Philippines
Mexico CS Taiwan Materials
0.0
S Africa Telecom
Taiwan IT Mexico Telecom
China Fin (1.5) (2.0)
(1.5)
(1.0)
(0.5)
0.0
0.5
1.0
No. of std dev from 10yr avg PB
Source: IBES, MSCI, Datastream, 21 July 2014.
8
1.5
2.0
2.5
Global Emerging Markets Equity Research 25 July 2014
Adrian Mowat (852) 2800-8599 [email protected]
Figure 21:As EPS growth in EM exceeds DM we expect valuation discounts to narrow (Forward P/E and trailing P/BV of key EM country sectors relative to MSCI US) 2.0
1.8
China IT Mexico Materials
Greece 1.6
EM / US forward PE
1.4 Mexico CS
1.2
Philippines
China CS
S Africa CD India Fin
Mexico
Taiwan Materials
India IT
Brazil CS
1.0
Chile Colombia Malaysia India China Telecom Taiwan Fin Taiwan IT Taiwan Peru Poland S Africa S Africa Materials Czech Thailand China Industrials Korea Fin Korea Materials Hungary India Energy Turkey Brazil EM India PSU Banks China Energy Korea Turkey Fin China Korea IT Korea Industrials
0.8
0.6
Indonesia
India Fin ex HDFC S Africa Fin Mexico Telecom
Brazil Fin
Brazil Energy China CD
Korea CD
Brazil Materials
0.4
S Africa Telecom
China Fin Russia Fin
Russia Russia Energy
0.2
0.0 0.0
0.5
1.0
EM / US trailing PB
1.5
2.0
2.5
Source: IBES, MSCI, Datastream, 21 July 2014.
9
Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
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Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
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Global Emerging Markets Equity Research 25 July 2014
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Copyright 2014 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P
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Adrian Mowat (852) 2800-8599 [email protected]
Global Emerging Markets Equity Research 25 July 2014
J.P. Morgan Emerging Market Strategy Team Chief Equity Strategists Adrian Mowat Pedro Martins Junior David Aserkoff Frontier Markets Aditya Srinath Christian Kern Diego Celedon Developed Markets Mislav Matejka Dubravko Lakos Jesper J Koll Country Strategists Adrian Mowat Emy Shayo Bharat Iyer Aditya Srinath Scott Seo Hoy Kit Mak Nur Cristiani Jeanette Yutan Alex Kantarovich Ayan Ghosh Anne Jirajariyavech Alvin Kwock Economic & Policy Research Joyce Chang Luis Oganes Colin P Fenton Jahangir Aziz Vladimir Werning Sin Beng Ong Grace Ng Haibin Zhu Jiwon Lim Sajjid Z Chinoy Fabio Akira Gabriel Lozano Michael Marrese Sonja Keller Yarkin Cebeci Anatoliy A Shal Nora Szentivanyi Nicolaie Alexandru Rates Research Bert Gochet Jonny Goulden Holly Huffman Eric Beinstein
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