Emerging Markets Quarterly: EM assets seeing better support

Q2 2016 Insights

FOR SOPHISTICATED INVESTORS ONLY

By Nikko Asset Management’s Multi-Asset team - 22 July 2016

Emerging Markets Quarterly

The UK’s late June vote in favour of ‘Brexit’ was initially read as a deep negative, particularly given that markets were priced strongly in favour a ‘Remain’ vote. However, after brief reflection, markets outside the region saw a rally, with risk asset performance more than making up for Brexit losses. Emerging markets (EM) have been a primary beneficiary of the return of risk appetite. This might seem counterintuitive given the negative impact on global growth, but the broader shift in central bank policy towards less tightening and more easing probably does offer more support to EM assets, offsetting the marginally negative economic impact.

Most importantly, US dollar strength relative to the Euro and British pound sterling did not spread to the EMs. In fact, EM currencies have remained well supported against the US dollar, sustaining significant capital flows to EMs. This can be seen in particular with local currency bonds in the hunt for yield given developed market bond yields continue to compress to multi-century lows. The shift in risk appetite is supported by relative fundamentals. EMs are among the few countries left with conventional yield curves and positive real yields that offer their central banks the capacity to cut rates as inflationary pressures ease.

Still, Brexit introduces three significant risks to EMs:

  • The European banking system is very weak and, with no current solution, EMs remain vulnerable to losing funding support—particularly in EMEA, including Eastern Europe, Turkey and South Africa;
  • Commodities have remained supported so far, but the supply-demand balance remains tenuous and even though the economic impact of Brexit may seem relatively small, any reduction on the demand side could lead to another leg down across the complex; and
  • The referendum outcome is symptomatic of much broader disapproval of current policies, indicating that the UK could be merely the first domino to fall, which would be deeply problematic for all markets, including EMs.

EMs require growth, which is assisted by reforms and a relatively calm environment in the form of reasonable demand for its exports and a properly operating global financial system. Neither of these is a given, but the prospect of broader global easing means that opportunities in EMs are increasing, albeit selectively and on a hedged basis.

Asia remains at the top of our regional hierarchy, benefiting from easing liquidity conditions, particularly where capital outflows in China remain contained despite further depreciation of the Renminbi. Latin America is in second place due to better macro political support and improving momentum. EMEA is at the bottom of the hierarchy with dimming prospects following Brexit and rising political instability.

We have lifted local currency bonds to the top of the asset class hierarchy for better macro political fundamentals and broadly improved momentum. As the Federal Reserve (Fed) is likely to be slow in normalising US rates, relative support for EM currencies (with concomitant slowing inflation trajectories) allows for monetary easing. Hard currency bonds are lowered to second place, but the outlook still remains promising with improving macro-political prospects as well as momentum.

Equities remain at the bottom of the asset class hierarchy as earnings prospects have yet to reveal a durable turn to the upside given still weak growth prospects and high levels of debt.

This quarterly report summarises our current views and quarterly adjustments by region, with an asset class score summary followed by the key elements of our current thinking.

Asia inexpensive with improving internal growth fundamentals

Asia remains at the top of the regional hierarchy with improving growth prospects due to continued currency stability and the tailwinds of still cheap commodities and reforms that are now translating to improved earnings. Equities are inexpensive, although to varying degrees depending on the country.

The impact of China’s stimulus earlier this year will likely be limited, but the move has helped to place a floor under further declines in demand. It is possible that we will see improving growth from other regions, including the US, but the still-cautious US consumer and Brexit may, for the moment, forestall external sources of growth.

Asset Class Scores

Asset Class Scores

Score Summary: For each country and asset class, scores are represented by colours where white is neutral, green is positive and red is negative. The overall score is shown to the right with the underlying scores – value, momentum and political/macro – shown to the left. The border shows gray for no score change, while green shows positive and red negative.

China bonds upgraded to neutral positive

In 2015, the image of China policymakers shifted from one of seeming omnipotence to rather amateurish, with one policy blunder quickly following the last. We downgraded local bonds by three notches to neutral negative in July 2015, just weeks before the poorly communicated August devaluation when market confidence was mostly lost, with rising speculation of a deeper devaluation ahead.

Liquidity conditions continued to tighten through first part of Q1, but eased considerably as capital outflows were contained despite further depreciation of the currency. The upgrade in Q1 for improved liquidity conditions continues to be supported, while in Q2 we upgraded local bonds again for more attractive valuations with the capacity to ease further.

China is not without risk of acceleration of capital outflows but critically, despite currency depreciation, FX reserve levels have stabilised, as have currencies across the region.

India equities upgraded to neutral & local bonds downgraded to neutral positive

India has long remained a positive growth story due to reforms and sheer demographic potential. We upgraded equities given more attractive valuations and an improving earnings outlook as reforms start to pay off.

Last year, we were concerned that valuations had begun to exceed the promise of reform as Prime Minister Modi was politically stymied in pushing certain reforms and the private sector faced the headwind of banks laden with bad debt, unable to assist in boosting private sector growth. However, growth is returning following the passing of certain fiscal reforms that have allowed for increased infrastructure investment, such as the gathering pace of road projects as shown in Chart 1.

Chart 1: India infrastructure spending

India infrastructure spending

Source: Goldman Sachs 2016

Modi is also now focused on the bank non-performing loan (NPL) issue that, along with rate cuts and a strong monsoon season are likely to help boost investment and consumer spending, respectively. We also note the likely passage of the Goods and Services Tax (GST tax) which provides additional capacity to expand the investment programme.

Both reported and forecasted earnings appeared to have bottomed in early 2016, reflecting these developments. We upgraded Indian equities both for improving macro politics and momentum.

In June, it was revealed that Governor Raghuram Rajan of the Royal Bank of India (RBI) will not sit for another term, negatively surprising markets. We downgraded local bonds to neutral positive on the concern that the RBI could depart from Rajan’s hawkish stance and otherwise sound policy. Nevertheless, we remain optimistic and, as the RBI has a fairly decent reputation that precedes Rajan, believe that policy risk remains relatively low.

South Korea equities and local bonds both upgraded

South Korea has suffered from both weak global demand for its exports and, more recently, loss of relative competitiveness to Japan given efforts there to weaken the Yen. Global demand remains weak, but Korea now benefits from a weaker currency (falling 25% relative to the Yen last year) and improving corporate governance. Both of these factors are helping to support earnings.

Equity markets have traditionally traded at a discount to global peers as management has historically done little to attend to shareholders’ interests. This is changing, as shown in Chart 2, with both dividends and share buybacks on the rise, helping to support an upgrade in the macro political score.

Chart 2: South Korea dividend and buyback trends

South Korea dividend and buyback trends

Source: Bloomberg 2016. 2016E—Estimate for 2016.

Malaysia equities and hard currency bonds both upgraded

As an oil exporter, Malaysia benefits from returning stability in oil prices, which has helped to lift both its terms of trade and the currency, as shown in Chart 3. Currency has helped push inflation to the lower bound of the central bank’s 2–3% comfort range (CPI: 2.1% year-on-year in April), providing scope for the central bank to ease. We lifted the macro political score for these improved fundamentals, leading to an upgrade of both equities and hard currency bonds.

Chart 3: Malaysia terms of trade vs. currency (Ringgit)

Malaysia terms of trade vs. currency (Ringgit)

Source: Bloomberg 2016

Thailand local currency bonds upgraded

Local bonds were upgraded mainly for more attractive valuations and positive momentum, but also a more supportive macro political outlook, with the current account having shifted to a massive surplus of 10%, lifting the currency as well as FX reserves by USD 19 billion over the past six months (see Chart 4).

The increase in the current account is partly driven by lower oil prices (as an oil importer), but also due to growth in tourism. On the negative side, the increase is also attributable to weak imports due to tepid demand as weak confidence has driven the savings rate to 33%, the highest rate since the Asian crisis in the late 1990s. On balance, a stronger currency and easing liquidity conditions favour Thai assets.

Chart 4: Thailand current account vs. changes in FX reserves

Thailand current account vs. changes in FX reserves

Source: Bloomberg 2016

Philippines equities upgraded

Philippine equities were lifted as a function of improving momentum. Valuations continue to remain expensive, but the macro story remains strong and earnings continue to deliver.

EMEA challenged by Brexit and rising political risks

EMEA was challenged to begin with but even more so following Brexit. This region is the most exposed of the EMs to slowing trade with the EU and potential interruptions in funding due to an increasingly stressed European banking system. The outlook varies by country, but generally political risk is rising—most clearly evidenced by the recent failed coup attempt in Turkey. Rising political risks coupled with funding risk make us particularly cautious about the region.

Asset Class Scores

Asset Class Scores

Score Summary: For each country and asset class, scores are represented by colours where white is neutral, green is positive and red is negative. The overall score is shown to the right with the underlying scores – value, momentum and political/macro – shown to the left. The border shows gray for no score change, while green shows positive and red negative.

Turkey hard currency bonds upgraded

The upgrade of Turkey’s hard currency bonds was purely due to improving valuations and momentum as macro politics remain negative, most recently confirmed by the failed coup attempt on 15 July. No doubt President Erdogan will try to use this event to consolidate his power and it is also likely that political tension and uncertainty will continue to rise.

Turkey maintains the veneer of macroeconomic stability, but dependence on foreign flows to fund its still large current account deficit remains its Achilles heel. European banks are the main supplier of funding and rising stress could ultimately threaten funding to inflict a harsh economic adjustment on Turkey. Nevertheless, these macro political risks are not without solutions, which is why it is important to also focus on valuation and momentum that together justify the upgrade of hard currency bonds.

Poland equities downgraded and hard currency bonds upgraded

The downgrade of Polish equities was due to still deteriorating macro politics. We first downgraded Polish equities in Q4 2015, following the October election when the PiS (Law & Justice party) came to power on a populist agenda. While governmental institutions remain strong, deterioration at the margin continues to weigh on capital markets.

The near-term issue is the government’s intention to restructure Swiss Franc-based loans to Polish Zloty (PLN), where banks are expected to bear some of the losses but with the details remaining hazy. Clearly, Brexit adds to uncertainty as shown in Chart 5. EMEA currencies (green bars) were the worst performing EM currencies and the PLN was, in fact, the worst performing currency.

We upgraded Polish hard currency bonds for more attractive valuations and improved momentum, helping to offset the downgrade in macro politics.

Chart 5: EM currency change since Brexit (23 June) relative to US dollar

EM currency change since Brexit (23 June) relative to US dollar

Source: Bloomberg 2016

Latin America maintains commodity stability and improved political capacity

Latin America (LatAm) remains second in the regional hierarchy, above EMEA, although we remain selective on countries and asset classes. There are a notable number of upgrades, while local currency bonds stand out as among the best opportunities for high real yields and declining inflationary pressures that allow for easing. Political capacity remains on an upward trajectory, particularly in Brazil, but there are risks regarding whether policymakers can stay the course in the execution of the many painful reforms required to achieve a sustainable fiscal and economic path.

Asset Class Scores

Asset Class Scores

Score Summary: For each country and asset class, scores are represented by colours where white is neutral, green is positive and red is negative. The overall score is shown to the right with the underlying scores – value, momentum and political/macro – shown to the left. The border shows gray for no score change, while green shows positive and red negative.

Political risk premium generally in decline

In the aggregate, the political risk premium is declining across the region, helping to lift risk assets. We have previously referred to the political risk pendulum showing signs of swinging back from populist to a more business-friendly agenda, but the shift is in its early stages and not yet universal nor guaranteed to persist.

Clearly, Argentina has made the greatest turn, with President Macri reversing decades of bad policy. Brazil is following Argentina’s lead, making significant progress this quarter, with Temer now assuming presidential powers with a strong reform agenda that Congress fully supports. In both cases, there is broad recognition that reform is the only way out, while both remain at risk in the execution should economic pain overcome the desire to continue with the adjustment.

Chile and Mexico, historically the most stable and business-friendly countries in the region, are losing support for their reform agendas from a disenfranchised middle class. The short-term political risk trajectory has recently improved for Chile but, ironically, only due to President Bachelet losing steam in pushing a more populist agenda. In both countries, despite slippage in reforms, strong institutions and prior reform efforts are likely to remain durable to maintain a positive outlook.

Peru and Colombia are among those countries most dependent on commodity exports—copper and oil, respectively. While both of these countries remain lacking in terms of reforms to diversify their economic base, at least commodity support helps to reduce near-term slippage toward a more populist agenda.

Latin America local currency bonds at the top of our hierarchy

LatAm is the primary beneficiary of commodity stability and improving political dynamics. The decline of commodities that began in 2011 coupled with rising political risk through the first month of this year pushed down currencies in the region resulting in high levels of inflation.

These dynamics have now reversed, with stronger currencies now reducing inflationary pressures, pushing LatAm real yields to the highest among any region in the world as shown in Chart 6. The prospect of rate cuts with a declining political risk premium means yield compression could be quite significant—particularly on a relative basis in light of negative real rates across developed markets.

Chart 6: Global real yields

Global real yields

Source: Bloomberg 2016. *Calculated by first subtracting headline inflation from policy rates and then aggregated using MSCI regional index weights, to approximate real rates for regions.

Latin America hard currency bond upgrades

Hard currency bonds are a direct reflection of a declining risk premium with bond yields compressing and momentum improving across all countries. Valuations are attractive and improving across certain countries, but mainly due to the outsized compression in US Treasury yields. US Treasuries are expensive, so we remain slightly more cautious with respect to hard currency bonds that embed this risk premium.

Latin America equity upgrades

Equities experienced similar improvements in momentum, with the notable exception of Mexico. Since 2011 when commodities began to weaken, Mexico strongly outperformed as a relative safe haven, but now suffers from a rotation back to riskier assets in the region. Part of this rotation is rational given the divergence of valuations, as Mexico is quite expensive, but we note that fundamentals in Mexico are still quite strong and improving with the consumer benefiting from high employment that has helped to lift retail sales as shown in Chart 7.

Chart 7: Mexico unemployment vs. retail sales

Mexico unemployment vs. retail sales

Source: Bloomberg 2016

Earnings are shown to be improving across Latin America, offering a strong lift to equity markets that remain very cheap. Nevertheless, we remain cautious on the premise that fiscal reforms will weigh on aggregate demand and therefore earnings, while debt levels remain quite high.

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