Emerging market debt outlook 2014: Will the horse outrun the snake?

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1 PORTFOLIO J.P. MORGAN DISCUSSION EMERGING MARKET STRATEGY Emerging market debt outlook 1: Will the horse outrun the snake? January 1 OUTLOOK & OPPORTUNITIES PLEASE VISIT for access to all of our Insights publications. IN BRIEF Last year was challenging for the emerging market asset class, both debt and equities, as investors priced in a withdrawal of liquidity from the US Federal Reserve. With tapering concerns likely to remain at the forefront of investor thoughts in 1, we consider the outlook for emerging market debt investors, analysing the key drivers of performance over the coming year. We then look specifically at the impact of these drivers on the outlook for local currency and hard currency sovereigns, emerging market currencies (EMFX) and emerging market corporates. Our base case forecast is for modest positive total returns for the emerging market debt sectors in 1. However, there is still scope for some volatility. Therefore, we remain cautious and continue to advocate tactical allocation to risk assets. Within emerging market debt, dynamic asset allocation and tactical alpha generation will be key. AUTHOR Pierre-Yves Bareau Managing Director Chief Investment Officer, Emerging Market Debt pierre-yves.bareau@jpmorgan.com Review of 13: Tapering fears hit confidence True to its Chinese zodiac interpretation as the year of the snake, 13 turned out to be a slithery, precarious year for the emerging markets (EMs). The year started on a strong note, with emerging market debt (EMD) performing well and significant corporate issuance taking advantage of the market s appetite for risk. However, away from EMs, developed market (DM) economies, led by the US, began to recover. After three years of adding liquidity to the markets, the US Federal Reserve hinted in May that its monthly asset purchases would gradually be tapered. The fear of tapering, originating in the market s incorrect interpretation of the timing and impact of a reduced scale of asset purchases, and concerns over a narrowing in the growth differential between EMs and DMs led some investors to question their bond vs. equity and EM vs. DM allocations. The potential for a hard landing for the

2 Emerging market debt outlook 1: Will the horse outrun the snake? Chinese economy also concerned the market, dragging down commodity prices and damaging sentiment toward large commodity exporters. As the market looked to adjust to a post-tapering world, worries grew over the funding of current account deficits in specific EM countries, with a particular focus on Brazil, India, Indonesia, South Africa and Turkey. These countries were quickly dubbed the Fragile Five. Currencies were especially vulnerable, being the most liquid way to express a short or hedged exposure, selling off broadly against the US dollar. Tapering fears led to a challenging year for EM assets, both debt and equities EXHIBIT 1: 13 ASSET CLASS PERFORMANCE S&P (US equities, total return) US HY EM corporate HY EM local (rates only) EM corporate US HG EM hard currency sovereign HY UST intermediate EM corporate IG EM equities (total return) Commodities EM hard currency sovereign EM hard currency sovereign IG EM local (FX) EM local USD unhedged -5.3% -5.5% -7.63% -8.7% -8.98% -.8% -.6% -.7% -.8% -1.3% -1.3% -.1% Source: J.P. Morgan; data as of December 31, % 8.% 3.38% For the year, both EMD and EM equities recorded negative returns, with local currency sovereign debt and hard currency sovereign debt recording some of the biggest falls (Exhibit 1). Hard currency EM corporate returns were close to zero, reflecting the lower duration of the index compared with sovereigns and the lack of selling pressure from retail clients. Outlook for 1: Dynamic asset allocation and tactical alpha generation will be key As the year of the snake gives way to the year of the horse, the themes of rising US Treasury yields and a gradual withdrawal of liquidity will undoubtedly remain at the forefront of investor thoughts. We believe US 1-year yields will rise, settling close to 3.5% at year-end, although we are likely to experience periods of overshooting through the year. Meanwhile, global liquidity should remain high, with the gradual withdrawal of US liquidity, dependent on data, being offset by liquidity injections from DM central banks, notably the Bank of Japan and potentially the European Central Bank. Within EMs, diversification will be key. Divergent economic directions will set the tone of the markets, driven by technical, fundamental, valuation and idiosyncratic factors. It is this differentiation in economic performance that will provide us with the opportunities to tactically position our portfolios through the year. Our base forecast calls for moderate positive total returns for each of the EMD sectors for 1 (Exhibit ). In our base case scenario, we forecast modest positive total returns for each EMD sector in 1 EXHIBIT : FORECAST RETURNS FOR EMD SECTORS BASED ON THREE ECONOMIC SCENARIOS Asset Class Index Source: J.P. Morgan; data as of December 31, 13. Current Spread (bps)/yield (%) Base/Muddle Through (7%) Forecast Levels Above Trend (%) Forecast Slowdown (1%) US Treasury UST 1yr 3.% 3.5% 3.75%.5% Base/Muddle Through (7%) Total Return Forecast Above Trend (%) Forecast Hard currency sovereign EMBI Global Div % -1.8%.3% Hard currency sovereign IG EMBI Global Div IG % -.% 3.9% Hard currency sovereign HY EMBI Global Div HY % 1.% 6.8% Corporate debt CEMBI Broad Div %.% 3.8% Local currency debt GBI-EM Global Div 6.85% 7.% 8.1% 6.% 3.%.% 3.9% Slowdown (1%) Emerging market debt outlook 1: Will the horse outrun the snake?

3 Technical factors: Investor flows will need to be monitored Technical factors will continue to play a large role in EMs in 1. In the past year, we have seen strong retail outflows from the EM asset class, concentrated in EM local currency and hard currency sovereign assets. J.P. Morgan has estimated these retail outflows to be approximately USD billion (EUR3.1 billion, GBP6. billion), representing around 1% of assets under management in EMD funds. Net inflows for 13 were positive at around USD 1 billion but were down significantly from 1 s USD 98 billion. Strategic inflows remained relatively stable through the year (Exhibit 3) and are expected to continue at around USD billion to USD 3 billion per month in 1, totalling about USD 3 billion. Although retail outflows weighed on the market, strategic inflows remained supportive EXHIBIT 3: EMD FLOWS SINCE US$ billions US/European mutual funds Japanese investment trusts Strategic mandates Source: J.P. Morgan and EPFR; data as of December 31, 13. We estimate that demand from strategic investors will remain strong in the year ahead, although retail flows may be muted until EM growth picks up later in the year. From a strategic allocation perspective, EMD as an asset class remains under owned, particularly by US investors. US pension funds have low holdings in EMD (according to the International Monetary Fund s Survey on Global Asset Allocation, 11 ), but more interestingly, life insurers are slowly increasing their EMD allocations (Exhibit ). Life insurance companies have scope to increase EMD allocations EXHIBIT : US LIFE INSURERS RETAIN A LOW ALLOCATION TO EM CORPORATE Life insurance holdings Index weights* Source: J.P. Morgan, SNL; data as of December 31, 13. *Share of EM corporate bonds in the combined US high grade and US high yield indices. Insurers could use benchmarks with a lower EM allocation than JPM Indices. In the US institutional space, the allocation to EMD typically varies in the range of 3%-%, compared with an EMD weighting in US high grade and high yield indices of around 1%. This indicates the potential for larger strategic allocations to be made to EMD. Fundamental factors: Modest recovery, with differentiation across regions The fundamental strength of EM countries remains broadly intact, with low debt-to-gdp ratios and average external financing positions comparing favourably with their DM counterparts. EMs are not facing solvency issues yet, but there are countries that will need to undergo further adjustments to attract capital and narrow current account deficits. Stronger growth will help, but it is unlikely to happen in a uniform fashion. Our proprietary leading economic indicators are pointing to stronger economic growth in the first quarter, with Eastern Europe the one region indicating slightly above-trend growth (Exhibit 5, next page). Stronger DM growth is pulling up individual EMs, primarily those countries with close associations to DMs, such as Mexico, Poland, Hungary and Korea. J.P. Morgan Asset Management 3

4 Emerging market debt outlook 1: Will the horse outrun the snake? Our proprietary leading economic indicators for EMs suggest a pickup in growth in the first quarter of 1 EXHIBIT 5: REGIONAL AVERAGE PROPRIETARY LEADING ECONOMIC INDICATORS Standard deviation above/below trend growth (%) EEMEA* Asia Latin America Source: J.P. Morgan; data as of November 3, 13. *Eastern Europe, Middle East and Africa. The Fragile Five, with their large current account deficits, will continue to rely on capital inflows. However, attracting flows is becoming more challenging. Currencies adjusted in 13, but they may need to adjust further to increase competitiveness and growth. It is important to analyse not only the actual fundamentals (deficit, growth, inflation) but also the rate of change. Even within the Fragile Five, differentiation is evident, with current account deficits beginning to narrow in India and Indonesia, compared with the more static level of deficits in Brazil, South Africa and Turkey. Although much of the adjustment in EM countries will be cyclical, there is also a need for structural reform. This brings us to another important theme of 1: political activity. Next year will see elections in several EM countries, including Brazil, Indonesia, Turkey and South Africa, and this may compromise reform momentum (Exhibit 7, next page). As can be seen from Exhibit 6a and Exhibit 6b, capital flows have maintained a modestly downward trend over the last few years, while the growth differential between EMs and DMs has narrowed. In the short term, we don t see any specific reason for a sharp upturn in capital flows. As a result, we maintain a more cautious stance regarding the fundamental turnaround of EM economies. Valuations: Looking cheap Following the sell-off in the summer of 13, EMD valuations remain attractive on both an absolute and a relative basis. With the Federal Reserve s forward guidance effectively anchoring short-term US interest rates at record lows for a prolonged period, we believe fixed income investors will continue to broaden their exposure into higher yielding, more diversified opportunities. Capital flows into EMs have been on a modest downward trend in recent years EXHIBIT 6A: EM PRIVATE CAPITAL INFLOWS, NET EXHIBIT 6B: EM-TO-DM GROWTH DIFFERENTIAL AND NET PRIVATE CAPITAL INFLOWS INTO EM COUNTRIES USD billion 1, 1, 1, 8 6 China EM Asia ex. China AFME* Latin America EM Europe Total, percent of EM % of EM GDP EM-DM growth differential Capital flows (% of GDP) F Source: J.P. Morgan, Morgan Stanley, Markit; data as of November 3, 13. *Africa and Middle East. Source: J.P. Morgan, Morgan Stanley, Markit; data as of November 3, 13. Emerging market debt outlook 1: Will the horse outrun the snake?

5 Politics has the potential to derail EM structural reform momentum in 1 EXHIBIT 7: BUSY ELECTION CALENDAR AHEAD FOR EM COUNTRIES COUNTRY DATES TYPE OF ELECTION Costa Rica February, 1 Presidential and legislative El Salvador February, 1 Presidential Colombia March 9, 1 Legislative Turkey March 3, 1 Local Hungary Spring 1 Legislative Indonesia April 9, 1 Legislative South Africa April-July 1 General Lithuania May 11, 1 Presidential Colombia May 5, 1 Presidential India May/June 1 General Indonesia July 9, 1 Presidential Turkey August 1 Presidential Brazil October 5, 1 Presidential and legislative Uruguay October 6, 1 Presidential and legislative Namibia November 1 Presidential and legislative Bolivia December 1 General Romania 1 Presidential Ukraine March 9, 15 Presidential Argentina October 1, 15 Presidential and legislative Source: J.P. Morgan, IFES Election Guide. Hard currency sovereign debt outlook: Country differentiation will be crucial Despite the likelihood of higher US Treasury yields in 1, we expect to see positive returns in hard currency sovereign debt markets, driven by carry and modest spread tightening. We anticipate fundamentals to turn more positive as the cyclical recovery in EMs continues, although structural headwinds remain, and that EM growth momentum will lag that of DM countries. We also may see a stagnation of the credit improvement story this year, as several key emerging markets are on watch for ratings downgrades. A heavy election calendar in several key EM countries, including all of the Fragile Five, could drive increased volatility. However, the underperformance in 13 has created value in many markets, especially those where tapering fears led to overblown solvency concerns. Outflows have also been a headwind for the asset class, but lighter investor positioning has provided more supportive technicals, amid negligible or negative net issuance. EM sovereign valuations have improved in recent months EXHIBIT 8: EM SOVEREIGN SPREAD AND YIELD Basis points 1, Spread (LHS) Yield (RHS) Source: J.P. Morgan; data based on JPMorgan EMBI Global Diversified Index as of December 31, 13. As we do not see a catalyst for broad EM outperformance in 1, country differentiation will be a crucial factor. Despite the 13 sell-off, we expect that capital outflows will continue to place pressure on deficit countries. We are wary of external vulnerabilities in Turkey and South Africa, although we believe there will be tactical opportunities in both countries. We are also concerned about political risks and a potential sovereign downgrade in Brazil. In Indonesia, however, we believe valuations have become very attractive, and the government has shown some willingness to address structural reforms. We favour countries with elevated yields and lower sensitivity to rising Treasury rates. Countries linked to DM growth through manufacturing exports should outperform, while commodity-oriented countries remain vulnerable, especially as global oil supplies grow. Mexico will continue to be a rising star as the implementation of its reform agenda progresses. Finally, curve positioning will be key in 1. We favour entering 1 with neutral-to-longer spread duration positioning, with a flattening bias. We believe long-end bonds, hedged against US Treasuries, have reached attractive levels in several markets and will be supported by strong demand. However, idiosyncratic risks in some higher-risk markets will again need to be monitored closely this year, particularly in Argentina and Venezuela, where the situation is fluid and spreads could widen J.P. Morgan Asset Management 5

6 Emerging market debt outlook 1: Will the horse outrun the snake? Local currency debt outlook: Challenges and opportunities as US rates rise Local currency debt had a challenging 13, but rising yields and tactical outflows have created cleaner technical positions as well as valuation opportunities. That being said, we are cognisant of the fact that in 13, the sell-off in the local currency bond index almost mirrored the sell-off in US Treasuries. This implies that, in a rising rate environment, the 13 selloff may repeat itself albeit to a lesser extent. Rising Treasury rates in 1 will therefore present both a challenge and an opportunity. Dynamically hedging US rate risk was one of the ways we added value in 13, and we will continue to explore this theme throughout 1. EMs offer attractive real interest rates compared with negative real rates in DMs EXHIBIT 9: CURRENT REAL POLICY RATES Current policy rate Inflation rate Real policy rate Ukraine Brazil China Romania Chile Hungary Poland Russia Colombia Korea Taiwan Peru Thailand Philippines Malaysia Mexico South Africa Turkey Indonesia Israel CzechRepublic India Egypt Emerging Markets Source: J.P. Morgan, Bloomberg; data as of December 31, 13. US UK Japan Euro zone Developed Markets Given the scale of the move in local rates in 13, we enter 1 with a conviction that much of the necessary adjustment in rates has already occurred and the pressure to move higher is less. Furthermore, markets have now built in a risk premium in both the nominal and real curves, indicating that there should be more opportunity for spread compression between EM local rates and core rates (Exhibit 9). In terms of returns, this means we expect to see a positive 1, with some contribution from a stabilisation of rates and from spread compression, but with the largest component of returns being carry (Exhibit 1). EXHIBIT 1: TOP LOCAL CURRENCY DEBT OVERWEIGHTS AND UNDERWEIGHTS TOP OVERWEIGHTS Brazil: At 13%+ yield levels, valuations appear very attractive, and we feel that risks are more than priced in. India: The Reserve Bank of India has been reinvigorated by its new governor, and there are early signs that the policy actions of the second half of 13 are now filtering through into an improving fundamental backdrop. The clearest sign of this improvement is the recent contraction in the current account deficit. India offers an attractive pickup to the global bond index (GBI), with 1-year bonds trading just below 9%, while the country could also benefit from being added to the index. Russia: Local debt outperformed many of its peers during a difficult 13, mainly due to having much less reliance on external sources of funding and stable inflation. We believe that Russia should be a lower beta long position in 1 as investors focus on more structurally sound EM economies. Source: J.P. Morgan; as of December 31, 13. TOP UNDERWEIGHTS Poland: We believe there is still insufficient risk premium priced in. The forward rates path seems asymmetric, while the Polish currency will continue to be a funding currency in 1. Malaysia: Valuations remain stretched, with 1-year bonds hovering around %, as the country faces balance of payment challenges. We expect maintaining an underweight here will be a cheap and low beta way to reduce portfolio duration and US Treasury correlation. Philippines: Valuations are not very attractive. EMFX outlook: Choice of funding currency likely to remain a key focus Stability in US Treasuries will be a key factor in reducing tensions, especially as the EMFX markets await more hard evidence of an EM export-led growth rebound and/or pickup in inflation. Relative value will remain the dominant theme in prospective positioning. As discussed before, the global growth profile is stabilising, although the sources of growth are more concentrated in DMs than in EMs. In turn, certain EM segments are set to benefit disproportionately from this divergence (Exhibit 11). Structurally sound currencies with closer links to the global manufacturing cycle and DM growth are likely to outperform for example, the Korean won, the Polish zloty and the Mexican peso. Meanwhile, certain currencies that are sensitive to commodity prices and foreign investment inflows could come under pressure for example, the Chilean peso and the Malaysian ringgit. 6 Emerging market debt outlook 1: Will the horse outrun the snake?

7 Concerns over growth in China have abated, although the future model for Chinese growth is likely to require less intensive commodity demand. The Chinese government is continuing to push forward a strong mandate to internationalise the yuan, with the potential for currency band widening next year. Finally, the choice of funding currency is expected to remain a key focus for investors, with the US dollar and the euro along with other G1 currencies (especially the Canadian dollar and the Japanese yen, plus the Australian dollar) staying under the spotlight along with the weaker EM currencies. EXHIBIT 11: TOP CURRENCY OVERWEIGHTS AND UNDERWEIGHTS TOP OVERWEIGHTS MXN: The Mexican peso benefits from the US recovery, positive structural reforms (particularly in the energy sector) and attractive valuations. KRW: The Korean won benefits from the DM recovery, a current account surplus, attractive valuations and a positive domestic growth outlook. CNY: The Chinese yuan benefits from Beijing s internationalisation policy drive and potential trading band widening. More consumptionled DM growth should support an export-led recovery and drive currency reserve accumulation through capital inflows. Source: J.P. Morgan; as of December 31, 13. TOP UNDERWEIGHTS CLP: Chile s peso is vulnerable to China s new growth model, which is likely to be less commodity intensive. Copper prices are under pressure from a supply overhang, and the economy is suffering from a drop in mining-related foreign direct investment. THB: The Thai baht could be hit by elections in early 1 amid ongoing political protests. The post-flood growth rebound has not been sustained, and the country s balance of payments is vulnerable to a growing current account deficit. RUB: Russia s ruble is being hurt by slowing growth, capital outflows, a diminishing current account surplus and a weak fiscal position. Central bank moves toward inflation targeting, weaker currency policy inclination and devaluing currency as authorities moderate interventionist policy. EM corporate outlook: Less volatility expected in 1 The JPMorgan CEMBI Broad Diversified Index was essentially flat in 13, returning -.6%. Although last year began positively, after May the index quickly slid into negative territory. Given that the markets now have more clarity about the timing and size of the US tapering schedule, we expect the EM corporate market to be less prone to rate shocks. We therefore expect relatively less volatile performance throughout 1. The EM corporate sector, in particular, has benefited from a higher participation of strategic investors, which should help it contain volatility going forward. Also, given the low yield environment and the strong performance of US high yield in 13, we expect investors to see relative value in certain parts of the EM corporate market, particularly in shorter- duration, higher yielding securities. We expect supply in 1 to remain robust, roughly comparable to 13 levels. Although investors will need to closely differentiate among the available securities, we believe there are plenty of opportunities for outperformance in the EM corporate debt market in 1. Earnings also should continue to improve in 1, leading to stronger fundamentals. Leverage on the EM corporate balance sheets remains a key concern, although leverage levels still compare favourably to those in DMs. EXHIBIT 1: TOP EM CORPORATE OVERWEIGHTS AND UNDERWEIGHTS TOP OVERWEIGHTS China property: Sales momentum is expected to remain positive. No severe tightening measures are foreseen from the government. Mexican corporates: The Mexican economy should continue to benefit from US economic growth. Recent political reforms have been quite market friendly. Oil & gas: Valuations look reasonable. Source: J.P. Morgan; as of December 31, 13. Conclusion TOP UNDERWEIGHTS Turkey: The current account deficit may leave Turkey vulnerable to capital flows. Political turmoil weighs on valuations. Metals & mining: Supply concerns and negative sentiment towards growth continue to weigh on prices. New style bank capital: New, deeply subordinated structures have not been tested throughout a market cycle. Although valuations look attractive across emerging market bond sectors, we believe some of the more fundamental risks have yet to be fully priced in. One of the key aspects of the markets in 13 was the lack of clarity around the timing and size of US tapering, which should be less of an issue in 1. However, more volatility could yet materialise due to idiosyncratic factors such as political events. That said, EM growth appears to be increasingly recoupled with DM growth, and as US and European growth picks up, the benefits should feed through to EM economies as well. The key will be to focus on turnaround stories and take advantage of fundamental improvements through cyclical adjustments. Overall, we retain a cautious bias and believe that a tactical allocation to risk assets will be more appropriate for 1. J.P. Morgan Asset Management 7

8 Emerging market debt outlook 1: Will the horse outrun the snake? To learn more about the Investment Insights program, please visit us at Past performance is not indicative of comparable future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations. Investments in emerging markets could lead to more volatility. As mentioned above, the normal risks of investing in foreign countries are heightened when investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property. Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. J.P. Morgan Asset Management does not predict outcomes of any political events, nor do we voice firm-wide opinions on any political candidates. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Distribution Services, Inc., member FINRA / SIPC. 7 Park Avenue, New York, NY JPMorgan Chase & Co. II-EMD-Q11