Emerging markets after Brexit

Transcription

1 FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION Emerging markets after Brexit Should political surprise in developed markets favor entrance into emerging market equities? July 216 IN BRIEF Before the UK s vote to exit the European Union, emerging market (EM) growth and earnings estimates which had been under pressure for several years were starting to signal the beginnings of a long-awaited turn in momentum. The Brexit vote and concerns about downside risks to global growth have pushed out expectations of Federal Reserve tightening (and raised the hope of policy forbearance elsewhere in developed markets). As markets debate the interplay of the Brexit shock and that policy response, a primary headwind to emerging markets namely, a strong U.S. dollar has been neutralized for now. Pre-Brexit fears that globalization had already stalled appear exaggerated. But in a world less flush with cross-border capital flows, current account balances again become relevant as influences on exchange rates. Those balances are beginning to diverge between emerging markets and developed markets, as earlier weakness in EM currencies is propelling a rising EM aggregate current account surplus. The impending departure of India s influential central bank governor introduces some intermediate-term market risk at a time when Indian equity valuation premia are elevated relative to their historical range. Even though emerging markets and Asia Pacific (EMAP) held on to their February-March surge though Q2, valuations remain at levels that have historically not been problematic for future returns. Rather, the paths of the USD and growth and earnings estimates remain the chief obstacles for EMAP performance from here. AUTHOR George Iwanicki Emerging Markets Macro Strategist Emerging Markets and Asia Pacific Equity Team NEAR QUARTER END, GROWTH AND EARNINGS ESTIMATES FOR EMERGING MARKETS SHOWED EARLY SIGNS OF A POSITIVE TURN IN MOMENTUM. Then came the UK s June 23 Brexit vote to leave the European Union, which sparked an initial selloff in global risk assets and significant declines in government bond yields. In this changed (and in some ways charged) environment, investors are reassessing the prospects for EM equities. They are asking, in particular, whether those early signs of a momentum shift will strengthen or fade in the coming quarters. As we have emphasized, the dollar s trajectory plays a critical role. In light of our long-standing concerns about the impact of USD strength on EM fortunes, we are encouraged that the post- Brexit USD bounce has been limited. We are encouraged, too, that fears of a stall in globalization fears that well pre-date the Brexit vote look exaggerated. In the following pages, we assess the outlook for emerging markets and Asia Pacific; weigh the impact of the Brexit

2 Since the global financial crisis, international capital flows have reverted to the norms of the 199s EXHIBIT 1: GROSS INTERNATIONAL CAPITAL FLOWS, % of global GDP Period averages Source: UBS; data as of May 216. vote and the current state of globalization; consider India s economic and investment prospects as it approaches the departure of its central bank governor; and, finally, discuss what investment opportunities we are seeing within the EM asset class. Through all the market tumult of 216, emerging markets, and Asia Pacific in particular, have held their own. Indeed, EM equities outperformed global equity indices during the first half of the year. In the second quarter, EM growth and earnings estimates began to signal early positive momentum a welcome shift amid a backdrop of only modest global growth. (Along with a strong USD and weak commodity prices, sluggish growth has been one of the three major headwinds for emerging markets.) Diminished downward pressure on earnings estimates could be seen in both the magnitude of earnings revisions and the breadth of those revisions (the number of company estimates revised up vs. revised down). In short, we see hints of improvement in earnings expectations. Going into the Brexit vote, this tentative optimism was tempered for some investors by concerns that globalization had already stalled. Certainly, the era of rapid globalization and intensified trade that began in the late 198s suffered a major correction in the global financial crisis. But while many have noted that trade growth has plateaued in value terms, trade integration is still deepening in volume terms. Put simply, declining relative prices of commodities and manufactured goods have exaggerated the slowdown in global trade. EMERGING MARKET-DEVELOPED MARKET DIVERGENCE IN CURRENT ACCOUNT BALANCES More significant is the recent trend in global capital flows (EXHIBIT 1). Between 2 and 28, cross-border capital flows exploded. Since the global financial crisis, flows have reverted to the norms of the 199s. In a world less flush with cross-border capital, current account balances once again matter for exchange rates. As we see it, nations dependent on foreign capital to fund current account deficits are more vulnerable than was the case during the 2 8 boom. The striking trend: Current account balances are beginning to diverge between emerging markets and developed markets. Slower growth, coupled with cheaper currencies, is prompting a rising EM aggregate current account surplus (EXHIBIT 2). Slower growth and competitive currency valuations are propelling a rising EM aggregate current account surplus EXHIBIT 2: CURRENT ACCOUNT BALANCES, SHARE OF GDP, % of GDP Emerging and developing economies G-7 Source: International Monetary Fund; data as of May EMERGING MARKET STRATEGY

3 Most measures of Indian equity valuations especially relative valuations are somewhat elevated on a historical basis EXHIBIT 3: INDIAN EQUITY ABSOLUTE AND RELATIVE VALUATIONS 3A: ABSOLUTE VALUATIONS 3B: RELATIVE VALUATIONS Multiples, 199 to Median Current Range PBV Trailing PE Forward PE Multiples, 199 to PBV vs. EM PBV vs. APxJ PE vs. EM PE vs. AxJP FWD PE vs. EM Median Current Range FWD PE vs. APxJP Source: MSCI, J.P. Morgan Asset Management; data as of June 3, 216. As Exhibit 2 illustrates, G7 nations have moved further into deficit, with the UK running one of the largest current account deficits in the developed world, at about 4.5% of GDP. Within broadly defined emerging markets, the smaller Middle East/ North Africa (MENA) countries, including Tunisia, Algeria and Nigeria, not to mention several Gulf Cooperation Council (GCC) countries, have very large current account deficits. From the perspective of an EM investor, any analysis of Brexit and globalization must ultimately focus on the central importance of the U.S. dollar. In our last quarterly report, we suggested that despite a sharp retracing in the dollar, the multi-year USD rally was pausing and might yet experience one last leg of appreciation. Today we are more confident that the pause will be extended, although we still expect one more upward move in the U.S. dollar. The Brexit vote and concerns about downside risks to global growth have pushed out expectations of Federal Reserve (Fed) tightening, despite a better June jobs report. For the foreseeable future at least, it looks like a significant threat to emerging markets a strong USD has been neutralized. INDIA AFTER RAJAN At this juncture, we shift our perspective to discuss India as it approaches the departure of Reserve Bank of India governor Raghuram Rajan. Since he took office in September 213, Rajan has forcefully implemented an inflation-targeting strategy that has had considerable success. For the past year, core CPI has converged toward its target of 5%, and survey expectations have begun to turn lower. However, implementation of these regimes elsewhere suggests that it takes more than three years to firmly anchor inflation expectations. We hope that Rajan s successor finishes the job, but at the moment the journey is incomplete. While the near-term trajectory of declining policy rates and slowly improving growth in India is largely unchanged, Rajan s exit does introduce some intermediate-term market risk. We note that this unexpected risk arrives as Indian equity valuations are elevated, especially in relative terms (EXHIBIT 3), both vs. other markets and its own history. Thus, Indian equities are priced for good news rather than new risks. CURRENCIES AND VALUATIONS: AN UPDATE Finally, we turn to a broader consideration of what is happening within the emerging market asset class. After the multi-year ascent of the U.S. dollar, the vast majority of EMAP currencies remain moderately below our best estimates of fair value (EXHIBIT 4, next page). But the pause in USD since the late January peak has reduced the degree of FX undervaluation for much of the EMAP basket. The two currencies that had flirted most recently with hypercheap valuations, the Russian ruble and the Brazilian real, re-rated in Q2 along with an upward move in commodity prices. The real now tilts slightly expensive; in comparison, the ruble looks measurably cheaper. After the Brexit vote, the USD unsurprisingly caught what we might call the safe reserve currency bid. Unexpectedly, though, the currency that really caught that bid was the J.P. MORGAN ASSET MANAGEMENT 3

4 Most EMAP currencies appear moderately but not decisively below their fair value EXHIBIT 4: EMAP CURRENCIES: REAL EFFECTIVE EXCHANGE RATE VS. CARRY Policy rate less U.S. (%) LOW CARRY HIGH CARRY RU 8 ZA TR CO IN 6 ID MX CN 4 CL 2 MY AUTW PH KR TH NZ PL JP HU HK U.S SG CHEAP EXPENSIVE REER relative to fair value Source: J.P. Morgan Asset Management estimates; data as of June 3, 216. REER: Real effective exchange rate; relative to fair value (export-adjusted 1-year average REER) on the X axis and policy rate on the Y axis. CARRY: a currency with a high IR. Countries over the line of best fit provide good carry for their currency valuation. Japanese yen. The big rebound in JPY has effectively pushed the yen back to fair value, despite Japan s negative interest rate policy and aggressive quantitative easing. BR EG We view the biggest emerging market of them all, China, as essentially two markets: new China and old China. At the heart of old China are the banks and industrials, which generally have very cheap valuations. Within new China are the consumer and (in particular) technology sectors, whose stocks are priced more richly but have very positive momentum. We like selected stocks in both the old and new economies on a tactical basis. CONCLUSION As we have observed in previous quarterly reports, the USD cycle and sluggish growth and earnings momentum, rather than valuations, presented the biggest challenges to further gains in EM equities. That was true before and after the Brexit vote. Encouragingly, the dollar s post-brexit bounce has been fairly restrained, and expectations of delayed Fed tightening support the notion that the USD pause will be extended. Additionally, growth and earnings expectations had begun to find their footing in the lead-up to the Brexit vote. Presuming the impact of the Brexit vote fails to undermine that nascent rebound and/or fails to reignite the USD rally we conclude that the severe headwinds that have restrained the asset class for the past several years are finally beginning to fade. As we distinguish among EM countries for investment prospects, we look for cheaper markets with positive trends. We like Korea, where favorable valuations and momentum have now been accompanied by relief for exporters (who benefit competitively from a rallying JPY). In Eastern European markets, we still like Turkey and Russia. Among what we call the reform markets (India, Mexico, the Philippines, Indonesia), equities seem to remain fairly aggressively priced in relative terms even though several have experienced either political or policymaker change. 4 EMERGING MARKET STRATEGY

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