Market Bulletin. Emerging markets and the Fed: A game changer? September 11, In brief

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1 Market Bulletin September 11, 2015 Emerging markets and the Fed: A game changer? In brief After the global financial crisis, flows into EM assets increased tremendously, as global investors searched for both growth and income. This large positioning led to capital flows out of emerging markets in 2013 when Federal Reserve (Fed) Chairman Ben Bernanke first communicated a shift away from easy U.S. monetary policy. With the Fed set to begin moving away from near zero interest rates, investors should consider the impact this may have on emerging markets. We do not expect a repeat of the taper tantrum once the Fed does begin to hike rates, as the pricing of EM assets has improved over the past two years, and global economic and monetary policy has evolved. Going forward, investors should focus on EM economies with less reliance on dollar funding, strong foreign exchange reserves, improving current account positioning and better growth and earnings prospects, as differentiation will remain key to investing in EM for the rest of 2015 and beyond. Gabriela Santos Global Market Strategist Ben Luk Global Market Strategist

2 Why would Fed policy impact emerging markets? In the wake of the global financial crisis, investors flocked to EM equities and debt, amid abundant liquidity, low rates and low growth in developed markets. These inflows did not always reflect positive domestic fundamentals, and the EM outlook has become increasingly difficult over the past four years. As a result, one concern with the Fed s upcoming tightening cycle is that global investors will reallocate portfolios away from riskier EM assets and back toward the U.S., given better growth prospects, rising yields (albeit from very low levels) and greater safety. As developed economies continue to heal, the liquidity tide will no longer lift all EM boats equally. This paper focuses on the impact of previous rate hikes on emerging markets, the lessons learnt during the taper tantrum period and how investors should differentiate within EM in today s environment. Once the Fed starts to normalize monetary policy, outflows could be especially challenging for EM countries that have developed large dependencies on external flows to finance economic growth. Over the past few years, accommodative policies fueled EM domestic demand, increasing EM imports. This has resulted in a worsening in current account positions for many EM countries. Current accounts mainly measure the difference between exports and imports, and any resulting deficits need to be financed by foreign inflows into equities and debt or investments in the real economy. Exhibit 1 highlights how the aggregate EM current account surplus was 3.8% of GDP back in 2007 and is expected by the IMF to fall to only 0.1% in This vulnerability is not the same across EM. Countries like Colombia, South Africa, Turkey, Brazil and Indonesia now have significant current account deficits, while others (mainly Russia and several Asian nations) still maintain large surpluses. Those with deficits now have a high dependence on foreign inflows, leaving them more vulnerable to changes in financial conditions abroad compared to a few years ago. EMs are increasingly reliant on global flows to finance growth EXHIBIT 1: EM CURRENT ACCOUNT, % OF GDP % 3.5% 1.3% 1.4% 1.6% 1.4% 0.7% 0.7% 0.1% '07 '08 '09 '10 '11 '12 '13 '14 '15 Source: IMF, J.P. Morgan Asset Management. Based on the World Economic Outlook from April Data are as of August 21, The chart above and the charts, graphs and tables herein are for illustrative purposes only. A Fed interest rate hike unlike all others We can look at previous Fed tightening cycles to draw some conclusions regarding their historical impact on EM assets. However, there is an important caveat when thinking about this particular cycle. Since the global financial crisis, the composition of international flows has changed, with EM inflows representing over half of total global capital flows, compared with less than 2 before the crisis.* In pre-crisis years, foreign capital overwhelmingly entered emerging markets via foreign direct investment (FDI) (for example, a foreign company investing in a company in a particular EM country). These inflows tend to be sticky, as business decisions can take years to change. FDI is still the main way that money enters emerging markets, but there has been a large increase in EM portfolio investment since *Based on the IMF s staff discussion note Emerging Market Volatility: Lessons from the Taper Tantrum written by R. Sahay, V. Arora, T. Arvanitis, H. Faruqee, P. N diaye, T. Mancini-Griffoli, and an IMF team, September EMERGING MARKETS AND THE FED: A GAME CHANGER?

3 These are foreign flows into EM equity, and particularly bonds, as global investors searched for income (Exhibit 2). This has left emerging markets vulnerable to changes in developed market growth prospects and monetary policy, as portfolio flows can be much more quickly reversed than FDI. Large inflows into EM assets post-crisis leave EM more vulnerable to shifts in DM policy and growth EXHIBIT 2: NET FLOWS INTO EM MUTUAL FUNDS AND ETFS, USD BILLIONS $80 $70 $60 $50 $40 $30 $20 $10 $0 -$10 EM Equities EM Debt '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 YTD Source: Strategic Insight, J.P. Morgan Asset Management. Data are as of August 21, Given these changes, a more recent example can be useful. The taper tantrum of 2013 occurred as a result of investors readjusting their expectations about a presumed Fed tightening cycle, and can provide some indication of potential EM reaction to changes in expectations regarding Fed policy. Lessons from EM history: Equities Exhibit 3 looks at previous Fed tightening cycles, as well as the taper tantrum, and their impact on EM equity returns (in local and U.S. dollar terms). Note that 1) short-term reactions to a first rate hike tend to be more negative than over the entire tightening cycle, 2) whether the U.S. dollar is strengthening is an important consideration, and 3) EM equity returns can vary significantly during individual rate hikes. EM EQUITIES: SHORT VS. LONG TERM EM equity returns tended to be negative in the shortterm (one week to one month) after the first rate hike, but more positive in the long-term (six months to the end of the tightening cycle). This may be explained by an initial panic following a first rate hike, while over the longer term, investors can refocus on emerging market fundamentals. Looking at the taper tantrum, the initial reaction was quite negative, but over time, performance stabilized. EM equities historical response to Fed rate hikes depends on time horizon, dollar performance and economic growth EXHIBIT 3: EM EQUITIES PRICE RETURN BY RATE HIKE CYCLE EME Price Return 1 Week After First Rate Hike 1 Month After First Rate Hike 6 Months After First Rate Hike Over Tightening Cycle (annualized) Period Local USD Local USD Local USD Local USD % 0.5% -2.2% -7.4% 17.6% -5.2% 0.2% -23.6% % 4.2% -1.7% -2.4% 19.9% 18.3% 12.9% % -1.1% -1.2% 17.2% 25.9% 28.6% 33.7% "Taper Tantrum" -1.3% -2.6% -10.4% -14.1% % -2.4% Source: MSCI, J.P. Morgan Asset Management. EME returns are based on the MSCI Emerging Market Index. Period : 2/3/1994-3/28/1995. Period : 6/29/1999-6/28/2000. Period : 6/29/2004-8/8/2006. Taper tantrum: 5/21/2013 9/19/2013. Data are as of August 21, J.P. Morgan Asset Management 3

4 EM EQUITIES: THE ROLE OF THE U.S. DOLLAR The second factor that stands out is the U.S. dollar s role for EM returns. In a direct way, dollar strength means lower returns once converted from local currency into dollars. During the cycle, the dollar appreciated 2% against a broad basket of currencies, denting returns for EM equities in dollars. During , on the other hand, the dollar depreciated 7%, helping dollar returns. The dollar s role for EM equity performance is not only limited to these currency translation effects. A stronger dollar tends to hurt commodity prices (which are priced in dollars), hurting commodity exporting EM countries and sectors. Exhibit 4 illustrates how EM equities underperform DM equities during periods of dollar strength. The U.S. dollar is crucial for EM equity performance EXHIBIT 4: USD EQUITY INDICES, REBASED, DEC. 1993= MSCI EM / MSCI DM EM equity outperformance and U.S. dollar depreciation USD (reversed) EM equity underperformance and U.S. dollar appreciation 0 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 Source: MSCI, Federal Reserve, J.P. Morgan Asset Management. MSCI EM is the Emerging Markets Index in USD terms, MSCI DM is the MSCI The World Index in USD terms. The U.S. dollar is the Fed s Real Broad Effective Exchange Rate. Data are as of August 21, EM EQUITIES: MORE THAN THE FED AND THE DOLLAR Lastly, within a tightening cycle, EM equity performance varies in response to each individual rate hike. Exhibits 5A and 5B plot each Fed rate hike since February 1994 against subsequent dollar EM equity price returns over one week and 12 months, respectively. There is a wide range of variation around the trend line. One week returns after a 25 basis point (bps) Fed hike range from plus 6.1% (February 2, 2000) to minus 7.2% (May 10, 2006). This range widens even further as the time horizon is extended. Twelve-month returns range from plus 60.6% (May 3, 2005) to minus 34.9% (March 21, 2000). This variation underscores the fact that U.S. rate hikes are only one variable affecting EM equity performance. The crisis in Mexico in negatively affected EM, while the commodity supercycle during the last two rate cycles underpinned strong equity performance unrelated to U.S. monetary policy. EM equity returns vary greatly after individual rate hikes EXHIBIT 5A: ONE WEEK AFTER FED RATE HIKE, Y AXIS=EM EQUITY PRICE RETURN, X-AXIS=BASIS POINTS OF FED RATE HIKE % % 1.0 EXHIBIT 5B: TWELVE MONTHS AFTER FED RATE HIKE, Y AXIS=EM EQUITY PRICE RETURN, X-AXIS=BASIS POINTS OF FED RATE HIKE % % 1.0 Source: MSCI, J.P. Morgan Asset Management. MSCI EM is the Emerging Markets Index in USD terms. Returns after each individual rate hike from February 1994 to June Data are as of August 21, EMERGING MARKETS AND THE FED: A GAME CHANGER?

5 Lessons from EM history: Fixed income Exhibit 6 illustrates the performance in dollars of the three main types of EM debt: sovereign bonds denominated in dollars (for which we have good data history), corporate bonds denominated in dollars, and sovereign bonds denominated in local currency. The performance of EM dollar debt after the first rate hike of the cycle was quite negative (reflecting the Mexican crisis and its contagion to other emerging markets), while returns after the beginning of the last two rate hike cycles were positive. During the taper tantrum, returns for the three main types of EM debt were negative, as EM yields followed U.S. yields higher. In addition, EM debt underperformed EM equities during this particular period. While we do not anticipate a major sovereign default given improved FX reserve positions, two risks have emerged for certain types of EM debt: 1) large foreign ownership in certain local debt markets, and 2) an increase in corporate debt issued in dollars. EM debt historical response to Fed rate hikes has been varied EXHIBIT 6: EM DEBT RETURN BY RATE HIKE CYCLE EM USD Denominated Sovereigns 1 Week After First 1 Month After First 6 Months After First Over Tightening Cycle (annualized) Period USD USD USD USD % -10.7% -18.9% % -0.6% 11.1% % 3.4% 13.9% 14.2% "Taper Tantrum" -2.5% -8.3% % EM USD Denominated Corporates 1 Week After First 1 Month After First 6 Months After First Over Tightening Cycle Period USD USD USD USD "Taper Tantrum" -1.7% -7.2% % EM Local Currency Sovereigns 1 Week After First 1 Month After First 6 Months After First Over Tightening Cycle Period Local USD Local USD Local USD Local USD "Taper Tantrum" -1.2% -2.5% -5.3% % -5.9% Source: J.P. Morgan, J.P. Morgan Asset Management. EM USD sovereigns are based on the J.P. Morgan EMBIG Diversified Index. EM USD Corporates are based on the J.P. Morgan CEMBI Index. EM Local Currency sovereigns are based on the J.P. Morgan GBI-EM Global Diversified Index. Data are as of August 21, Period : 2/3/1994-3/28/1995. Period : 6/29/1999-6/28/2000. Period : 6/29/2004-8/8/2006. Taper tantrum: 5/21/2013 9/19/2013. Data are as of August 21, J.P. Morgan Asset Management 5

6 EM FIXED INCOME: FOCUS ON SOVEREIGN VULNERABILITIES The large flows into EM debt have created an increasing dependency on foreign funding in certain local EM debt markets. Exhibit 7 illustrates how growing foreign ownership of local debt has created a vulnerability for some EM countries should foreign investors decide to sell their investments. Some of these countries, such as Mexico, may choose to hike rates in tandem with the Fed in order to protect their markets. This is economically challenging, given an already difficult growth backdrop for many EMs. Some EM sovereigns increased their dependency on foreign holders, leaving them vulnerable to outflows EXHIBIT 7: FOREIGN OWNERSHIP OF LOCAL DEBT, % OF TOTAL % 58% 57% 19% 46% 15% 16% 12/31/2007 3/31/2015* 39% 37% 11% Poland Mexico Malaysia Indonesia South Africa Source: National agencies, J.P. Morgan Asset Management. *South Africa s data is as of the end of Data are as of August 21, EM FIXED INCOME: FOCUS ON CORPORATES Over the past few years, many EM companies took on more credit in the form of bank loans and corporate debt. Given the appetite for yield post-crisis, there was a meaningful increase in dollar-denominated debt (Exhibits 8A and 8B). This makes EM corporates vulnerable to a diminished foreign appetite for EM debt, as well as to dollar appreciation (as it makes servicing dollar debt more expensive). Companies that have local revenues, in particular, may find it harder to service their dollar debt if their currencies depreciate. This risk increases as we move down the credit curve. EM corporate external debt has increased post-crisis, leaving some companies vulnerable to currency depreciation EXHIBIT 8A: EM PRIVATE EXTERNAL DEBT, % TOTAL EXTERNAL DEBT, INCLUDES BANK LOANS AND CORPORATE BONDS '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 EXHIBIT 8B: EM CORPORATE BOND ISSUANCE, USD BILLIONS EM ex-china Other foreign currency EUR USD Local currency Share of Foreign Currency (rhs) Source: BIS, Thomason One, IIF, J.P. Morgan Asset Management. Data are as of August 21, EM % 50.7% EMERGING MARKETS AND THE FED: A GAME CHANGER?

7 MARKET BULLETIN The wage puzzle Lessons from EM History: Currencies EM CURRENCIES: SELECTIVITY MATTERS IN THE LONG TERM During the taper tantrum (May-September 2013), EM currencies broadly came under pressure. However, by the end of 2013 there were clear winners and losers within EM (Exhibit 9). Countries with large current account deficits, the so-called fragile five countries (Turkey, South Africa, India, Indonesia and Brazil), saw their currencies depreciate over 8%. Countries with smaller deficits or surplus current account positions saw more stable currencies. Differentiation within EM fundamentals pays off in the long run EXHIBIT 9: EM CURRENCY PERFORMANCE VS. CURRENT ACCOUNT,Y AXIS=CURRENCY PERFORMANCE VS. USD, X AXIS=CURRENT ACCOUNT AS A % OF GDP Turkey India Brazil Indonesia 8% 4% China Korea -8% -4% 4% 8% Colombia -4% Russia South Africa Mexico -8% Malaysia -12% -16% -2 Lessons from EM History: Tape Tantrum version 2.0? EM ASSETS MUCH BETTER PRICED COMPARED TO 2013 Since monetary conditions and portfolio flows dynamics have changed post-crisis, we believe further analysis of the taper tantrum period is necessary to determine whether we can expect the same adjustment as seen in The statement made by ex-fed chairman Ben Bernanke in May 2013 resulted in a jump of more than 140bps from 1.6% to 3. in U.S. 10-year Treasury yields within a few months. This quickly led to foreign portfolio outflows across both EM equities and bonds, currency depreciation across emerging markets, and a steep rise in EM bond spreads. We believe EM assets are less vulnerable this time. Investor sentiment towards emerging markets has not recovered since 2013, resulting in much lower positioning across the EM universe. The EM share of global equity flows, which reached close to 3 during mid-2013, has halved to less than 15% by June While total annual net flows into EM equities and bonds were close to USD60-70bn prior to the taper tantrum, flows are less than USD10 billion year-todate (Exhibit 2, page 2). Source: IMF, FactSet, J.P. Morgan Asset Management. Currency performance from 5/21/13 to 12/31/13. Current accounts are for Data are as of August 21, J.P. Morgan Asset Management 7

8 MARKET BULLETIN J.P. Morgan Asset Management The strength of the dollar has also continued and many policy makers in EM have allowed their currencies to depreciate over the last two years. Prior to the taper tantrum, many EM currencies were trading higher than their 10-year average in real effective exchange rate terms, but most currencies today are trading at much lower levels (Exhibit 10). In addition, both EM dollar and local currency bond yields have remained elevated since the taper tantrum, with yields today trading one standard deviation higher than the unsustainably low levels of 2013 (Exhibit 11). In short, yields are unlikely to move significantly higher when the Fed does normalize because the EM situation is much better priced in terms of lower investor positioning, weaker currencies and higher yields. and boost consumption in the short-term, while the reduction of spending on subsidies means the government can deploy more resources into other projects to boost productivity and improve competitiveness. Most of Latin America, on the other hand, continues to wrestle with high inflation, limiting the scope for interest rate cuts, despite weaker growth in this commodity exporting region. EM currencies at much lower levels compared to the taper tantrum period of 2013 EXHIBIT 10: % DEVIATION FROM REER 10-YEAR AVERAGE 3 15% REER April 2013 REER June 2015 Appreciation LOWER COMMODITY PRICES ALLEVIATE PRESSURE FOR CERTAIN EMS -15% Depreciation Another key difference for EM compared to 2013 has been the plunge in commodity prices. In just the last year, oil, gold, copper and iron ore prices have dropped -57%, -14%, -26%, and -33%, respectively. While there is a misconception that many EM economies are commodity exporters, 67% of EM countries have experienced a positive terms of trade adjustment as a result of commodity weakness compared to last year, highlighting that most commodity exports are concentrated in a few countries*. Weaker commodity prices have effectively kept a lid on aggregate EM inflation, giving some central banks more leeway to lower interest rates to stimulate growth if deemed necessary. In particular, the net oil importers of emerging Asia should continue to benefit from falling energy prices, enabling countries with fuel subsidies, like India and Indonesia, to improve their fiscal positions and retain global capital. Lower oil prices should improve household disposable income Source: BIS, FactSet, J.P. Morgan Asset Management. Data are as of August 21, EM bond yields have not recovered since 2013 and still remain elevated EXHIBIT 11: EM LOCAL AND USD DEBT YIELD TO MATURITY 8% 7% 6% 5% Average +1 S.D. -1 S.D. 4% '10 '11 '12 '13 '14 '15 Source: J.P. Morgan, J.P. Morgan Asset Management. Yield-tomaturity based on a blended yield, which comprises of 5 EMBIG (USD denominated) and 5 GBI-EM (local currency). Data are as of August 21, * According to the Citi commodity terms of trade indices, which measures the relative performance of commodity export and import prices, we analyzed trade data from all 18 available EM countries by comparing each countries term of trade index since July We found that 12 out of 18 EM countries have improved their terms of trade compared to one year ago. 8 EMERGING MARKETS AND THE FED: A GAME CHANGER?

9 Pressure will continue on commodity-dependent economies, and countries have dealt with this situation in different ways. Russia and Malaysia have deployed their foreign exchange reserves to stabilize their currencies, while other net oil exporters like Mexico and Colombia have instead allowed their currencies to depreciate with less intervention in order to help make their other exports more competitive and continue building a strong reserve buffer (Exhibit 12). Commodity importers have benefited from lower commodity prices and continued to build stronger FX reserves EXHIBIT 12: % CHANGE IN EM FX RESERVES SINCE APRIL 2013 India Colombia Mexico Korea China Taiwan Indonesia Brazil Philippines South Africa Turkey Thailand Peru Malaysia Russia Total FX Reserves (USD Billions) , Source: Bloomberg, J.P. Morgan. Data are as of August 21, GLOBAL MONETARY POLICIES HAVE CHANGED SINCE 2013 Many investors fear that the first U.S. rate hike will trigger a liquidity crunch, but we would argue these fears are a bit exaggerated. While the Fed was the most aggressively easy central bank during the summer of 2013, global central banks soon followed. The Bank of Japan pledged to expand its balance sheet to stimulate growth, with assets on track to reach close to 9 of nominal GDP by The European Central Bank has also committed to its own QE program, potentially expanding its balance sheet to EUR 3 trillion by mid-2016 (Exhibit 13). Even without further global monetary easing, liquidity should remain ample as both Japan and the eurozone should compensate for the normalization of U.S. monetary policy. Accommodative global monetary policies despite Fed normalization thanks to the BoJ and ECB EXHIBIT 13: CENTRAL BANK BALANCE SHEETS, % OF NOMINAL GDP Projections* BoJ ECB 2 Fed 1 BoE '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: European Central Bank, Bank of England, Bank of Japan, Federal Reserve System, J.P. Morgan Economics, FactSet, J.P. Morgan Asset Management. *Balance sheet forecasts are based on central bank s stated economic intentions. (i.e. assumptions are that the BoJ will expand its balance sheet at an annual rate of JPY80 trillion, the ECB will expand its balance sheet at a monthly rate of EUR60 billion, BoE and Fed both will keep their balance sheets at their current levels). Nominal GDP growth forecasts provided by J.P. Morgan Investment Bank Macro Research. Data are as of August 21, J.P. Morgan Asset Management 9

10 MARKET BULLETIN J.P. Morgan Asset Management Stronger global growth is much needed to lift emerging markets Emerging markets have become more resilient since the late 1990s, with flexible exchange rates, better fiscal positions and better monetary policy frameworks in place. However, improving global growth is even more important than the actions of the Fed to reduce EM vulnerability. This includes the stabilization of the Chinese economy and further recovery of the eurozone. STABILIZATION OF THE CHINESE ECONOMY Despite various monetary stimulus measures taken to stabilize the Chinese economy, macro data disappointed in the first half of While both property prices and sales volume have rebounded in recent months, helped by previous incentives and declining interest rates, property construction and investment have remained weak as most developers are in destocking mode. New housing starts contracted by 15% y/y in June, while land purchases dropped 35% y/y in 2Q Chinese leaders have emphasized that economic growth remains one of the government s top priorities in 2H 2015, and we expect further fiscal and monetary stimulus to boost infrastructure investment projects to offset weakness in the manufacturing and real estate sectors (Exhibit 14). The State Council has recently raised target units in its shanty town renovation program from a three-to-five million range to 18 million units. There are also around 1,000 publicprivate-partnership projects that are expected to be rolled out in the medium term with total spending of RMB 2 trillion. The Chinese government s intention to push economic growth through infrastructure investment should boost demand for related EM economies, as well as help stabilize commodity prices as China consumes around 5 of the world s total iron ore, nickel, zinc, copper, aluminum and crude steel. Infrastructure to boost Chinese growth to offset weakness in the manufacturing and real estate sectors EXHIBIT 14: CHINA FIXED ASSET INVESTMENT, YEAR-OVER-YEAR % CHANGE, 3-MONTH MOVING AVERAGE Infrastructure Manufacturing Real estate -1 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 Source: National Bureau of Statistics, FactSet, J.P. Morgan Asset Management. Data are as of August 21, EMERGING MARKETS AND THE FED: A GAME CHANGER?

11 REVIVAL OF EUROPE MORE IMPORTANT THAN THE U.S. While the U.S. remains a key source of global liquidity, we believe Europe is an even more important partner to emerging markets. European banks have provided more loans and cross-border credit compared with the U.S. and Japan (Exhibit 15) and further incentives from the ECB to promote credit growth should indirectly boost liquidity for emerging markets. In terms of trade, Europe is also a larger EM trading partner, as EM exports to Europe as a percentage of total reached 23% in 2014, compared with exports to the U.S. at 17%. The European economy should strengthen further as expansionary monetary policy, weaker currency, ongoing structural reforms and lower oil prices all bode well for a broad-based economic expansion. European consumers have reacted enthusiastically to lower oil prices as consumer confidence has reached its highest level since the global financial crisis, while retail sales have expanded to multi-year highs, implying stronger demand for EM exports. Europe is a much stronger source of funding for EM economies compared to the U.S. and Japan EXHIBIT 15: % OF TOTAL DM BANK LENDING TO EM % European Union U.S. Japan 57% 86% 72% Not all EMs are positioned equally After the taper tantrum episode, a jump in U.S. longterm interest rates initially led to a broad sell-off across emerging market assets, but investors quickly separated out the strong economies. We believe a wide dispersion will persist as EM economies will no longer move in tandem with each other. The key is to identify the least exposed countries to the Fed s normalization. Near-term liquidity risks will be affected by the overall current account and foreign direct investment position of the country, as well as the ratio of its short-term external debt to its currency reserves. In general, Asian economies, especially north Asian markets like China, Taiwan and Korea, are much better positioned compared to the rest of EM (Exhibit 16). Liquidity risks vary across EM, so search for less vulnerable economies once the Fed starts to normalize EXHIBIT 16: LIQUIDITY RISK PER EM COUNTRY Short-term debt as % of FX reserves, High Liquidity Risks Turkey South Africa Malaysia Czech Republic 6 Mexico Hungary Chile Indonesia Taiwan 4 Israel Colombia Poland Thailand Korea India 2 Philippines Egypt Russia China Brazil Low Liquidity Risks -6% -3% 3% 6% 9% 12% Current account and net FDI (% of GDP), % 21% 21% 22% 4% 6% 11% 1 EM Asia CEEMEA LATAM Source: BIS, IMF, Haver, BoA ML, J.P. Morgan Asset Management. Data are as of August 21, Source: BIS, Bank of Japan, HSBC, J.P. Morgan Asset Management. Data as of J.P. Morgan Asset Management 11

12 MARKET BULLETIN J.P. Morgan Asset Management We believe one of the most important determinants of EM equity performance in the medium term will be the growth differential between emerging and developed markets. This gap has been shrinking since 2011 as emerging market growth slowed while developed market expansion has picked up. As a result, DM equities have outperformed EM equities. Some improvement in the growth differential will be key for EM equity performance going forward. While low EM equity valuations already reflect risks being priced into the asset class, it will be hard for foreign investors to justify their EM holdings based on valuations alone. Earnings will have to improve in the medium term as forward earnings expectations have been too optimistic in recent years, as analysts overestimated the impact of favorable demographics and higher absolute economic growth (Exhibit 17). Still awaiting an improvement in EM earnings outlook after years of disappointment EXHIBIT 17: FORWARD EARNINGS PER SHARE, LOCAL CURRENCY, INDEX, 2008 = EM Asia EM Investment implications There is no doubt that headwinds remain for emerging markets such as tightening financial conditions in the U.S., weaker short-term growth prospects and an increase in EM corporate leverage. While these have turned global investors sentiment against the EM universe, depressed valuations are already evident across EM currencies, bonds and equities. Investors should not ignore the significant improvements made in many EM economies since the taper tantrum in Going forward, we believe that current account position, inflation outlook, growth fundamentals and reserve levels will be dominant factors affecting EM portfolio flows once the Fed starts to raise interest rates. While short-term prospects are challenging, investors should not forget the longer-term fundamentals of emerging markets, which as a broad asset class deserves a strategic long-term allocation to an overall diversified portfolio. We continue to favor EM countries that have managed to focus their monetary and fiscal policies on reducing vulnerabilities and strengthening structural reforms to improve productivity and boost long-term economic growth prospects EM Europe EM Latin America 40 '08 '09 '10 '11 '12 '13 '14 '15 Source: MSCI, FactSet, J.P. Morgan Asset Management. Data are as of August 21, EMERGING MARKETS AND THE FED: A GAME CHANGER?

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