Recoupling Stalemate. Emerging Markets Strategy INVESTMENT INSIGHTS IN BRIEF THE RECOUPLING STORY: AN ONGOING STALEMATE AUTHOR.

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1 INVESTMENT INSIGHTS Recoupling Stalemate Emerging Markets Strategy February 215 FOR INSTITUTIONAL/WHOLESALE OR PROFESSIONAL CLIENT USE ONLY NOT FOR RETAIL DISTRIBUTION. IN BRIEF The recoupling of emerging market (EM) growth with developed market (DM) growth has reached a stalemate. EM macro growth forecasts have stabilized, but earnings continue to struggle, with estimates still being downgraded. The divergence of DM monetary policy is underwriting further strength in the U.S. dollar. Combined with the impact of oil price declines, the stronger dollar has helped push the majority of EM currencies down to levels we see as below fair value. Concerns about further dollar strength and the start of the U.S. Federal Reserve s (the FED s) policy normalization are justified. However, history suggests that dollar strength is problematic for EM equity performance when U.S. yields and rates are falling, but less so when U.S. yields are rising. Absolute and relative valuations suggest that the sluggish macro backdrop for EM earnings and the external challenges facing the asset class are reflected in current share prices. We continue to favor Korea, Eastern Europe and Russia, and have begun to add back to China as monetary easing progresses. The extended rebound in India and the rebound in Turkey in the second half of 214 mean we are cautiously assessing the relative attractiveness of these two beneficiaries of the oil price decline. THE RECOUPLING STORY: AN ONGOING STALEMATE When it comes to the recoupling story, there s good news and bad news. The good news is that recoupling is happening, with the correlation of economists consensus 12-month gross domestic product (GDP) forecasts for emerging markets and developed markets picking up in recent months (Exhibit 1). The bad news is that the rebound in EM growth hasn t yet been significant, and DM growth has also flattened out over the past few months after weakness in Europe and lingering concerns about Japan. We continue to believe that earnings challenges largely explain poor EM performance in this slow-growth environment. Exhibit 2A shows that developed markets have held up quite well after rebounding from the global financial crisis. Conversely, emerging markets rebounded and then withered. This divergence is due to the difference in earnings performance. AUTHOR George Iwanicki Emerging market macro strategist

2 So are EM earnings experiencing a structural break? In fact, Exhibit 2B shows that EM earnings performance has simply tracked the usual operating leverage to GDP growth. Realized GDP growth has slowed down by enough to explain lackluster earnings per share (EPS) growth over recent years. Across emerging markets, earnings estimates have largely been revised downward, led by the commodities sectors. Based on the magnitude of the oil price decline, we anticipate that earnings expectations will remain the major headwind for the asset class for some time to come. Yet the commodities space offers one glimmer of hope. The last of the major EM currencies that we had valued on the rich side of fair value have now moved towards the cheap side. The first is the Brazilian real (Exhibit 3), which has moved from 4% expensive at its peak to the cheap side of neutral. We believe this marks the end of overvaluation in the real. The second is the Russian rouble. A maxi devaluation has moved the currency from 2%-3% expensive relative to fair value two years ago to very cheap levels in real effective terms (and hyper-cheap relative to the dollar) today. Consequently, it is getting harder to find an EM currency that could be described as overvalued. In a globalized world, it s hard for two large economic blocs to move in opposite directions for long EXHIBIT 1: EM VS. DM GDP GROWTH FORECASTS FOR THE NEXT 12 MONTHS % EM GDP NTM DM GDP NTM 12 month correlation: EM vs DM -3 1/93 1/94 1/95 1/96 1/97 1/98 1/99 1/ 1/1 1/2 1/3 1/4 1/5 1/6 1/7 1/8 1/9 1/1 1/11 1/12 1/13 1/14 Source: J.P. Morgan Asset Management, Consensus Economics; data as of ember 31, 214. NTM = next 12 months; EM = emerging markets; DM = developed markets. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecasts, projections and other forward statements, actual events, results or performance may differ materially from those reflected or contemplated. EM and DM earnings performance has diverged significantly since the global financial crisis EXHIBIT 2A: EARNINGS SHARE OF GDP FOR EMERGING MARKETS AND DEVELOPED MARKETS No evidence of a structural break for emerging markets EXHIBIT 2B: EM EARNINGS RELATIVE TO GDP INDEX VS. REAL EM GDP GROWTH Earnings/GDP Earnings/GDP Real GDP growth (%, y/y) EM Earnings/GDP Index DM Earnings/GDP Index EM Earnings/GDP Index EM Real GDP Growth (%) 1% 8% 6% % % % % Source: Emerging Market Advisors, MSCI; data as of September 214. Left-hand scale represents emerging markets; right-hand scale represents developed markets. Shown for illustrative purposes only. 2-year average is 1. Source: Emerging Market Advisors, MSCI; data as of September 214. Shown for illustrative purposes only. 2 EMERGING MARKETS STRATEGY EXECUTIVE SUMMARY

3 Few EM currencies are now overvalued EXHIBIT 3: CURRENCY VALUATION AND SUPPORT REER vs CARRY Policy rate less U.S. Low carry High carry BRL Line of best fit 8 TRY INR RUB 6 IDR ZAR 4 CNY COP HUF MXN MYR 2 CLP PHP PLN TWD KRW THB Cheap REER relative to fair value Expensive Source: J.P. Morgan Asset Management estimates; data as of ember 31, 214. 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 interest rate). Countries over the line of best fit provide good carry for their currency valuation. UNFOLDING RISKS: DOLLAR STRENGTH AND FED TIGHTENING, COMMODITIES AND CHINA S CYCLE Challenge one: the dollar rally could see higher U.S. rates force rising U.S. yields So what challenges do emerging markets now face? First, there s the impact of the dollar rally and the potential for U.S. rates to move higher if U.S. yields have risen after the rally. Exhibit 4 shows the distribution of dollar and U.S. Treasury yield movements over the past 15 years. In relative terms, a EGP rising dollar is clearly unfavorable for emerging markets. But in absolute terms, it depends whether U.S. yields are rising or falling in this rising dollar environment. When U.S. yields are falling and the dollar is rallying, EM equity tends to be hit by negative absolute and relative returns. However, when the dollar is strengthening, but U.S. yields are rising, emerging markets typically struggle to keep up with developed markets. This means that absolute (vs. relative) performance is generally positive. We think the reasons for this unexpected result are actually straightforward. When the dollar is rallying, but rates are falling, one of two things is happening. Either a global crisis is increasing risk aversion and causing investors to flock to the dollar and U.S. Treasuries as a safety trade, or the dollar is rallying because U.S. growth is strong, but the rest of world s growth is weak. As a result, U.S. Treasury yields are being dragged down by the absence of growth outside the U.S. Arguably, that s precisely the environment we have been in over the past few months, fuelled by speculation about the European Central Bank s (ECB s) adoption of quantitative easing (QE) and the Bank of Japan s aggressive pursuit of QE. And emerging markets, as we have highlighted, are still struggling. As markets have largely discounted the ECB s well-advertized QE policy, the next move in U.S. yields and rates may well be an upward one as the Fed embarks upon its normalization process. This would transform the current environment from a very hostile one for emerging markets to a more balanced one, where the dollar remains the headwind, but rates are less of a headwind than before. A rising dollar is unfavorable to emerging markets when U.S. yields are falling EXHIBIT 4: THE RELATIONSHIP BETWEEN THE DOLLAR, U.S. RATES AND EM RETURNS 12 Month Rolling Returns 87 to 14 69% 14% 33% 16% (7)% (15)% Absolute¹ Absolute Relative² 46% 33% 17% 11% (9)% (1)% Relative USD (%) Rates flat/falling Rates rising Dollar flat/falling 1-year UST yield (bp) Rising Dollar 55% 1% (1)% Absolute Absolute 26% (6)% (16)% Relative 33% 19% (9)% (11)% (4)% (35)% Relative Max Median Min Source: Factset, J.P. Morgan Asset Management, data as of ember 31, 214. U.S. dollar measured by the U.S. Dollar Real Trade-Weighted Exchange Rate Index, Broad Definition. Absolute* measures 12-month rolling returns of the MSCI Emerging Market Index. Relative** measures MSCI EM Index returns vs. MSCI ACWI returns. ¹ Trigger to count EM returns if the dollar rose more than 2% in prior 12 months. ² Trigger to count EM returns if the 1-year yield rose more than 5bps in prior 12 months. J.P. MORGAN ASSET MANAGEMENT 3

4 Challenge two: the reversal of the commodity supercycle The second challenge to the asset class is the reversal of the commodity supercycle. Prices in two big sectors are particularly relevant for emerging markets: industrial metals and energy (Exhibit 5A). Historically, metals have behaved like most commodity prices: they fluctuate significantly, but tend to trend downward in real terms over the long term. Furthermore, the ongoing reversal in industrial metals prices (particularly iron ore) has finally erased virtually the entire relative price overshoot measured against the long-term trend. Performing the same analysis for energy reveals two things (Exhibit 5B). First, the trend line does not slope downward. Second, the sharp decline in oil prices during the latter half of 214 has pushed relative energy prices significantly below their long-term trend for the first time in a decade. For both sectors, the extended correction has now erased the overshoot portion of the commodity super cycle. Consequently, while we remain underweight commodities across the board in our EM portfolios, we are becoming more pragmatic on the chances of an ongoing correction. Exhibit 6A highlights the reasons for our continuing caution on this segment of the asset class. When the dollar rallies, both the energy and materials sectors typically struggle to keep up with the rest of the emerging markets. The final point to note is the degree of underperformance and, as a result, the reduction in market capitalization share for the EM commodities space. Exhibit 6B shows the breakdown of the MSCI EM Index in market capitalization terms between the three major components: commodities, consumer and financials. Commodities are now below levels that we saw back in the 199s, prior to the rebound at the turn of the century. Indeed, some of an emerging undershoot in metals and energy is already being priced in by markets, so we do not believe this is the time to get more bearish on commodities. Many investors view emerging markets as synonymous with commodities, but most of EMEA (ex-russia) and Asia are beneficiaries of lower oil prices in terms of GDP and revenue impact. In short, the export exposure of the commodities sector (particularly oil) is concentrated in a handful of EM economies, but most of the asset class is a net beneficiary of lower oil prices, similar to the developed economies. Challenge three: China s cycle The third challenge is China s cycle, particularly given the divergence between the real economy and the local A-share market. The Purchasing Managers Index (PMI) has been relatively sluggish, although the services component appears to have rebounded over the past few months, driven by the economy s shift away from investment and exports. Strikingly, as deceleration continues, the Chinese A-share market surged by almost 6% from July 214 to the end of the year, forcing policymakers to invoke margin requirements to cool the speed of the rally. This surge suggests the A-share market may be the first responder to monetary easing and the first repository for liquidity from China s monetary policymakers. They are reluctantly being forced to ease, not only by slower growth, but also by decelerating money and credit growth, which is driving down inflation and nominal GDP growth. Gauging the extent of the commodity supercycle reversal in the metals and energy sectors EXHIBIT 5A: REAL METALS PRICE INDEX EXHIBIT 5B: REAL ENERGY PRICE INDEX Index, 199=1 Index, 199= Source: J.P. Morgan Asset Management, BLS, World Bank; data as of ember 31, EMERGING MARKETS STRATEGY EXECUTIVE SUMMARY

5 In a dollar rally, materials and energy typically struggle to keep up with other EM sectors EXHIBIT 6A: CORRELATION OF THE DOLLAR AND EM SECTOR RELATIVE PERFORMANCE Materials Industrials Energy Financials Consumer Discretionary Information Technology Utilities Telecoms Consumer Staples Healthcare (.3) (.3) (.1) (.1) (.) Source: J.P. Morgan Asset Management, BLS, World Bank; data as of ember 31, 214. Correlations are based on monthly sector returns in % terms, adjusted for the performance of the MSCI EM Index vs. the USD measured in real trade adjusted terms. Commodities are now below levels seen in the 199s, prior to the rebound at the turn of the century EXHIBIT 6B: MSCI EM INDEX WEIGHTING OF MAIN EM SECTORS Commodities Consumer Financials Source: J.P. Morgan Asset Management, MSCI; data as of ember 31, 214. Correlations analysis spans 1994 to 214. ACTIONABLE IDEAS: FAVORING KOREA AND CHINA, DEBATING INDIA AND TURKEY We believe there are three distinct groups of countries from a value/momentum perspective today (Exhibit 7). The first group is the manufacturing exporters, notably North Asian exporters (e.g. Korea, Taiwan) and Eastern European markets, which offer a favorable combination of cheap valuations and relatively positive momentum. The second group is the reformers, such as Mexico, India and Indonesia. These markets stand out as comparatively expensive within a generally cheap asset class, as the market has rewarded countries that undertake structural reform to boost long-term growth. We believe India s reform story is progressing well, although it has now moved out to valuation levels that are currently more expensive than those of Mexico. In our top-down-informed portfolios, we have significantly reduced our overweight exposure, but have not been willing to move underweight given the quality of the reform story. The third group is the BRICs (Brazil, Russia, India, China) markets ex-india, which remain cheap, but lack momentum. China, where economic growth has been slow enough to motivate grudging monetary easing, is probably the best positioned for fresh momentum. As such, we have begun to add back to China in our top-down-informed portfolios over the past couple of months. Identifying the winners among EM countries EXHIBIT 7: VALUE VS. MOMENTUM AMONG EM COUNTRIES 1.2 Low momentum High momentum PH IN MX ZA EG ID CL MY GR TH TW CO PL CZ CN TR BR (.2) (.2)..2 Expensive Cheap 1.2 Source: J.P. Morgan Asset Management estimates; data as of ember 31, 214. Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. Countries ranked on last 12 months price movement on the y-axis and a composite of valuation metrics on the x-axis. Units are percentile ranks which go from to 1. AR = Argentina; BR = Brazil; CL = Chile; CN = China; CZ = Czech Republic; GR = Greece; HU = Hungary; ID = Indonesia; IN = India; KR = South Korea; MX = Mexico; MY = Malaysia; PL = Poland; RU = Russia; TH = Thailand; TR = Turkey; TW = Taiwan; ZA = South Africa. KR HU RU J.P. MORGAN ASSET MANAGEMENT 5

6 Meanwhile, Turkey has been a key beneficiary of lower oil prices, which have helped reduce its large current account and depress the inflation rate. The country s strong run over the past year has caused valuation discounts to start receding and we have begun trimming exposure in our top-downinformed portfolios, purely based on performance. We have concentrated much of the paper on the ongoing earnings pressure and risks facing the asset class. However, it s important to emphasize that valuation is not the problem in emerging markets. Our standard valuation metric is the price/book (p/b) ratio (Exhibit 8), which has been very useful in identifying when to own and when to reduce EM equities in our portfolios. The historical rule argues that investors should look to buy the asset class at 1.5x p/b or below, and reduce the asset class at 2.5x p/b or above (as that is generally the valuation level at which the price is ahead of the story). Today, we are still hovering at 1.5x p/b below the historical average. Any dip from these levels would generally indicate positive forward returns in dollar terms for emerging markets. Valuations look attractive on a historical basis, but remain rangebound for now EXHIBIT 8: MSCI EMERGING MARKETS INDEX: P/B RATIO X Std dev -2. Std dev Average: 1.81x 214: 1.52x.75 '95 '97 '99 '1 '3 '5 '7 '9 '11 '13 Source: J.P. Morgan Asset Management, Guide to the Markets Europe, FactSet, MSCI; data as of ember 31, 214. Linear regression of price-to-book ratios on next 12 months price return from September 1995 through ember 214 results in a R-squared of.17%. Exhibit 9 shows the cyclically adjusted price/earnings (p/e) ratio for the MSCI Emerging Markets Index. The EM underperformance of the last few years has eroded fundamental equity valuations to levels that are consistent with the lows we have seen historically in emerging markets, creating a large discount to the U.S. (which is back through its own long-term average), while trading at the same level as crisis-plagued Europe. EM valuations: Optimism on the U.S. contrasts with pessimism on Europe and emerging markets EXHIBIT 9: PRICE TO 1-YEAR AVERAGE EARNINGS (X) ACROSS EMERGING MARKETS, EUROPE & THE U.S. Cycle adjusted valuations Europe (MSCI Europe) US (S&P 5) Emerging Markets (MSCI EM) Source: J.P. Morgan Asset Management, IBES, MSCI; data as of ember 31, 214. Cyclically adjusted price/earnings multiple using 1-year average EPS US 26. vs 23.6 Long term average GEM 15.7 vs 25.3 Long term average Europe 15.6 vs 2.7 Long term average 6 EMERGING MARKETS STRATEGY EXECUTIVE SUMMARY

7 CONCLUSION To sum up, selective recoupling is underway, but appears to be paralyzed by a stalemate between EM recovery and DM stabilization. Furthermore, we have yet to see that recoupling matched by a recovery in earnings. As a result, EM earnings have struggled and estimates are still stuck in the quagmire that has characterized the past few years. The challenges facing the asset class include dollar strength and the start of Fed policy normalization. History suggests that dollar strength is a particular problem for EM equity performance when U.S. yields and rates are falling (as was the case until recently), but less problematic when U.S. yields are rising. Within equities, we continue to favor Korea, Taiwan, and Eastern Europe, along with Russia, which currently look very cheap. We have also begun to add back to China as monetary easing continues. The extended rebound in India and the recent rebound in Turkey have left us cautiously assessing the attractiveness of these two beneficiaries of the oil price decline. Finally, the combination of a sluggish macro backdrop for earnings and unfolding external challenges may seem daunting for the emerging markets. But the favorable driver of the EM story is the same as it has always been: valuation. When it comes to commodities, the ongoing correction has forced relative energy prices and relative metals prices back down to their respective long-term trend lines and below them, in the case of energy prices. As such, we are now entering undershoot territory typically the less predictable part of the cycle and therefore caution against a more bearish stance as the reversal deepens. NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by local laws and regulation. The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited; in Australia by JPMorgan Asset Management (Australia) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. Member FINRA/ SIPC. LV JPM /15 4d3c2a825b7