Emerging Market Trends. From caution to optimism

Transcription

1 Emerging Market Trends From caution to optimism For Qualified Investors in Switzerland or Professional Investors or Eligible Counterparties as defined by the relevant laws Asset Management October 2016

2 Key points Current Economic Situation Supportive global factors Emerging Markets (EM) equity and bond performance has been strong this year, helped by global developments: Two major pressures on emerging markets the generalized dollar uptrend and lower commodity prices have dissipated, contributing to the return of portfolio investments to these markets. Emerging market economic fundamentals have improved since the beginning of the year with more clarity on Chinese policy, evidence of better growth and economic rebalancing elsewhere As a result, both emerging bond and equity markets have performed strongly year-to-date, and we expect these markets to continue to outperform in the near future. The pressure on commodity prices has calmed down on expectations of an increase in global demand and a stabilisation in oil production (with growth estimated at % in according to IEA/US government forecasts vs 3% growth in 2014 and 2015). Investors belief in a gradual US rate hiking cycle has been reinforced by slower US growth with downward revisions in 2016 GDP growth expectations (from 2.5% expected at the end of last year to the current consensus of 1.6%) and dovish comments from the Federal Reserve (Fed). The US treasury rate curve has flattened, the dollar uptrend has stalled and capital flows have returned to emerging markets. Outside of the US, developed market (DM) fixed income yields have also fallen to near-multi decade lows on expectations of persistently loose Japanese, UK and eurozone monetary policy in response to low inflation and burgeoning growth risks. Extremely low government bond yields in these countries have in turn contributed to dragging down US yields pushing investment flows into higher yielding (including EM) assets. Low global yields are helping money into EM Emerging Markets Developed Markets growth differential likely to widen again EM economic fundamentals are on a stronger path, after five years of an economic slowdown and policy adjustment. They have generally come through in a stronger shape and have benefited from commodity price stabilisation. EM currencies have rebounded from weak levels, implying a net positive fundamental impact because the rebound has eased the pressure on EM issuers with foreign currency debt while not significantly impacting export performance. As a result, the EM versus DM growth differential is likely to widen again in EM s favour, as expected by the IMF and, for the first time since 2011, supporting EM equity and fixed income asset performance. Rebalancing in India, Indonesia, Brazil and Russia EM re-balancing. Several EM countries, including India, Indonesia, Russia and more recently Brazil, have benefited from economic rebalancing (such as a reduced current account or fiscal deficit), which has made them less vulnerable to capital outflows. The rebalancing triggers occurred at different times and with varying severity but in all four cases, there was an initial phase of capital outflows and sharp currency depreciation. In India and Indonesia, this was triggered by the Fed s warning of tapering quantitative easing in May 2013; in Russia it was the economic sanctions in 2014; while in Brazil it was the collapse in commodity prices combined with the Lava Jato corruption scandal starting late in Following the initial shock, monetary and fiscal policy was forced to tighten. This led to current account improvements (India, Russia, Brazil), a drop in the aggregate stock of external debt (Russia, Brazil) or a lengthening in the maturity profile of private sector external debt (India and Indonesia). These adjustments were accelerated by sensible economic policy, such as the anti-inflation focus of the new Indian central bank governor; the reduction of energy subsidies in India and Indonesia; and conservative fiscal policy in Russia. Other EM countries are also starting to show signs of rebalancing and if these solidify, these economies and their financial markets are likely to strengthen further (e.g. Argentina, Colombia, Ghana and Malaysia). Some EM country balance sheets are now stronger Portfolio flows to EM, USD bn, RHS Global yields (Barclays Global Aggregate bond index) Source: Bloomberg Finance L.P., Barclays, UBP Union Bancaire Privée, UBP SA Asset Management Emerging Market Trends October

3 EM growth picking up in most countries Source: Bloomberg Finance L.P., World Bank, IMF, UBP August 2016 Gradual rebalancing in China Our China outlook has not changed: the economy should be able to avoid any hard landing. It is slowly rebalancing to services and domestic consumption; GDP is likely to rise 6.5% in We expect some depreciation in the Renminbi (to CNY per USD) and a lengthy restructuring of weak state owned enterprises (SOE). We think China is likely to go through phases of growth boosted by infrastructure spending and credit easing policy, followed by periods where SOE restructuring will weigh on growth and trigger a fresh wave of infrastructure spending and credit easing. This process of stimulus-reform is likely to persist and while it may build some risks over the longer term for Chinese markets, we believe that the stimulus reform is controlled; it is probably also better understood by global investors compared with a year ago; and thus less likely to drive big swings in EM risk appetite. Ecomonic Outlook Improving EM fundamentals EM idiosyncratic factors have supported asset prices and should continue to do so for the rest of the year. EM growth outlook is improving Several major EM economies are gaining speed. Indian and Indonesian GDP have posted successive gains (second quarter GDP up 7.1% and 5.2% year-on-year respectively) and are likely to hold the current level of momentum given high government infrastructure spending. Russia is coming out of a recession; with the boost from interest rate cuts; GDP growth there could reach 0.5% this year and 1.0% in In Brazil, leading indicators are turning less negative and business confidence has improved significantly after the impeachment of Dilma Rousseff and her replacement as President by Michel Temer of the more market-friendly PMDB party. This, together with stronger exports, could limit this year s recession to -2.7% setting up the economy for 1.0% GDP growth in Overall, we expect EM GDP growth to bottom-out at 4.2% this year and to accelerate to 4.6% in This would be a turnaround from the decline in growth seen between 2010 and Limited political risk ahead Source: Bloomberg Finance L.P., UBP, EM: average Brazil, China, India, Indonesia, S: Korea, Mexico, South Africa, Turkey DM: average Euro area, Japan, UK, US With the exception of the upcoming US presidential elections, which is likely to be met with some market volatility in the event of a Trump victory, we see the EM electoral calendar as fairly light for the rest of 2016 and Political risks in some EM countries cannot be ignored though - ranging from the anti-us rhetoric of Philippines President Rodrigo Duterte to political infighting in the South African government but their contagion impact on the overall EM fixed income and equity markets should be fairly muted. The averted-coup in Turkey (15/16 July) and the government s efforts to clean out conspirators and coupsupporters is likely to weigh on investment and economic growth in the country. Monetary and fiscal policy, as well as business-related regulations, should however remain orthodox, offsetting some of the growth fallout. GDP growth could be around 3.4% this year, compared to our previous expectation of 4%. Government institutions checks and balances have been weakened, which has weighed on the sovereign s rating and prompted Moody s to downgrade the country to sub investment grade (Ba1). Although volatility in Turkish markets is likely to be elevated, we do not think that it has the capacity to be contagious for the rest of EM. Union Bancaire Privée, UBP SA Asset Management Emerging Market Trends October

4 The Turkish economic and financial sector's interconnections to other emerging countries are modest. For example, China and Russia are Turkey s largest EM trade partners and in 2015 their exports to the country were only 0.2% and 1.7% of their own GDP. Our Seasoned Convictions - Emerging Debt EM hard currency bonds: improving fundamentals and strong technical Dollar-denominated emerging market bonds have had a strong run year to date (YTD), driven both by the fall in US treasury yields (US 10-year yields have fallen by 53 basis points (bps) to 1.74% in the year to October 20th), and significant spread compression, as highlighted in the table below. With developed market yields in very low to negative territory, emerging sovereign and corporate bonds are likely to continue to attract the attention of investors. We continue to favour EM corporate bonds, as the investment universe is far more diversified than EM sovereign bonds (in terms of number of issuers or sectors), which helps limit idiosyncratic risk. Additionally, EM corporate bonds benefit from lower interest rate duration, thus limiting their sensitivity to US interest rates. As a result, EM corporate bonds have shown greater resilience in periods of rising US rates than EM sovereign bonds thanks to their higher carry, higher spread cushion and lower duration. EM sovereign and corporate bonds sensitivity to rising US rates EM bonds performance drivers YTD Total Return Treasury Return Spread Return Spread change EM Sovereign $ EM Corporate $ % -84 Source: Bloomberg Finance L.P., JP Morgan, UBP In our view, the aforementioned improvement in EM macroeconomic fundamentals supports the observed performance. In addition, market technicals have also played an important role. Inflows into EM hard currency bond markets have reached over $42bn YTD, compared with outflows in the years 2013 and 2015, and a total of only $15.1bn for the full year of Local debt (+$12.3bn YTD) and EM equities (+$17.0bn YTD) have also regained investors favour, though to a lesser extent. In EM hard currency bonds, retail flows have clearly favoured EM sovereign bonds (notably through investments in ETFs), while EM corporate bonds attracted primarily institutional investors, which constitute a fairly stable and long-term investor base. These increased flows have been met with higher issuance, especially for sovereigns ($106bn), where issuance is well above the trend of the previous five years. In contrast, supply in EM corporate bonds ($255bn) remains in line with previous years. A significant part of this issuance is used for debt management purposes (e.g. buybacks and maturity extension), which should help reduce issuers debt servicing vulnerability in the coming years. Asian corporate bonds continue to dominate supply, with over half of the new bonds issued so far this year. Issuance from the Middle East and Africa has picked up over the summer and is now above its levels for the same period in In contrast, supply from Latin American and European corporate issuers has remained more limited, but has strengthened in the last few weeks. Importantly, issuance net of coupons and amortisations is expected to be close to zero, which again could provide additional support to EM corporate debt. Source: JP Morgan, Bloomberg Finance L.P., UBP Both these factors of high diversification and low duration, have also helped limit the volatility of EM corporate bonds and contributed to the higher risk adjusted returns (Sharpe ratios) exhibited by this asset class over the last five years compared to EM sovereign debt. EM bonds risk-adjusted returns last five years Annualised Return Annualised Volatility Sharp Ratio EM Sovereign $ EM Corporate $ Source: JP Morgan, UBP While spreads have tightened significantly YTD, we believe that valuations still remain attractive. Looking ahead, we do not expect a repeat of this year s double digit returns, but believe that spreads should be able to cushion any increase in US rates. EM investment grade corporate dollar denominated bonds appear best suited for investors with a lower risk appetite or tight credit constraints. Historical (12- month rolling) volatility has averaged only 2.7% over the last five years (4.15% over the last 10 years) vs 5.38% for EM IG sovereign (6.11% resp.) and 4.26% (5.04% resp.) for US IG corporate bonds. Union Bancaire Privée, UBP SA Asset Management Emerging Market Trends October

5 For investors, with a higher risk appetite, investing across the full universe of EM corporate bonds appears the most attractive option as it offers the chance to take advantage of attractive opportunities across the whole credit spectrum. Given the improvement in fundamentals, we have gradually increased our allocation to high yield issuers over the year, from 36% to 47% as at the end of September. Our Convictions - Emerging Equities EM equities: dead cat bounce or the end of a five-year slump? The performance of emerging market equities relative to developed markets reached the lowest point of the last decade on January 21st Since then, the MSCI EM index has returned 36.9% and outperformed the MSCI DM index by 18%. We believe there may be fundamental structural reasons why this reversal of relative performance may continue for longer. Despite the recent outperformance, price to book for EM equities is still at a 31% discount relative to DM. This is close to the decade s highest discount of 39% reached in August It is also significantly higher than the median discount of 11% since The valuation argument in favour of EM is nothing new. In fact, EM price to book has consistently derated against DM since August This derating could be justified by falling margins and return on equity across the emerging markets universe. In fact, the steep fall in EM operating margins relative to DM that started in September 2009 was the precursor to the valuation derating that followed in subsequent years. Similarly the ROE differential between EM and DM reached a peak of around 660bps at the end of 2008 and troughed at -230bps at the end of What has now changed is that the downward trend in margin and ROE differential seems to have reversed with this process starting from After hitting a low of -92 bps in December 2014, the margin differential has consistently and significantly increased to +120bps as of the end of June Similarly, the ROE spread has moved in favour of EM from its low of -230bps to +129bps during the same period. Even though this important development has received little commentary from market participants, we do not see it as a coincidence that it was a precursor to the recent relative outperformance of EM Is that improvement sustainable? We are cautiously comforted by the fact that it is non sector specific and has been going on consistently and significantly since the end of This may have a number of reasons including corporate restructuring to adapt to lower commodity prices, stabilization in global GDP to support exports, currency adjustment, productivity growth, rebalancing economies from export-oriented manufacturing to domestic goods and services. While reasons may differ from country to country and sector to sector, the data so far supports the view that it is more than a one-off, regional or sector specific development. India arises: structural and cyclical supports India is one of the largest countries in our fund with a weight of 8.5%. While the Indian equity market has not outperformed so far this year, we believe that a number of structural and cyclical drivers will support it going forward. The main structural benefits in the long term are favourable demographics, strong catch-up potential in terms of per capita consumption, urbanization and productivity growth, and a cheap currency. Furthermore, India is one of the least exposed markets to a potential slowdown in China. As a commodity importer, it also offers some diversification within EM from a potential commodity-related weakness. In the short term, manufacturing PMI is on the rise. We believe the 23% increase in government wages and 25% increase in infrastructure spending is likely to support GDP growth. It is also likely that we will get positive news on the inflation side with a good harvesting season keeping food inflation under control. Given that food accounts for nearly half of India s CPI basket, the divergence between the headline inflation and core inflation could reduce. Meanwhile, on the reform side, the long awaited GST (Goods and Services Tax Bill) legislation has finally passed. For the first time, this allows India to be a unified market from a tax perspective and could create significant cost savings for businesses. It also supports public finances by making it easier and less costly to collect taxes. India earnings now accelerate Relative profitability is finally rebounding in EM s favour Source: Bloomberg Finance L.P., MSCI Adjustments to a new reality: some countries have turned a corner Source: Bloomberg Finance L.P., MSCI Union Bancaire Privée, UBP SA Asset Management Emerging Market Trends October

6 Russia has been one of the best performing emerging equity markets this year. The Russian economy appears to have finally found the bottom and is beginning to turn upwards. Manufacturing is supported by increased competitiveness after the recent devaluation of the rouble and by state spending in chosen industries (such as defence). Agriculture and food production are already benefitting from Russia s counter-sanctions and other protective measures. As inflation is slowing down, real wages are recovering, and the probability of rate cuts by the Central Bank is increasing. Some banks are already increasing issuance of loans and while retail sales and investments are yet to rebound, most analysts expect the country s GDP to return to growth next year, and the equity market is already pricing this in. The second driver concerns geopolitical stabilisation. It is quite likely that the worst is behind for Russia as its dialogue with the leading Western countries continues. The spirit and mood of its relationships with G7 are far from warm and cosy, but at least the contacts are maintained. Some forms of cooperation are evolving in certain areas. This stabilisation decreases the equity market s risk premium, and it is likely to continue going forward, particularly if we see further gains in the oil price. Brazil has been the best performing equity market in MSCI EM so far in 2016 with a return of 69% in USD terms supported both by rising equity prices and an appreciating currency. This has clearly been driven by political change and rising expectations of the implementation of much needed fiscal reform with the new government. Brazil's corporates could now benefit from the operational leverage of growing sales in addition to benefiting from lower interest rate expense. That said, in our view, much is in the price already on the equity front. Relative valuations 1 and 2 years out point to a market slightly on the expensive side, and given the challenges ahead, this is likely to put a cap on performance for now. We keep a diversified exposure to EM equity markets A potentially useful contribution to diversification Crude benchmark constraints do not drive our attitude towards country allocation. We are therefore able to offer investors a much broader approach in crafting portfolios with the appropriate level of diversification. We have chosen to be structurally underweight across some of the bigger countries in the benchmark and particularly China. Existing EM benchmarks already have a heavy concentration on the Chinese market and this seems likely to increase still further with the gradual inclusion of A shares in the future. Such an overemphasis makes standard EM benchmarks and those funds that closely track them especially vulnerable to China centred risks. We believe our targeted country allocation avoids over reliance on any single economy as the main driver of portfolio returns. Our China underweight position is counterbalanced by our overweights on Chile, Malaysia and Mexico. As mentioned above, Russia and India are two markets in which we are making opportunistic additions as the stars look like falling into alignment for both countries. This strategy gives our investors a real chance of capturing any upside in a general EM rally while limiting the downside risk in case of volatility in any single country like China. As well as our country analysis, we also focus on offering investors a diversified exposure to various sectors by seeking a balance between growth and cyclicality. Our main overweights are Financials, Materials and Consumer Staples. We are currently more cautious when it comes to Technology and Energy. Brazil s valuation should cap further gains, but Russia s still looking attractive Source: Bloomberg Finance L.P., MSCI Union Bancaire Privée, UBP SA Asset Management Emerging Market Trends October

7 Koon Chow Emerging Fixed Income Mathieu Nègre Emerging Equities Karine Jesiolowski Emerging Fixed Income Disclaimer This is a marketing document and is intended for informational and/or marketing purposes only. This document is confidential and is intended only for the use of the person(s) to whom it was delivered. This document may not be reproduced (in whole or in part) or delivered, given, sent or in any other way made accessible, to any other person without the prior written approval of Union Bancaire Privée, UBP SA or any entity of the UBP Group ( UBP ). This document reflects the opinion of UBP as of the date of issue. 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