2010 Outlook. Emerging markets debt

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1 Insights 21 Outlook Emerging markets debt January 21 Please visit for access to all of our Insights publications. In 21, we expect three key themes to influence emerging markets debt: global rebalancing; exit strategies; and country differentiation. Introduction The market recovery in 29 across all asset classes was truly impressive considering the levels of leverage that needed to be drained from the system, the (initially) tepid economic recovery, and the persistent fear that the recovery could not be sustained. Despite all this, the market seemed to find its sweet spot during the year thanks in part to a synchronized, large and successful global policy stimulus. The current environment of excess liquidity, improving economic data, and very low inflationary pressures has led to low and stable interest rates across the globe, a decline in volatility, and falling risk premia, which have all contributed to the risk rally. In 21, we expect emerging economies to continue to lead the global recovery and we expect inflation, for the most part, to remain well anchored. While difficult to make long-term predictions, we expect the market environment to be more volatile and full of opportunities as well as risks in 21. Furthermore, we expect the sustainability of the recovery and inflationary fears to be challenged by investors throughout the year. If 29 was the year of excess liquidity and the beta play, we believe 21 will be the year of exit strategies, strengthening fundamentals and the alpha play. Although valuation metrics are not as compelling, we expect: sovereign spreads to tighten between 5-1bps in the first half of 21 due to positive market technicals and supportive fundamentals corporate and sovereign spreads to diverge between clear winners and obvious losers as corporates are undervalued and high yield opportunities emerge during the recovery phase currency appreciation pressures to persist on the back of capital inflows, but these pressures to be offset by either direct or indirect capital control measures (which may potentially lead to asset bubbles) domestic rates to differentiate in the first half of 21 and the repricing of global rates to increase the attractiveness of local bonds for institutional use only

2 21 Outlook Key Themes Driving Our Investment Decisions in 21 Global rebalancing The financial crisis in 28/29 was largely the result of excessive leverage in the developed world, particularly at the consumer and banking level. As the global economy continues to recover, an important theme going forward will likely be rebalancing and its ramifications on asset prices and policy decisions. While emerging markets (EM) declined during the financial crisis, similar to advanced economies, we believe this drop was driven by the disruption in global liquidity, not by solvency issues. The extension of financial support by the IMF and G-2 Summit in the spring of 29 helped to improve liquidity in the emerging markets and also served as a direct acknowledgment of the importance of these economies to global growth. With the exception of eastern Europe (and pockets within the Middle East), emerging economies now have stronger balance sheets and are on much more solid footing than the developed markets (see Exhibit 1). Going forward, we expect growth in these economies to outpace the developed world as consumers (and the banking system) continue to de-lever and cap the overall growth prospects of advanced markets. In fact, we expect emerging economies to be the major contributors to global growth in the months and years ahead. This role reversal represents a significant rebalancing of the global economy. As the developed consumer repairs its balance sheet and saves a bit more, the EM consumer is likely to prosper, leading to the faster development of their respective capital markets and pension fund systems. We believe these market conditions will be positive for risky assets, but asset valuations will need to be monitored closely. Although markets have already priced in a strong recovery in emerging economies, we do not believe the global rebalancing theme has been entirely accounted for. Over the next year, we expect EM spreads to tighten further due to improved credit ratings and increased allocations from global pension funds. We believe stronger and more sustained growth should benefit overall credit ratings and EM corporate balance sheets. In fact, we expect the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) to achieve an average investment grade credit rating before the end of 21. Allocations to EM in global pension funds, meanwhile, should strategically increase over the year and will likely result in significant inflows to the asset class. Exhibit 1: Debt and Deficits in Advanced and Emerging Market economies 12 Public debt advanced Public debt EM Fiscal balance advanced Fiscal balance EM Debt/GDP Fiscal deficit/gdp Outlook: Emerging markets debt

3 Exhibit 2a: EM spread comparison EMBI Global vs. High Grade Indices Exhibit 2b: EM spread comparison cembi broad vs. High Grade Index Basis points EMBI Global JULI EMBI Global JULI BBB Mar 5 May 5 Jul 5 Sep 5 Nov 5 Jan 6 Mar 6 May 6 Jul 6 Sep 6 Nov 6 Jan 7 Mar 7 May 7 Jul 7 Sep 7 Nov 7 Jan 8 Mar 8 May 8 Jul 8 Sep 8 Nov 8 Jan 9 Mar 9 May 9 Jul 9 Sep 9 Nov 9 Basis points CEMBI Broad JULI BBB Dec 7 Jan 8 Feb 8 Mar 8 Apr 8 May 8 Jun 8 Jun 8 Jul 8 Aug 8 Sep 8 Oct 8 Nov 8 Dec 8 Jan 9 Feb 9 Mar 9 Apr 9 May 9 Jun 9 Jun 9 Jul 9 Aug 9 Sep 9 Oct 9 Nov 9 Note: The J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) is representative of the sovereign debt market. The J.P. Morgan US Liquid Index (JULI) is representative of the investment grade corporate bond market. Data as of November 3, 29. The fact that EM benchmark indices trade wide in comparison to high grade indices makes the case for spread compression even stronger (see Exhibit 2a and 2b). Despite volatility, spreads have a good chance of further tightening by as much as 1 bps due to both fundamental and technical reasons. This is, of course, assuming no policy missteps. From a currency perspective, rebalancing will most likely be accompanied by currency appreciation as capital inflows build up (so long as policymakers allow it). As the EM asset class gains greater weight in portfolio allocations, the natural consequence will likely be markets pricing stronger currencies. Resistance by countries to capital flows may lead to the formation of real asset bubbles, particularly real estate and commodities; an important risk to monitor. The impact of rebalancing on emerging markets corporate debt should also be quite positive. Beyond the strategic case for EM credit strong economic momentum, urbanization, industrialization and infrastructure development EM corporate debt should benefit from higher trend growth rates and better debt dynamics than developed countries. The credit quality of EM corporate debt has been transformed over the past 1 years and reinforced lately by de-leveraging and a pick-up in earnings. Note: The J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) is representative of the corporate debt market. The J.P. Morgan US Liquid Index (JULI) is representative of the investment grade corporate bond market. Data as of November 3, 29. The globally synchronised recovery also bodes well for credit expansion and access to capital. Corporate default rates in emerging markets are now lower than those of major developed countries. Abundant liquidity on and offshore, coupled with investor appetite for credit and yield diversification, should remain supportive of the sector. In addition, EM corporate debt continues to post attractive returns versus the developed market in excess of what can be expected from EM equities. 21 should see a normalization of this premium and EM corporate debt to outperform its credit peers. In terms of regions, we believe Asia will drive growth within the emerging economies in 21. Eastern Europe, primarily former members of the Commonwealth of Independent States (CIS), will lag due to its structural need to de-leverage. Latin American economies, meanwhile, should benefit from supportive commodities and relatively sound financing needs at both the public and private sector level. Tighter policies are, therefore, likely to emerge first in Asia, followed by Latin America and then Eastern Europe. Over the course of the year, markets will likely test the more leveraged and fiscally weaker economies. Looking ahead, we expect stronger domestically driven growth, particularly across Asia and Latin America, with CIS commodity exporters benefiting as well. Global rebalancing, however, may result in policy challenges for many emerging economies. J.P. Morgan Asset Management 3

4 21 Outlook Policy: Exit Strategies, Capital and Currency A key theme in the year ahead will be the timing and intensity of measures related to monetary and fiscal policy, capital flow and currency. Of these, we believe the withdrawal (or perception of it) of policy stimulus will be the main issue for 21. Exit strategies Exit strategies will likely impact three central policies: liquidity, policy rates, and fiscal policy. Our general view is that liquidity will be withdrawn first, followed by a mix of monetary and fiscal tightening; the latter two likely to vary from economy to economy. The immediate market concerns will likely center on monetary policy, more specifically the speed and timing of policy action, while longer-term concerns will likely be linked to fiscal policy. Timing is difficult to predict, but we do not expect policy measures to be an issue in the first half of 21. That said, we will continue to watch policy actions closely, cognizant of the fact that any policy errors could lead to more significant and longer lasting market movements within the emerging economies (even more so now as the developed world s fiscal position has been weakened significantly). The Federal Reserve will likely be the key focus of policy in 21. Our base scenario assumes that the U.S. recovery will steadily continue and unemployment will peak during the year. We do not believe the Fed will raise rates anytime soon, however, with the output gap likely to remain considerable and inflationary pressures to remain low. Key risks to this scenario include: i) the market forcing the Fed to raise rates ahead of time or ii) the Fed staying behind the curve, resulting in a rise in medium-term inflation expectations. Higher growth and a strong consumer will likely cause the Fed to move sooner. Emerging economies are likely to address exit strategies related to monetary policy sooner than their developed counterparts. In fact, over the course of the year, we expect to see signs of asset-price inflation and a further rise in commodity price-driven inflation, especially in Asia. Combined with strong growth, large capital inflows, and resistance to currency appreciation, this environment should be challenging for many emerging economies. From a market perspective, an earlier exit from stimulative policy in Asia, compared to the developed world, could initially lead to higher rates, but continued strategic inflows should tend to flatten domestic curves and anchor the long-end relatively well. While fiscal policy is likely to be more of an issue in 211, some problems may arise in 21. We believe those emerging economies that entered the financial crisis as net creditors, or commodity exporters, are best placed to consolidate their fiscal position during the year. That said, the main way to reduce budget deficits is through economic growth. Thus, the biggest risk on the fiscal front for many emerging economies is disappointing growth (even if offset by a low policy rate environment). Absorption risk or crowding out effects are also likely to be the key fiscal factors impacting emerging markets in 21, as net issuance matches, or surpasses, the record set in 29 (see Exhibit 3). If inflows reverse, the markets could face a possible price correction. In 211 and forward, fiscal prospects will be important for solvency reasons. Exhibit 3: Issuance in Emerging Markets USD (billions) Sovereign Corporate Quasi-sovereign F Note: 29 data as of November 3, data are a forecast Outlook: Emerging markets debt

5 Capital and currency Capital is expected to flow into emerging economies in 21, encouraging more countries to deepen and broaden their capital markets. These inflows, however, may add concerns about asset-price inflation and future currency policy, particularly in those emerging economies linked to the dollar. Accommodative policy in the U.S. and Europe may feed bubbles in emerging markets over the coming year as investors search of higher returns. However, these capital moves will likely be into economies with a limited capacity to absorb such inflows. In the past, the strategy for countries facing such a dilemma has been to reserve accumulation and thereby create insurance for the hard times and curb significant currency movements. However, reserve accumulation can also lead to liquidity creation and potential inflationary consequences. Therefore, this strategy can transform into a vicious cycle of higher yields, more capital inflows, and higher asset price inflation. The market implication of this recurring cycle is: i) sustained currency pressures, in many cases overshooting fair values; and ii) higher volatility as policy decisions and actions lead to rapid shifts in currency trends, sentiment, and hence flows. We believe the region most likely to experience currency appreciation pressures and asset price inflation in early 21 will be Asia. This is due to their tight link to the dollar and net creditor status. Countries with large commodity exposure and undervalued currencies, such as Russia, Kazakhstan and other net exporters of commodities, may also face similar pressures. Differentiation: Credit, Domestic Rates and FX We expect differentiation to be a key theme and driver in 21 for credit spreads, domestic rates, and FX. With volatility likely to increase relative to 29 due to lower systemic tail risk as a result of the well coordinated global effort to prevent a systemic breakdown and the ongoing economic recovery differentiation among credits and regions will be crucial. The investment challenge and our focus for 21 will be to correctly identify the winners versus the losers or the alpha as opposed to the beta. Credit In the credit space, as liquidity starts to drain from the system, the sustainability and quality of macro polices, debt dynamics, and fiscal solvency issues will likely become extremely relevant in assessing valuations. Those with sustainable debt dynamics should benefit from their strong balance sheet positions, while those facing high debt burdens and unsustainable fiscal positions will be more challenged. The recent events in Dubai have served as a reminder that even in an environment of excess global liquidity, solvency can be tested either by markets or governments. As systemic risk declines, we expect corporate and even sovereign restructuring stories to unfold throughout 21, and perhaps into 211, but with limited contagion. Timing may be much later than expected, but if debt burdens are higher than sustainable levels, public and corporate sectors will sooner or later need to reassess their respective sustainability. From this perspective, we believe central eastern Europe, the Middle East and Africa (CEEMEA) will remain the weakest emerging markets, in particular those countries that had pre-crisis growth rates heavily supported by plentiful flows of credit. Our reasons for this view are two-fold. First, low levels of credit extension will constrain recovery in these countries, given the relatively weak prospects for import demand from the Eurozone. Second, public finances in these countries are unlikely to cover the high deficits they have accumulated relative to other regions such as Latin America. Hungary and Ukraine are good examples where we see the markets potentially re-testing their policy response and resiliency. J.P. Morgan Asset Management 5

6 21 Outlook Exhibit 4a: Solvency indicators Refinancing Needs 1 9 Sri Lanka Egypt 8 Hungary 7 Ghana India Brazil 6 Argentina Pakistan Philippines Poland Morocco Turkey 5 Thailand Uruguay Costa Rica Vietnam El Salvador Malaysia Czech Rep Dom Rep 4 Colombia Panama Indonesia Mexico Croatia Slovakia Ukraine 3 Peru South Africa China Serbia Romania Venezuela 2 Gabon Ecuador Nigeria 1 Trinidad Chile Bulgaria Kazakhstan Russia Debt as a percentage of GDP Refinancing needs (as a percentage of reserves) Exhibit 4b: Solvency indicators Public and External Debt 14 Hungary External debt as a percentage of GDP 12 Bulgaria Croatia 1 Kazakhstan Ukraine 8 Serbia Romania Slovakia Turkey Poland 6 El Salv Chile Panama Uruguay Czech Rep Vietnam Argentina Ghana Sri Lanka 4 Ecuador Indonesia Costa Rica Philippines Russia Peru South Africa Malaysia Pakistan Thailand 2 Venezuela India Egypt Trinidad Gabon Mexico Morocco Colombia Dom Rep Brazil Nigeria China Public debt as a percentage of GDP Exhibits 4a and 4b show countries with weak public finances and still considerable refinancing needs. While we remain constructive, we expect to see volatility, pockets of underperformance and potential risk in some areas of the region, particularly if global growth disappoints. payments trends, in addition to the monetary stance, to play an important role in evaluating how rates will perform. Countries with still high real rates and enjoying a balance of payments surplus are likely to outperform in the local markets space (see Exhibit 5). Domestic rates Differentiating among those economies facing early inflationary pressures either because of a faster than anticipated closure of output gaps or because of more exposure to food/energy price inflation should be a key metric for domestic rates. We expect the relationship between real interest rates and balance of Foreign exchange Decisions on capital control policy, coupled with fundamental trends in the balance of payments and overall macroeconomic framework, should impact FX dynamics and become an important metric with which to evaluate and identify countries with the greatest upside potential. As the 29 excess liquidity phase of the cycle benefited virtually all EM currencies, finding value in 21 will be reliant on differentiating opportunities in FX Outlook: Emerging markets debt

7 Exhibit 5: Balance of Payments versus Real Interest Rates (Expected) real interest rates South Africa Ghana Dom Rep Vietnam Brazil Uruguay Romania Sri Lanka Argentina Ukraine Turkey Bulgaria Guatemala Indonesia Colombia Peru Croatia Mexico Czech Chile Philippines Hungary Costa Rica Poland Venezuela Thailand Israel India Kazakhstan Egypt Russia Real yield (12 months ahead of expectations) Theoretical real rate Nigeria China Malaysia Current account Risks to Our View Our 21 outlook is one of continued growth, led by rebalancing and higher volatility, and positive asset price returns. During the year, however, there is a genuine risk that extremely low policy rates, particularly in the U.S., will create an environment where risk is not sufficiently priced into the market. Low policy rates can encourage bad behavior and crowded trades, profitable only if you can exit before the rest. While leverage may be limited, continuous low rates can facilitate asset price bubbles; an important issue for 21 and beyond. Based on current valuations in the property, equity, spread, and commodity markets, however, we do not believe this will be an issue over the coming year. Perhaps a more imminent risk is the perception of central banks, and the Fed in particular, being behind the curve. This view may force the central bank to tighten earlier than expected, making risky assets unstable and potentially leading to a re-pricing of the market. Monetary policy changes in the past have always led to more volatility and we do not expect this trend to change in the future. Early tightening, triggered by a faster economic recovery, however, should be positive for spreads in the medium term (after an initial correction). Across the emerging world, the risk of an upside surprise should not be overlooked. The combination of policy stimulus and positive underlying fundamentals could impact stronger-than-expected growth in China, among others. If anything, we expect higher global growth to be the main risk/surprise of the year ahead, with the U.S. consumer being the key trigger for the Fed s policy actions. The political agenda will likely heat up in emerging markets in 21, with 47 elections scheduled during the year. As such, traditional concerns over fiscal expansion and populist policies may be again at stake. While we do not expect dramatic changes in the political landscape, political headwinds will contribute to country differentiation throughout the year. Last, but not least, a downturn in global economic growth the so-called double dip and the return of a boom-bust cycle remains a risk and a powerful negative for the asset class in 21. The scale of debt in Western economies, concerns that a private sector problem has been substituted with a public debt problem, and the U.S. economy s extremely rapid recovery in 29, all support the probability of this tail risk scenario occurring. In our view, however, we do not believe this risk will be an issue in 21, but may feature in the years ahead. That said, we believe this tail risk scenario can be avoided as long as rebalancing continues swiftly and unabated, and monetary and fiscal policy continues to respond. Draining liquidity from the system sooner than anticipated is likely to be the most prevalent risk for 21. J.P. Morgan Asset Management 7

8 21 Outlook author Matias Silvani Vice President Strategist and Portfolio Manager, Emerging Markets Debt This commentary is intended solely to report on various investment views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. These views and strategies described may not be suitable for all investors. 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, recommendations. The information is not intended to provide and should not be relied on for accounting, legal, or tax advice. Past performance is no guarantee of future results. Please note that investments in foreign markets are subject to special currency, political, and economic risks. The manager seeks to achieve the stated objectives. There can be no guarantee the objectives will be met. J.P. Morgan Asset Management does not make any express or implied representation or warranty as to the accuracy or completeness of the information contained herein, and expressly disclaims any and all liability that may be based upon or relate to such information, or any errors therein or omissions there from. This material must not be relied upon by you in making a decision as to whether to invest in the opportunities described herein. Prospective investors should conduct their own investigation and analysis (including, without limitation, their consideration and review of the analyses referred to herein) and make an assessment of the opportunity independently and without reliance on this material or J.P. Morgan Asset Management. 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. In addition investments in emerging markets could lead to more volatility in the value of an investment. 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. 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. 245 Park Avenue, New York, NY JPMorgan Chase & Co. IMEMO_EMD21OUTLOOK