Emerging Markets: Economy Update

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Emerging Markets: Economy Update November 2014 MACRO REPORT Executive Summary Monica Defend Head of Global Asset Allocation Research Also contributing Alessia Berardi Senior Economist Andrea Brasili

sustainable growth as long as the labour market remains healthy. They are likely to stick with targeted measures and fine-tuning policy to support the economy.

1 Emerging Markets: Economy Update November 2014 MACRO REPORT Executive Summary Monica Defend Head of Global Asset Allocation Research Also contributing Alessia Berardi Senior Economist Andrea Brasili Senior Economist Elina Ribakowa Senior Economist Qinwei Wang Economist Riccardo Soggiu Senior Economist, Central Banks CHINA: Policymakers seem comfortable accepting slightly slower but probably more sustainable growth as long as the labour market remains healthy. They are likely to stick with targeted measures and fine-tuning policy to support the economy. The structural adjustment of the economy is still in its early stages. A lower growth target for 2015 would provide more space for pushing reforms ahead. INDIA: After winning the two regional elections, with oil prices at historically low levels and the inflation rate the lowest in five years, Modi deregulated diesel prices and approved a new gas price formula and direct benefit transfers. All hard decisions taken at the right time. EMEA: Concerns regarding European energy security continued, as Russia and Ukraine are yet to reach an agreement on gas prices and therefore gas supply to Europe for the coming winter. In Russia, we worry about downside risks to our -1.5% forecast for GDP growth in In Poland, we will be waiting for the inflation report to see if the Central Bank is likely to cut rates further amid an economic slowdown and deflation. LATAM: We remain negative on the growth outlook for the region and particularly Brazil. In Brazil, Dilma Rousseff won re-election in the second round by a very tight margin, with markets reacting negatively to the news. All eyes will be on the announcement of the new Minister of Finance as a signal of the direction the current presidency of Dilma Rousseff will take. The Central Bank hiked rates unexpectedly by 25 basis points to 11.25% to soothe the markets. Rating agencies are likely to give a grace period of a few months to the new government before making their adjustments. Asia Policymakers seem comfortable accepting slightly slower but probably more sustainable growth as long as labour markets remain healthy. They are likely to stick with targeted measures and fine-tuning policy to support the economy. The structural adjustment of the economy is still in its early stages. A lower growth target for 2015 would provide more space for pushing reforms ahead. 1. China Growth The macro figures just released for September and Q3 should have eased fears of a hard-landing in China s economy after downbeat data for August: GDP growth for Q3 came out at 7.3% YoY, better than the consensus expected. Industrial Production growth recovered to 8.0% YoY following a sharp drop to 6.9% in August. More 1

2 importantly, the labour market, now policymakers primary concern, seems to have remained healthy. Digging deeper, there was further evidence that a structural adjustment in rebalancing the economy is underway. Consumption and services activity held up relatively well although weakness remained in investment and real estate. With recent targeted policy measures, including lending support to the real estate sector, we expect GDP growth for Q to stay at around 7.3% YoY, and we are maintaining our forecast of 7.4% for the full year. We confirm our GDP growth expectation at 7.4% YoY. China GDP Growth by Sector (value-added, % y/y) , , , Services excl. real estate Industrial sector Real estate sector Source: Bloomberg, CEIC as of October 31, Looking further ahead, growth is likely to slow again, as structural adjustment is still in its early stages. The balance faced by policymakers is between guiding growth towards a slower but more sustainable pace while avoiding a hard-landing of the economy. Policymakers seem to be comfortable with a slower growth rate than 7.5% as long as labour markets remain healthy. In particular, there is increasing evidence recently suggesting that China's leaders are probably seriously considering cutting the GDP growth target for 2015 from this year s about 7.5%. This, if true, would allow policymakers to focus more on structural reforms, which are necessary for China to achieve a smooth adjustment. The recent announcement of detailed rules to strengthen oversight on local government debt and budget discipline are the latest evidence that reforms are proceeding in the right direction. Inflation Price pressures remain low but relatively stable. Headline CPI inflation softened further to 1.6% YoY in September from 2.0% in August. That said, the fall was largely due to a temporary drop in food inflation and lower energy prices. Core inflation, a better gauge of general price pressures, has little changed (edging down from 1.6% YoY to 1.5%). PPI inflation remains negative, down to -1.8% YoY in September. However, this largely reflected the weakness in global commodity prices and lower input costs for Chinese firms, as this index only covers industrial goods and is skewed towards investment products. Monetary Policy The People s Bank of China (PBOC) provided temporary liqudity to the banking sector through its Standing Lending Facility (SLF) over the last few weeks, around renminbi500 billion to the five largest banks and about 200 billion to medium-sized listed banks, according to media reports. That said, it appears that these efforts were mainly aimed at smoothing the interbank markets, which typically suffer high volatility around this time of the year. Overall, policymakers seem to remain 2

3 reluctant to ease monetary conditions much to shore up credit growth, which they fear will channel credit back towards unproductive sectors and add to higher credit risks. We expect the PBOC to continue fine-tuning its policy to provide support to lending and the economy. 2. India In India, a big effort in terms of political reforms is needed to unlock the economy. Growth According to the latest industrial output figures, in the second quarter ending September 2014, the Indian economy lost some of its positive momentum: Manufacturing Production declined by 1.0% YoY and by 1.4% YoY in July and September Capital and Consumer Goods were the main drivers of the reduction, while Basic and Intermediate Goods continued to grow. Taking into consideration the more recent economic trends, it seems unlikely that in the quarter ending September 2014 that GDP grew as strongly as in the previous quarter (5.7% YoY). However, in our opinion, this does not necessarily mean that the economic recovery has peaked. We remain confident that reforms will succed over a longer term horizon, and productivity improvement will be crucial in lifting economic growth. On the the political side, after winning the two regional elections, with oil prices at historically low levels and the inflation rate the lowest in five years, Modi deregulated diesel prices and approved a new gas price formula and direct benefit transfers. Inflation The news on Indian inflation in September was quite good, with a better than expected print of 6.5% YoY from 7.7% YoY: the Food component contribution to CPI yearly growth has been the lowest (at 3.8%) since February In the next two months, the inflation rate is expected to be even lower, before climbing back at the end of 2014 and beginning of The impact from the recent measures on diesel and gas prices will be contained and mitigated by the current low level of oil prices. The target of 8% by January 2015 seems to be easily achievable; the spotlight will be on the target of 6% by January Recent GDP Dynamics: Contributions to the CPI Growth % YoY CPI Contribution (% YoY) 12,0 10,0 8,0 6,0 4,0 2,0 0,0 Target Jan15: 8% Target Jan16: 6% Food, Beverages and Tobacco (49.7%) Fuel and Light (9.5%) Clothing, Bedding and Footwear (4.7%) Housing (9.8%) Education (3.3%) Medical Care (5.7%) Recreation and Amusement (1.4%) Transport and Communication (7.6%) Personal Care and Effects (2.9%) Others (5.4%) Source: CEIC, Pioneer Investments, data as of October 31,

4 Monetary Policy The inflation rate of 6.5% YoY in September is a good sign in the right direction, so good that our internal Taylor Rule, based on the current output gap and inflation gap is signalling a policy rate cut of 100 basis points to 7.0%. However, in the short term, we are likely to see some worsening figures in terms of economic growth and inflation. As long as the Reserve Bank of India (RBI) is not comfortable (despite benign global factors) that the inflation path is steadily moving towards the 2016 target, they will not cut rates. They have succeded in anchoring inflation expectations for January 2015;, they are now committed to doing the same for January Triggers India: An effective government in India, able to address the inflation issue and unlock the investments, together with RBI support. Risks China: The real threat would be policymakers making too much effort to keep growth of credit and GDP at unsustainable paces without pushing ahead on necessary reforms ahead, which would add tomedium-term risks. EMEA 1. Poland Poland is seeing a healthy economy despite a difficult external environment. The minutes of the October Central Bank Meeting Showsa Wide Range of Opinions among Policymakers The National Bank of Poland cut rates by 50 basis points at its early October meeting, and both the statement and the press conference suggested some differences in assessment among policymakers. The release of the minutes gives a wider picture of the range of positions. All seemed to agree on the fact that the slowing of the German economy (and Eurozone in general) affects Poland exports in turn. There was less agreement on the evaluation of the imported financial conditions, with some members highlighting the expansionary mode of the European Central Bank and others emphasizing more the impact of the upcoming changes in U.S. Federal Reserve policy. The second area of widely different evaluations regards the assessment of the extent of the domestic economy slowdown, with some members highlighting its temporary nature and others more worried regarding its persistence. Different diagnoses and even more different therapies were suggested, at least three apparently: cut aggressively and immediately, cut but sayg that the cut is a one off adjustment, and finally, don t cut. Given the fact that, in the end, they cut quite aggressively (50 basis points is a lot given the low starting point while citing the possibility of further adjustments, the intent of the doves was to cut even more. The November meeting could hence be highly relevant and actions will be strongly based on the evidence collected in the inflation report to be released just before. The Slowdown in the Economy In fact, the economy is slowing: retail sales have declined the last two months on a monthly basis and quite severely (-0.9% MoM in September after -1.1% MoM in August). This is despite the wide gap between wages (still growing at 3.4% YoY) and consumer inflation that in September at -0.3% YoY was stuck below zero for the third 4

5 month in a row. In addition, the manufacturing purchasing managers index was below its threshold (50) for the third month in a row in September (although slightly so, at 49.5). Industrial output re-accelerated after the huge dip in July, growing 4.2% in September after the -1.9% recorded in August (probably linked to the same seasonal pattern of the summer s industrial output in Germany). Poland: Inflation Items (89) and YoY change range 1 0,9 0,8 0,7 0,6 0,5 0,4 0,3 0,2 0,1 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 < and -1-1 and 0 0 and 1 1 and 2 > 2.0 Jul-08 Source: Pioneer Investments on Eurostat data, as of Oct 23, Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Inflation continues to move up as a consequence of ruble weakness, and is hurting consumer purchasing power. Inflation While there is no evidence whatsoever of price pressure coming from domestic demand, the slowdown in the economy could prove short lived. While the pace of the economy would not jump up immediately, it is difficult to imagine a furhter slowdown if the Eurozone stabilizes. In this context the final question would be real rates. If inflation projections are much lower than in the past a further cut may be warranted and its measure could, as in the previous circumstance, surprise. 2. Russia While we are keeping our forecast for a 1.5% contraction in 2015, we believe that the downside risks have increased. In our view it is unlikely that either EU or US sanctions will be lifted in the coming year. Together with a lower oil price, this will have further damaging impact on access to funding (Russia s external credit, mostly private, is in excess of US$ 700 billion), business and consumer confidence, and therefore output. Furthermore, monetary and fiscal policies are likely to remain tight in order to maintain Russia s still favorable credit ratings and financial stability. In the uncertain business environment and with tight public sector spending, we don t expect a substantial increase in investments. The surprising uptick in industrial production, 2.8% YoY, is somewhat misleading. It is to a large extent due to an acceleration in the extraction sector ahead of the deadline for implementation of sanctions and, ironically, closure of some of the related projects. While we do not fully rule out some recovery in industrial output due to import substitution following the sanctions and ruble depreciation, we believe such an effect is not to be expected before the second half of Real wages entered negative territory in September/August for the first time since the 2008/2009 crisis. Real wages declined -1.0% YoY in September despite record low unemployment at 4.9%. According to our model, retail sales can be accurately predicted by real wages, consumer confidence, and wealth effects. While retail sales 5

6 for now have continued to hold up, with real wages already in negative territory, we expect consumption to slow rapidly in the coming quarters. Historically low unemployment despite the slowdown in the economy underlines the unfavorable demographic trends, and supports our premise of low potential growth in Russia. We do not expect inflation to fall under 7.0% in 2014, despite cooling domestic demand, with risks to the upside. In the past month, inflation has accelerated to 8% due to ruble weakening and the ban on agricultural imports. We estimate a passthrough effect of about where a ruble devaluation of 10% brings about 2 percentage point increase in inflation. Further sanctions on car imports and textiles will put additional pressure on CPI. Further monetary tightening should not be ruled out. During its last meeting in September, Bank Rossii decided to keep rates on hold, possibly owing to political pressure. The move was not welcomed by the market and the ruble weakened sharply, more than its emerging market peers. Should the sharp devaluation dynamics accelerate and prompt local depositors to accelerate dollarization, we expect Bank Rossii to react with a combination of FX interventions (spot, FX swaps and repos) and/or monetary tightening. Since March 2014, Bank Rossi has been forced by the fallout from political unrest in Ukraine to increase its key rate, the one used for one week open market (liquidity providing and absorbing) operations, from 5.50% to 8% in a bid to sustain the exchange rate of the ruble. Going forward, we expect the need for US dollars to be acute among Russian corporates and banks as a result of the sanctions, and therefore the ruble to have a tendency to depreciate. Triggers EU sanctions on Russia are lifted before summer Risks Main risks are still on the geopolitical side: The Ukraine-Russia issue can impact via volatility in the market, commodities prices and also direct trade links. Latin America 1. Brazil President Rousseff won re-election in the second and final round in one of the tightest presidential elections in recent history. Dilma Rousseff received 51.6% of the votes, winning against the opposition candidate Aécio Neves, who received 48.4%. The President s four-year mandate starts on 1 January A reform to extend the term to five years was discussed during the election. The tightest election in recent history should send a strong message to President Rousseff. The lastminute rise in the polls of the candidates as different as the environmentalist Marina Silva and the perceived pro-business candidate Neves, likely demonstrates voter fatigue with the interventionalist policies of the current government. All eyes will be on Rousseff s announcements regarding her economic team, which should signal the direction her new term will take. The original market reacion has been strongly negative, with equity markets coming off, currency weakeningr and rate and credit spreads widening on annoucement ofthe results on Sunday, October 26. There were some conciliatory comments by President Rousseff and a surprise hike by the central bank of the policy rate by 25 basis points to 6

7 11.25%. However, it is yet unclear whether President Rousseff will respond to the strong opposition vote by attempting to re-engage with those that voted against her, or instead focus squarely on her core constituency as we have seen play out in the recent elections in Turkey and Russia. In the past, President Rousseff has shown herself as a pragmatic, with the Central Bank starting a rate hiking cycle following street protests that were at least partially motivated by lower real wages on the back of accelerating inflation. In the menatime, we remain negative on the growth outlook. On the consumption side, some deceleration in the labor market going forward (the unemployment rate, while as low as 4.9%, has been increasing in the majority of the metropolitan areas since the beginning of the year), could be driving a weakness in consumers' expectations. Add to this some deceleration in credit growth and high consumer indebtedness, we should see a significant reduction in the ability of Consumption to be a driver of growth to the extent it has been in the past. Some rebound in investments is possible as election uncertainty is now removed, but we do not see a significant uptick until the government embarks on more business-friendly reforms. In 2Q 14 Brazil entered a technical recession; nontheless, inflation remained above the central bank target, presenting a diffcult dilemma for the central bank. In QoQ terms, real GDP growth further contracted in 2Q by -0.6% (1Q decline was -0.2%), bringing average growth for the year to 0.5%. The most significant decline was registered by investments with Gross Fixed Capital Formation plunging -5.3% QoQ. Net trade posted a positive contribution, growing 4.9% as Imports contracted -2.1% versus an improvement in Exports of 2.8% QoQ. The IBGE IPCA Consumer Price Index was up 6.75% YoY in September (6.5% YoY prior) remaining above the central bank target of 4.5% +/- 2%. Food was an important contributor together with housing and transportation. The central bank remained on hold and signalled no rate cuts in the near term, however credit subsidies continued. While Brazil is in technical recession, inflation remains above the central bank target. Brazil Real GDP, by Expenditure, Contribution 6,0% 4,0% 2,0% 0,0% -2,0% -4,0% -6,0% Household Consumption Gross Formation of Fixed Capital Net Trade Government Consumption Changes in Inventories GDP QoQ Source: Datastream, Pioneer Investments, data as of October 31,

8 Trigger Appointment of market-friendly Minister of Finance. Further hikes by the central bank while allowing for currency weakness. Structural reforms. Risks Social unrest as economic conditions continue to worsen. No pick-up in investments now that election uncertainty is out of the way. 2. Venezuela Continuous Deterioration in Outlook Macro-economic mismanagement is driving the country deeper into a classical balance of payments crisis was another muddle-through year where the authorities decided to maintain their multiple exchange rates regime at an overvalued level leading to depletion of reserves. Simultaneously, government spending increased sharply, largely financed by the central bank, leading to more than doubling of money supply since 2012 and inflation in excess of 60% YoY. Further risks stem from lower oil prices; a US $10 change in the average annual price would cost Venezuela roughly US $6-8 billion in exports proceeds. Output volumes are hard to forecast, but some academics estimate based on government arrears to state-owned oil producer PDVSA s suppliers, contractors, and jointventure partners that oil exports are down by 45% since A large number of court cases are outstanding for Venezuela to honor its obligations to private companies. Any political window for decisive reforms has likely been closed. September s government reshuffle dismissed the more reform-oriented Ramirez agenda and reassigned duties among existing government members. Government expenditures are already on the rise and we expect them to pick up further in anticipation of the Parliamentary elections in the second half of2015. Maduro s approval ratings are already at historically low levels for the position and the leaders of the party have been on the news commenting that they cannot lose the Assembly to the opposition. Exactly the measures needed to stabilize the economy devaluation and unification of the exchange rates, reining in domestic demand, and higher domestic gas prices might be perceived as too politically costly during the pre-election period. Investors should monitor the government s ability to pay on a month-to-month basis. It is becoming increasingly more difficult to assess the country s ability to pay due to increasingly more limited statistical coverage of the key indicators. According to the official data, central bank reserves stand at US $20 billion, possibly lower as some of these may be illiquid. Large external debt repayments are expected in November and February-May On average, Venezuela will be repaying over US $10 billion in 2015, with a large part of it expected to come out of official reserves. Additional FX inflows could be found via sale of Citgo (US $3-7B), renegotiation of the Petrocaribe/Cuba oil subsidy scheme (up to US $7B) and obligations to China. Triggers A credible adjustment package where exchange rate devaluation is supplemented with tight fiscal and wage policies to control inflation passthrough. Risks Lower oil price. Escalation of social unrest 8

9 Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of October 31, Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: November

Emerging Markets: Economy Update September 2014

Emerging Markets: Economy Update September 2014 MACRO REPORT Executive Summary Monica Defend Head of Global Asset Allocation Research Also contributing Annalisa Usardi Economist, Global Asset Allocation