Taking measure of the cycle

Transcription

1 PORTFOLIO INSIGHTS Taking measure of the cycle Emerging markets strategy November 2017 IN BRIEF After 20 months of strong absolute and relative performance, we believe emerging market (EM) equities are merely approaching the middle of their recovery. Valuations and flows have yet to reach overshoot territory, and the trajectories of earnings, commodities and the U.S. dollar (USD) all argue for further gains for the asset class. Amid growing arguments for a new paradigm to explain the favorable combination of solid growth and well-behaved inflation globally, we conclude that the old paradigm (i.e., output gap analysis) continues to work well. Although the current expansion is more than seven years old, the paradigm suggests that the global economy is still operating slightly below potential, implying that the Goldilocks combination of solid growth and well-contained inflation should persist through The likelihood of a renewed USD rally appears much diminished good news for EM investors, given the inverse historical correlation between the U.S. dollar and EM performance cycles. Our sense is that a series of USD-favorable developments would be necessary to prompt the currency to reach new highs, and the probability of that combination unfolding is low, in our view. AUTHOR George Iwanicki Emerging Markets Macro Strategist, Emerging Markets and Asia Pacific Equity Team, J.P. Morgan Asset Management When discussing emerging markets with our clients, the most frequently asked question is Where are we in the emerging market performance cycle? It s an issue our team discusses often as we consider the state of global growth, inflation, the U.S. dollar, and earnings potential, among other factors. Some cycles are tough to call, but today we answer the question with confidence: We believe that emerging markets Asia Pacific (EMAP) equities are only approaching the middle of their cycle, with few late-cycle signals on the horizon. What many have called a Goldilocks backdrop for risk assets generally, and EMAP equities in particular solid global growth coupled with well-contained inflation should support further gains for some time to come, even after 20 months of emerging markets outperformance vs. developed markets. Another question is often twinned with the first: How can inflation be so low seven years into the global economic recovery and don t we need a new paradigm to explain the phenomenon? Our short answer: No. The old paradigm is working just fine in explaining the global backdrop. We elaborate on this theme in the following pages, taking a fresh look at the output gap (the difference between an economy s actual and potential output) as we make the case for a continued Goldilocks environment. As we examine a range of factors earnings and expectations, valuations, flows and the always-key USD cycle we conclude that the EMAP performance cycle has further to go. As always, we wrap up our quarterly paper with some tactical investment ideas.

2 SOLID GLOBAL GROWTH COUPLED WITH STILL-LOW INFLATION Start with the global business cycle. Purchasing managers index (PMI) numbers are strong for both developed market (DM) and emerging market economies, and we see increasing evidence of self-reinforcing growth globally. Macroeconomic growth expectations are accordingly still rising, led by EMAP economies. While the growth story is widely recognized, persistently low core inflation is a bit of a puzzle. But as Exhibits 1A and 1B illustrate, output gap analysis, the old paradigm that relates the output gap to movements in inflation, is doing a good job of explaining inflation in most parts of the world. Essentially, output gap theory (sometimes referred to as Phillips curve theory) posits that when an economy is operating below its potential level of activity, disinflationary pressures will arise. When it is operating above its potential, acceleration in inflation becomes more likely. In Exhibits 1A and 1B, the vertical axis shows the output gap, the difference between actual levels of activity as of mid-2016, vs. the estimates of potential at that time. The horizontal axis shows the change in inflation since mid If the old paradigm which relates the output gap to movements in inflation still holds, you would expect to see most countries in the charts lower left quadrants (excess capacity and disinflationary pressures) or the upper right (short capacity and inflationary pressures). If there were a new paradigm, then you d expect countries to be in that lower right quadrant (in the green shaded area), seemingly at risk via the old model of overheating but nonetheless seeing falling core inflation. But across both developed and emerging markets, the vast majority of countries are either in the gray quadrants or concentrated around the middle of the chart. The bottom line: It s premature to come up with a new paradigm to explain why inflation is well contained. What does the output gap framework, the old paradigm, tell us about inflation in 2018? (Exhibits 2A and 2B). It suggests that most parts of the global economy are still likely to be operating at or slightly below potential, with no danger of overheating for most economies even as the expansion enters its eighth year. Output gap analysis shows there is no need to rely on a new paradigm to explain why inflation is well contained EXHIBIT 1A: 2016 OUTPUT GAP AND CHANGE IN CORE INFLATION DEVELOPED MARKETS Output gap SW UK Euro U.S. JP Change in core inflation (latest 12 months) EXHIBIT 1B: 2016 OUTPUT GAP AND CHANGE IN CORE INFLATION EMERGING MARKETS Output gap mid TU RU -4.0 BR CZ HU CN IN PH Change in core inflation (latest 12 months) Source: OECD, Oxford Economics, J.P. Morgan Asset Management; data as of September PORTFOLIO INSIGHTS

3 Output gap analysis implies that inflation will be well contained through 2018 EXHIBIT 2A: GDP GAPS BY REGION AND COUNTRY EXHIBIT 2B: UNDERLYING OECD ASSUMPTIONS % of potential GDP E 2018E Inflationary Disinflationary OECD U.S. EU Japan UK EM OECD U.S. EU Japan UK Potential GDP NAIRU* * NAIRU is an acronym for the non-accelerating inflation rate of unemployment and refers to a level of unemployment below which inflation rises. Source: OECD, Oxford Economics; data as of September 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. EARNINGS AND EARNINGS EXPECTATIONS To examine what is happening within the EM market cycle, we look first at earnings and earnings expectations. Both realized earnings and earnings estimates are increasing, but even more impressively, realized earnings per share have bottomed and are now rising in every EM sector. We are confident that there is plenty of earnings growth still ahead, judging by our analysts five-year earnings projections for EMAP companies. Without resorting to heroic assumptions about potential profit growth, our team expects a trend line trajectory of low doubledigit earnings per share growth from current levels. VALUATIONS AND FLOWS As investors are aware, EM equity valuations have recovered measurably from their January 2016 lows. However, our preferred metric, price-to-book ratio (P/B), has merely reached roughly 1.7x for the MSCI Emerging Markets Index, still modestly below its long-term average of 1.8x. Similarly, fundamental P/E multiples (the ratios of current index price to 10-year average EPS) for emerging markets still remain well below their own long-term average; they are also below that of either Europe or the U.S. Hence, we see little reason to view current valuations as an obstacle to further gains. Investor flows also do not appear to be an obstacle to further performance for emerging markets. Steady retail flows into both EM debt and equity in recent months have only now pushed cumulative retail EM equity flows back toward their prior peak, in Against a backdrop of a more muted mood among institutional investors, we do not see the flow picture as signaling exuberance for the asset class. CURRENCY AND COMMODITIES We have long emphasized the U.S. dollar as a critical factor in EM performance; in fact, we regularly argued that the USD rally constituted one of the three headwinds to EM performance from 2011 through After worrying earlier this year that the U.S. dollar could post one last leg of a rally before peaking, we are increasingly of the view that the December 2016 high marked the top for the latest cycle. It is important to note that USD cycles in the modern era have shown a repeated pattern. Measured in real effective exchange rate (REER) terms, the USD has typically peaked at 20% or so above its 10-year moving average (in December 2016 it traded 16% above that average). More important, the shape of USD cycles has appeared to be biblical that is, seven years of rally followed by seven years of retracement. While we can t rule out the possibility that the USD will rally to a new, final peak, we now believe that the trend is down, and we expect lower highs and lower lows in the USD. J.P. MORGAN ASSET MANAGEMENT 3

4 Given the well-known inverse correlation between U.S. dollar cycles and EM performance cycles historically, this should present an extended tailwind for the asset class. USD cycles have also correlated, albeit positively, with the relative performance of the U.S. equity market. Put simply, the downtrend in the USD appears to be a positive omen for not only relative EM performance but also for Asia Pacific and European relative performance within global equity. Regarding commodity prices, those that matter most for emerging markets (energy, agriculture and metals) are generally back to levels seen in 1990 when adjusted for overall inflation. It s difficult to find a commodity whose price looks way out of line save the so-called crypto-currencies, which have surged in 2017 (Exhibits 3A and 3B). Whether we re looking at bitcoin or one of the 1,000-plus crypto-currencies now available, we are of the view that these may be the canaries in the coal mine for those investors worried that DM central bank policy rate and balance sheet normalization will crimp liquidity and possibly threaten risk asset markets more generally. Given that crypto-currencies are de facto substitute money, perhaps we shouldn t be surprised that they arose amid significant, sustained monetary stimulus. Hence, we are inclined to view them simply as beneficiaries of easy monetary policy and thus a potential early warning of when policy normalization turns into tightening. TACTICAL VIEWS Finally, we present some views within the EMAP markets. Most EMAP currencies lean somewhat cheap, the mirror image of the USD, which remains moderately above fair value. The Egyptian pound is the lone hyper-cheap currency, while the Turkish lira and Colombian peso appear measurably cheap. So, too, does the Philippine peso, which offers the first unambiguously positive signal in years for a market once favored by foreign investors. We continue to puzzle over the South African rand, which looks slightly expensive (as does the country s equity market in relative value terms) despite ongoing political dysfunction that is stifling needed fiscal adjustments and pro-growth reforms. At the country level, where we tactically seek combinations of attractive valuations and positive momentum, we continue to favor Korea and the smaller East European markets, which have performed well this year. Despite the sharp third-quarter rebound in Brazilian stocks, the market is still favored by positive momentum as economic data (and rebounding earnings) confirm the end of recession. Among the higher risk, deep value countries, we find good but slightly less compelling value in both Russia and Turkey than that seen earlier this year (and see less basis to distinguish the two than at points earlier in 2017). Real commodity prices are finding support near 1990 values and then there s bitcoin EXHIBIT 3A: REAL COMMODITY PRICE INDICES Index (1990 = 100) 260 Energy 220 Metals Agriculture EXHIBIT 3B: BITCOIN PRICE (USD) 6,000 5,000 4,000 USD 3,000 2, , Source: Bureau of Labor Statistics, World Bank, J.P. Morgan Asset Management; data from January 1990 to September Past performance is not a reliable indicator of current and future results. 0 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Aug-17 Source: Bloomberg; data from August 2010 to October 16, Past performance is not a reliable indicator of current and future results. 4 PORTFOLIO INSIGHTS

5 CONCLUSION We believe that emerging markets are merely approaching the middle of their performance cycles, as earnings growth and a downtrending U.S. dollar drive performance. In similar fashion, we believe the global business cycle is approaching its midpoint and expect that the combination of firm growth and contained inflation will continue through Although EMAP equities have outperformed for close to two years and multiples are well off their lows, neither valuations nor flow data give us cause for concern. We encourage EM investors to stay the course. J.P. MORGAN ASSET MANAGEMENT 5

6 THIS PAGE INTENTIONALLY LEFT BLANK 6 PORTFOLIO INSIGHTS

7 THIS PAGE INTENTIONALLY LEFT BLANK J.P. MORGAN ASSET MANAGEMENT 7

8 FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION PORTFOLIO INSIGHTS J.P. MORGAN ASSET MANAGEMENT The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. J.P. Morgan Asset Management is the marketing name for the investment management business of JPMorgan Chase & Co and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number Kanto Local Finance Bureau (Financial Instruments Firm) No. 330 ); in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN ) (AFSL ); in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan Investment Management Inc. Copyright 2017 JPMorgan Chase & Co. All rights reserved. PI-EMCYCLE 0903c02a81f9fe6b