Total EM income: Maximizing the EM income opportunity set

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1 J.P. MORGAN RGING MARKET STRATEGY Total EM income: Maximizing the EM income opportunity set MARCH 2014 OUTLOOK & OPPORTUNITIES Please contact your J.P. Morgan representative for access to all of our Insights publications. IN BRIEF Emerging markets continue to drive global growth, and also represent an increasingly important source of income. Many emerging market companies are paying high and rising dividends, and the power of compounding means high yielding emerging market stocks have historically outperformed the broader market. With many emerging market countries in stronger fiscal positions than their developed peers, emerging market debt has become an increasingly mainstream asset class. Combining emerging market equities and debt in a single portfolio has the potential to improve risk-adjusted returns while providing more broadly diversified exposure across the emerging world. With fears of a 1990s-style emerging market crisis looking overdone, there currently appears to be a buying opportunity. We are overweight equities vs., but are finding attractive opportunities for income investors in both asset classes. AUTHORS The great rebalancing Richard Titherington Chief Investment Officer, Emerging Market Equities The most transformational change in the world today is the rebalancing of economic growth, from north to south, from west to east, from developed to emerging markets. The story of this rebalancing has become a familiar one: across the emerging world, people move from the countryside to the cities to seek higher wages, productivity grows, and the new urban dwellers become a new class of consumers. As a result of the virtuous circle of development, emerging market (EM) growth is outstripping that of the rest of the world. Between 2010 and 2018, emerging markets are forecast to contribute 55% of global growth (Exhibit 1). According to the International Monetary Fund (IMF), 2013 is the first year in which emerging markets will account for more than half of world GDP on a purchasing power basis. Pierre-Yves Bareau Chief Investment Officer, Emerging Market

2 Total EM income: Maximizing the EM income opportunity set Emerging markets are powering global growth EXHIBIT 1: CONTRIBUTION TO GLOBAL GDP GROWTH Global Economy % Developed 68% 32% 1980s Emerging 64% 36% Source: J.P. Morgan, IMF; IMF forecasts from 2012; data as of 30 September 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. For investors, emerging markets increasingly represent not only an attractive source of long-term capital growth, but an important tool in income portfolios. In the low interest rate environment that has prevailed since the financial crisis, EM debt has been sought for its higher yields, as well as for the fiscal strength of many issuers relative to their developed world peers. Meanwhile, with more and more EM companies paying strong and rising dividends, EM equities have become a sustainable source of income. Combining the two asset classes allows investors to access diversified streams of income and tap into EM growth with lower volatility than a pure equity approach. EM equities: An increasingly sustainable source of income investors don t buy GDP growth, but corporate earnings, and specifically the dividends that companies pay out. The most impressive reforms in emerging markets over the past decade are arguably not the well-documented macro reforms, but multi-year improvements in corporate governance and capital discipline. In the 1990s, EM stocks had among the lowest levels of return on equity (RoE) in the world. EM companies had too much debt on their balance sheets and prioritised market share gains over profitability. Since the Asian Crisis, though, companies have shifted their focus to their core businesses, targeted profitability rather than market share growth, and funded a greater proportion of their investments through internal cash flow. EM companies now benefit from improved operating efficiency and reduced financial leverage, allowing them to pay sustainable and growing dividends. 52% 48% 45% 55% 1990s 2000s Exhibit 2 shows the long-term growth in dividends and earnings for the MSCI Emerging Markets Index vs. the MSCI World. The fact that emerging markets have consistently delivered higher growth in earnings per share (EPS) than the developed world is perhaps not a surprise. However, what many investors may have overlooked is that dividend per share (DPS) growth has been higher than developed world DPS growth and has also outpaced EM EPS growth. We believe these trends are sustainable as increased RoE allows the higher growth of emerging markets to be translated into profits. Robust profitability continues to drive earnings and dividend growth EXHIBIT 2: LONG-TERM GROWTH IN PROFITS AND DIVIDENDS... SHORT TERM CHALLENGES Index, 100 = 31st December EM DPS EM EPS (Fwd) DM EPS (Fwd) DM DPS year compound annual growth rates EPS DPS Emerging markets (EM) 9.3% 9.9% Developed markets (DM) 6.6% 6.3% Source: MSCI, IBES, FactSet, J.P. Morgan Asset Management. Regular dividends only in local currency. As at end Dec Past performance is not an indication of future performance. EPS Earnings per share. DPS Dividends per share. Importantly for investors, dividends also tend to be more stable than earnings. With over 20 years of data now available on EPS and DPS in emerging markets, it is clear that dividends are significantly less volatile. In and , dividends were cut, but the cuts were much smaller than the decline in earnings. This comparative resilience means dividends can offer investors a cushion against earnings volatility, making dividendpaying stocks less volatile. EM DM 2 Total EM income: Maximizing the EM income opportunity set

3 The power of compounding As EM companies across regions and sectors increasingly recognise the benefits of returning capital to shareholders, we expect dividends to continue to grow significantly. Over the next five years, we expect dividend growth in emerging markets to average 12% a year. The power of compounding means this superior growth has the potential to create a significant long-term return premium. The combination of income and growth has been powerful for EM dividend strategies over time. Not only have emerging markets strongly outperformed an equities, but higher yielding EM stocks have consistently beaten the wider EM asset class over the last 15 years. Exhibit 3 shows the performance of the highest yielding third of stocks in the MSCI Emerging Markets Index, which have generated a total return (including dividends) of 16.8% per annum since the end of 1998, well ahead of the return of 11.3% per annum from the standard MSCI Emerging Markets Index (data to end September 2013). The combination of income and growth has been powerful: Emerging markets have strongly outperformed, and high yielding EM stocks have beaten the EM index EXHIBIT 3: PERFORMANCE OF MSCI EM HIGH YIELD VS. BROAD EM INDEX AND EUROPE Index, 100 = 28 February EM High Yield MSCI EM MSCI Feb 01 Feb 03 Feb 05 Feb 07 Feb 09 Feb 11 Feb 13 EM higher dividend yield 16.8% p.a. MSCI EM Index 11.3% p.a. MSCI Index 5.1% p.a. Source: Bloomberg, FTSE, MSCI, UBS, rebased to USD; as of 30 September Annualised returns. High yield as provided by UBS. Calculated as top third yielding stocks in MSCI EM Index. Past performance is not an indication of future performance. For illustrative purposes only Diversified and diversifying As a global asset class, EM equity income offers healthy diversification across a broad range of currencies, sectors and companies. New equity supply has contributed to a significant expansion of the EM investment universe in recent years, with the number of investable companies growing fourfold since This makes a diversified income strategy in emerging markets possible today in a way it wouldn t have been 10 years ago. Today, there are 395 EM companies with a forward estimated yield of greater than 4%, a market capitalisation of at least USD 1 billion and an average daily trading volume of USD 1 million or more. Using the same criteria but a yield of 2% or greater produces a list of close to 1,000 stocks (source: Bloomberg; data as of October 2013). Historically, investors looking for income in emerging markets have focused on Asia. Today, though, the opportunity set stretches well beyond Asia, with compelling opportunities to be found in Latin America, emerging, the Middle East and Africa. EM debt: A broad asset class with solid fundamentals At the same time as EM companies have reduced their leverage and boosted their profitability, EM governments have undertaken dramatic reforms that have transformed their economies. The year 2004 marked a turning point of sorts. Until then, EM wounds, as represented by high borrowing costs, were largely self-inflicted, the product of imprudent policy. The crises of the 1990s and early 2000s forced on EM countries the painful austerity measures that developed markets have undergone in recent years, and taught them critical lessons. Many EM governments brought their deficits under control, and moved to floating rates and inflation targeting and away from fixed exchange rates and from monetary policy that was driven by developments in the advanced economies. As their relative stability during the eurozone debt crisis demonstrated, many emerging markets now benefit from much stronger fiscal positions than their developed peers. This has been reflected in a sharp decline in spreads of EM debt over US Treasuries and a dramatic improvement in credit ratings: today, over 60% of the EMBI Global is investment grade (Exhibit 4). However, EM debt continues to offer a significant yield premium to developed markets. J.P. Morgan Asset Management 3

4 Total EM income: Maximizing the EM income opportunity set The transformation of an asset class: Spreads and credit ratings reflect the long-term improvement in fundamentals EXHIBIT 4: EM DEBT STILL PROVIDES YIELD PICK-UP TO DEVELOPED MARKETS RELATIVE TO THEIR CREDIT RATINGS EMBI Global spread to Treasuries (LHS) Ratings (RHS) Emerging market crises Developed market crises Spread (bps) 1,600 1,400 1,200 1, Mexico crisis Russia default / LTCM Asia Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Turkey crisis Argentina default Brazil fears Dec-00 Dec-01 Lehman bankruptcy / Global credit crisis FED tightening fears Sub-prime fears an Crisis Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Source: J.P. Morgan Asset Management, January Note: The J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) is representative of the sovereign debt market. An increasingly sophisticated opportunity set CCC+ The breadth and depth of the EM debt asset class presents investors with a wealth of income opportunities. In recent years, EM debt markets have grown in sophistication as well as size, with emerging markets not only issuing more debt, but issuing more kinds of debt. Although they have become less reliant on dollar issuance for funding, EM sovereigns continue to issue dollar-denominated. Today, they use new issuance to refinance amortising debt, to take advantage of the developed world s near-zero interest rates, and, not least, to set a benchmark for domestic corporations seeking to access international markets. Meanwhile, backed by sound currencies, public sector EM issuers, represented in the GBI-EM index, have been tapping local markets. EM local currency government debt stock has increased fourfold over a decade to total close to USD 5.9 trillion as of August This local currency sovereign market has developed in response to increasing demand from domestic pension and retirement funds. A deep domestic investor base provides the liquidity and stability that make international participation not only sustainable but attractive. Dollar-denominated EM corporate debt, tracked in the CEMBI, is probably the fastest growing, least liquid and least known sector of the market. EM corporates have modernised along with EM economies. Until the second half of the last decade, investor appetite for corporate debt was limited to maturities of between B- B B+ BBB- BB- BB BB+ Credit rating (inverted scale) three and seven years. As a result of the improvement in their home markets and the globalisation of their operations, EM corporates now have little trouble issuing 10-year maturities, and established investment grade EM names have gone out 30 and even 100 years. The newfound breadth and depth of the markets, together with the vastly improved fundamentals, have transformed EM debt into a strategic asset class. Today, even though EM debt markets have become more liquid, international flows the source of so much EM volatility in the past have stabilised. In addition to the large domestic investor base, a significant number of global funds have come onstream, dedicated to capturing the growth inherent in emerging markets. The three sub-asset classes external sovereign debt, local currency sovereign debt and EM corporate have common drivers, but each also has its own individual fundamental and technical drivers, allowing for different positioning in different environments (Exhibit 5). Broad market allows for different positioning in different environments EXHIBIT 5: A BROAD MARKET PROVIDES LARGE SCOPE FOR DIVERSIFICATION Corporate (4.86%, 4.86 years) Local Sovereign (5.76%, 4.82 years) USD Sovereign (6.16%, 6.46 years) Source: JPMorgan Securities, December USD Sovereign: EMBI Global Diversified, Local Sovereign: GBI-EM Global Diversified, Corporate: CEMBI Broad Diversified. The benefits of a combined approach Combining EM equities and EM debt in a single portfolio allows investors to diversify their income exposure and capture the growth potential of EM economies, with reduced volatility compared to investing in equities alone. Exhibit 6 shows the annual return in euro terms of a range of asset classes over the past decade. EM equities have delivered the strongest annual performance in six of the 11 years, and a 13.5% annualised return over the period as a whole. Compared with an and world ex an equities, which have each delivered annualised returns of around 8%, EM equities have produced compelling performance A Latam Asia Total EM income: Maximizing the EM income opportunity set

5 The benefits of diversification: Complementary performance EXHIBIT 6: ASSET CLASS PERFORMANCE (% IN EUR) Ann. 9.7% 30.0% 16.9% 55.0% 20.2% 26.1% 9.3% 73.4% 27.5% 10.5% 18.1% 22.4% 12.2% -4.8% and 17.8% 12.6% and 42.2% 18.6% and 10.5% -10.3% and 51.7% and 24.1% 3.4% 16.8% 20.5% and 10.7% and -12.5% 15.8% and 10.4% 29.4% and 8.5% 3.2% and -30.5% 32.5% 24.0% 0.4% and 16.5% 2.2% 7.7% -20.2% 9.5% 7.6% 26.8% 2.7% 1.7% -34.2% 30.0% 20.7% and -2.4% 16.1% -6.5% 7.4% -30.5% 5.6% 4.6% 26.7% -0.2% -3.3% -43.3% 24.2% 11.7% -7.5% 13.5% and -7.4% 6.7% -32.3% 4.1% 3.8% 5.4% -1.6% -5.2% -50.8% 4.3% 1.1% -15.4% 11.0% -8.3% 4.5% Note: Total returns in euro. Annualised returns are for Euro government is the Barclays Euro Aggregate Government - Treasuries Index; is the Barclays Emerging Markets (USD) Index; is the MSCI Emerging Markets Index; an is the MSCI Index; is the MSCI World ex Index. Source: MSCI, Barclays, FactSet, J.P. Morgan Asset Management; As of end December However, in two of the 11 years EM equities were the worst performing asset class. This level of volatility deters some investors from making significant allocations to emerging markets, and may be a disincentive to income investors seeking to allocate away from developed markets. Although long-term investors are told not to worry about volatility as their time horizon allows them to ride it out, large swings in price can make this challenging, particularly for investors who are new to the asset class. Combining EM equities and EM debt in a single portfolio allows investors to maintain exposure to EM growth, but with lower volatility. This has historically been effective because EM equities and debt have displayed complementary performance, with debt typically performing well in periods of recession or economic shock, while equities typically perform well when economies are recovering or growing steadily. Since 2001, the correlation between EM equities and US dollar-denominated EM debt has been 65%. 1 As the chart shows, in 2002, 2008 and 2011, when EM equities struggled, EM debt was among the stronger asset classes. As a result, over the period as a whole, a simple equity/debt strategy has delivered strong returns with lower volatility than equities alone. Exhibit 7 plots the annualised return and volatility of this 50/50 strategy against a range of asset classes. Over the past 10 years, this blend of assets delivered an annualised return of 8.4%, just below the 8.5% return of EM equities, but with volatility similar to that of US equities. 1 Source: Bloomberg; monthly pricing and returns for MSCI EM Index and EMBI Global from January 2002 to September The benefits of diversification: Improved risk-adjusted returns EXHIBIT 7: HISTORICAL RETURN/RISK Annualised return 12% 9% (USD Sovereigns) US IG Corporate Global HY 50% / 50% 6% Euro IG US Equities US Treasury Barclays Aggregate an Equities 3% 0% 5% 10% 15% 20% 25% Annualised volatility Source: J.P. Morgan, Bloomberg; data as of 31 December Monthly data for past 10 years. EM equity and debt not only offer complementary return profiles, but also complementary regional exposures (Exhibit 8). While Asia makes up the largest share of the MSCI Emerging Markets Index by a significant margin, the three major EM debt indices external, local currency and corporate are more broadly diversified, with Latin America and eastern playing a larger role. The debt indices also offer varying exposures the largest weighting in the CEMBI Broad, for example, is to Asia, while the EMBI Global has a significant weighting to eastern. As a result, combining EM equity with a broad allocation to EM debt provides diversified exposure across the emerging world. While a typical EM equity J.P. Morgan Asset Management 5

6 Total EM income: Maximizing the EM income opportunity set portfolio might invest in 20 markets, a combined portfolio can be well-diversified across regions and invest in over 60 countries. The benefits of diversification: Complementary regional exposures EXHIBIT 8: REGIONAL EXPOSURES OF EM DEBT AND EM EQUITY MARKET WEIGHTING (%) Latin America Africa & Middle East Eastern Asia CEMBI Broad 45.2 GBI EM Global 42.6 EMBI Global Source: J.P. Morgan, Morgan Stanley; data as of 30 April Outlook: Tapering fears have created value brought testing times for emerging markets, as the Federal Reserve s (Fed s) indication that it may soon begin to taper its asset purchases led to sell-offs in EM assets and sparked sharp currency depreciation in markets with large current account deficits. The question is, are there significant funding risks that could create a 1990s-style crisis today? To assess the vulnerability of EM countries to a shift in capital flows, we need to look at the reliance of emerging economies on capital inflows from the developed world. Exhibit 9 juxtaposes each country s financing needs (horizontal axis) with its level of reserves, to assess which countries would have sufficient reserves to cover the removal of inflows and which countries are at risk of having insufficient reserves. The fan pattern rotates from the lower left, which is high risk (reserves are less than a year s worth of expected or required inflows), to the upper right, which is low risk (reserves represent two or more years of cover). 0 MSCI EM Vulnerability to global tightening is selective rather than systemic EXHIBIT 9: VULNERABILITY TO TIGHTENING GLOBAL LIQUIDITY: SELECTIVE RATHER THAN SYSTEMIC Funding gap Reserves / GDP (%) based on 2014e 60% LOW RESERVES HIGH RESERVES 50% 40% MY TH 30% KR CZ PL RU 20% MX IN ZA BR 10% TR CL ID AR 0% FINANCING NEED FINANCING SURPLUS Current Account + Foreign Direct Investment short-term Source: IIF, JPMorgan Securities, J.P. Morgan Asset Management as at January Please refer to the country code chart provided on page 9. Funding gap: 1997 prior to the Asian Crisis Reserves / GDP (%) 60% LOW RESERVES HIGH RESERVES 50% 40% 30% HU Funding gap: 1994 prior to the Mexican Peso Crisis Reserves / GDP (%) 60% LOW RESERVES HIGH RESERVES 50% MY TW CN TW (85%,+8.4) 40% TW 30% MY TH HU CZ 20% CL PLCN 10% ID KR MX BR TR ZA RU AR IN 0% FINANCING NEED FINANCING SURPLUS Current account + foreign direct investment short-term debt 20% HU ID CL CZ 10% MX BRAR IN TR CN RU KR ZA PL 0% FINANCING NEED FINANCING SURPLUS Source: IIF, J.P. Morgan Asset Management as at end September 2013 Comparing the scatter chart today with the same picture in 1997 (the eve of the Asian crisis) and 1994 (the eve of the Mexican peso or Tequila crisis) illustrates the progress EM countries have made in shoring up their reserves. On the eve of both crises of the 1990s, 6 Total EM income: Maximizing the EM income opportunity set

7 EM countries were broadly ill-prepared to cover their financing needs. As a result, when global liquidity tightened, the asset class as a whole was dragged into crisis. Today, in contrast, most EM countries are well protected by their reserves against an external funding slowdown. We therefore believe the vulnerability to tightening global liquidity is selective (limited to certain countries) rather than systemic (affecting the entire asset class). Beyond the strengthening of reserves, there are other marked differences between the emerging markets of the 1990s and the emerging markets of today that mean a repeat of the decade s crises is unlikely. First and foremost, in the 1990s, EM currencies were pegged to the dollar, meaning there was no safety valve. Now, emerging markets have floating currencies, which may be painful in the short term a 20% fall in the Indian rupee is not much fun but which allow economies and markets to adjust to changing circumstances. Today, much of this currency adjustment has already taken place, with risks appearing largely priced in following the depreciation over the summer and many currencies looking cheap relative to our assessment of fair value. Second, as discussed earlier, improvements in corporate governance and allocation of capital mean EM profitability is structurally higher today than it was in the 1990s. Finally, in the 1990s, EM companies and sovereigns alike had too much leverage, with balance sheet weakness compounded by the fact that most borrowing was in dollars, so that rate rises had a catastrophic effect. Today, excessive leverage and currency mismatches are limited. Although the eventual tightening of global liquidity will inevitably create headwinds for certain EM countries, floating currencies mean the process of adjustment is already well underway, and the strength of many EM economies compared to the 1990s means a systemic crisis looks highly unlikely. As a result, further weakness may be viewed as a selective buying opportunity. Preparing for tapering The withdrawal of quantitative easing (QE) and the eventual normalisation of monetary policy are likely to be very gradual. In the meantime, the need for income is unchanged. Different asset classes will respond to an environment of rising yields in different ways, so it is more important than ever to maintain a diversified income strategy. Emerging markets have a central role to play in this strategy. While EM equities are perceived as being vulnerable to the end of QE, tighter US monetary policy will ultimately be a sign of improving economic conditions, benefiting EM exporters. Highyielding EM stocks are also well placed to weather any volatility that results from tapering as a result of the cushion provided by the dividend. Similarly, the higher coupon offered by EM debt vs. developed market provides some protection against rising interest rates. A combined approach with significant asset allocation flexibility can help investors to navigate equity and debt markets when rates are rising. Finding value in today s markets In the current environment, we are overweight equities vs., reflecting signs of a strengthening economic recovery in emerging markets, as well as tentative improvements in earnings estimates and the continued cheapness of EM equity valuations. However, both markets continue to offer attractive opportunities for income investors. J.P. Morgan Asset Management 7

8 Total EM income: Maximizing the EM income opportunity set EM equity income: Plenty of value to be found EM equities have looked attractive in absolute terms for some time. Now, though, the attractive absolute valuation is finally being echoed by attractive valuations relative to developed markets, on a fundamental basis. As a result, the asset class currently offers plenty of opportunities for income and long-term capital growth. In a rising rate environment, high yield/low growth stocks such as REITs may come under pressure. Instead, our focus is on income plus growth, through both high yield cyclical stocks and core stocks (stocks with a 3%-6% yield and market-level growth). By region, we believe emerging A currently offers the best value for EM equity income investors (Exhibit 10). South Africa is particularly attractive from an income perspective, thanks to a strong dividend culture. The market has some of the best corporate governance standards in the world, and many companies have mature management teams with advanced policies on capital allocation. Across a wide range of industries, from clothing retail to industrials, company managements are focused on generating good returns on equity, and on returning cash to investors through dividends. Both our equity and our debt teams are cautious on the financing requirements for Turkey. However, equities have already discounted the majority of these risks. Therefore, while we are underweight from a debt point of view, we are overweight equities. We are also overweight Russia, where the dividend yield is already higher than the EM average and is set to grow as payouts rise. Emerging A offers the best value EXHIBIT 10: DIVIDEND YIELD BY REGION Elsewhere, we are underweight South Korea, which, in contrast with South Africa, has little culture of paying dividends. In Latin America, we have started to add to Brazil as valuations have come down. Brazilian companies have a legal obligation to pay dividends equivalent to 25% of their shareholder capital, and also have to compete for investor attention with fixed income markets that until recently offered double-digit returns. We are underweight Mexico, which has become expensive and therefore offers few income plus growth ideas. However, both teams like the macro and reform agenda in the market, so we are overweight on the debt side a good example of the complementary exposures available through a combined strategy. EM debt: Differentiation is key Given the continued focus on US monetary policy, differentiation on a country, sector and individual bond basis will be key in EM debt. We expect investors to refocus on the fundamentals underpinning each country, differentiating between those facing more structural issues (India, Brazil, Indonesia, Turkey and South Africa) and those with the potential for cyclical upside, linked to the recovery in developed market growth (for example, Mexico, Korea, China and Taiwan). From a valuation perspective, the most attractive sector is US dollar sovereign debt. The sector bore the brunt of selling in the second and third quarters, and spreads and yields have not tightened significantly in the subsequent months, so value has been created (Exhibit 11). At the same time, this remains the most liquid sector in the EM debt space, and while it is important to be selective, we believe that issuers overall remain strong and stable. % MSCI Emerging Markets yield MSCI Emerging Asia yield MSCI Emerging & Middle East yield MSCI Latin America yield Hard currency sovereign debt represents attractive value EXHIBIT 11: EMBI GLOBAL DIVERSIFIED SPREAD AND YIELD EMBIGLOBAL DIVERSIFIED yield to maturity (%, LHS) EMBIGLOBAL DIVERSIFIED strip spread (bps, RHS) Source: MSCI, Bloomberg ; data as of 30 September Sep 10 Nov 10 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep Source: J.P. Morgan; data as of 4 September Total EM income: Maximizing the EM income opportunity set

9 The next most attractive sector is local currency sovereign debt, which rallied after the upset of the summer but has subsequently seen some selling. With the inflation picture remaining benign, we do not expect central banks overall to embark on rate-raising cycles in the near term. Most importantly, we believe EM currencies remain oversold, creating the potential for appreciation in this sector (Exhibit 12). There is also value in local currency rates, particularly given the potential for currency appreciation EXHIBIT 12A: YIELD DIFFERENTIAL GBI-EM GLOBAL DIVERSIFIED VS. GBI GLOBAL GBI-EM Global Diversified yield vs. GBI Global Yield* Yield differential (%) Median + 2SD Median + 1SD Median Median 1SD Median 2SD EXHIBIT 12B: VALUATION OF EM CURRENCIES VS. US DOLLAR EM currency (FX) vs. USD valuation 30% EM FX overvalued 25% 20% 15% +1 SD 10% 5% Mean 0% -5% -1.87% -10% -1 SD -15% -20% EM FX undervalued -25% Conclusion: A combined approach yields benefits Investing in high yielding securities across emerging markets, rather than only in equities or debt, brings powerful diversification benefits. EM debt continues to offer a significant yield pickup relative to developed markets, despite the dramatic improvement in credit ratings over the past decade. Meanwhile, the growing dividend culture among EM companies means EM equities represent an increasingly sustainable source of income. Combining the two asset classes allows investors to build a portfolio with real breadth and depth across the emerging world, with equities and debt offering complementary exposures as well as a complementary return profile that has historically boosted riskadjusted returns. Country codes AR Argentina BR Brazil CL Chile CN China CO Colombia CZ Czech Republic EG Egypt HU Hungary ID Indonesia IN India KR South Korea MX Mexico MY Malaysia PH Philippines PL Poland RU Russia TH Thailand TR Turkey TW Taiwan ZA South Africa Source: J.P. Morgan, Bloomberg; data as of 31 August Following its strong relative performance in 2013, the EM corporate sector appears somewhat expensive. However, fundamentals remain solid and technical support is still strong. Given the dominance of institutional investors in this space, volatility has historically remained at the lower end of the spectrum, while supply has been well absorbed. For now, we look to take advantage of pockets of value in the sector and concentrate on relative value opportunities, while waiting for a rotation. J.P. Morgan Asset Management 9

10 Total EM income: Maximizing the EM income opportunity set About the authors Richard Titherington, managing director, is the Chief Investment Officer and is Head of the Emerging Markets Team based in London. An employee since 1986, Richard transferred to the Pacific Regional Group in He was appointed as a managing director in April 2001 and appointed head of the global emerging markets business in December Prior to 1994 Richard was a US and international pension fund manager, working in the UK until he transferred to Hong Kong in Before joining the firm, Richard spent two years as an analyst with UKPI in London. Richard obtained an M.A. in politics, philosophy and economics from Oxford University. Pierre-Yves Bareau, managing director, is the head of the Emerging Markets team. In this role, Pierre-Yves is responsible for coordinating resources located in New York, London, Asia and Latin America. He is also tasked with broadening our investment set to include the Middle East and Africa. Prior to joining the firm in October 2009, Pierre-Yves was at Fortis Investments for 10 years, serving as the chief investment officer for Emerging Markets Fixed Income. At Fortis, Pierre-Yves oversaw teams based in London and Singapore, guided strategy decisions and managed a range of emerging markets mandates. Before that, he spent two years at FP Consult (France), an emerging markets bond and equity boutique, working as a portfolio manager. Pierre-Yves began his career at BAREP Asset Management, a hedge fund boutique owned by Societe Generale, in 1991 serving as an emerging markets portfolio manager. Pierre-Yves holds a graduate degree in finance and a master s degree in management from the Groupe Ecole Supérieure de Commerce et de Management Tours-Poitiers (ESCEM) in France. 10 Total EM income: Maximizing the EM income opportunity set

11 Past performance is not a guarantee of future results. Any forecast contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. 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 further notice. The information provided herein should not be assumed to be accurate or complete. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The 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 interpreted as recommendations or investment, product, accounting, legal or tax advice. J.P. Morgan Chase & Co. group assumes no responsibility or liability whatsoever to any person in respect of such matters. The views expressed are those of J.P. Morgan Asset Management. These views do not necessarily reflect the opinions of any other firm or other division of the JPMorgan Chase & Co. group. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in Hong Kong by JF Asset Management Limited, JPMorgan Funds (Asia) Limited or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in India by JPMorgan Asset Management India Private Limited which is regulated by the Securities & Exchange Board of India; in Singapore by JPMorgan Asset Management (Singapore) Limited or JPMorgan Asset Management Real Assets (Singapore) Pte. Ltd., both are regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers 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 Korea by JPMorgan Asset Management (Korea) Company Limited which is regulated by the Financial Services Commission (without insurance by Korea Deposit Insurance Corporation) and 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 ) which is regulated by the Australian Securities and Investments Commission. This communication is for intended recipients only and may only be forwarded or presented to other persons in compliance with local law and regulations which shall be the intended recipients sole responsibility. Investment involves risks. The value of investments and the income from them may fall as well as rise and investors may not get back the full or any of the amount invested. Recipient of this communication should make their own investigation or evaluation or seek independent advice prior to making any investment. It shall be the recipient s sole responsibility to verify his / her eligibility and to comply with all requirements under applicable legal and regulatory regimes in receiving this communication and in making any investment JPMorgan Chase & Co. J.P. Morgan Asset Management 11

12 Total EM income: Maximizing the EM income opportunity set To learn more about the Investment Insights program please contact your J.P. Morgan representative.