Defining reflation, gauging momentum

Transcription

1 Defining reflation, gauging momentum Emerging Markets Strategy May 217 IN BRIEF Today s reflation story is much more about growth than inflation. Despite setbacks and reduced expectations for fiscal stimulus from the U.S., growth momentum looks solid for both developed and emerging markets. We see undeniable evidence of the long-awaited turn in the emerging market (EM) corporate earnings cycle. In sum, we are optimistic about the prospects for EM equities. We acknowledge, however, that the asset class faces three potential challenges: China s growth momentum may be peaking, the multi year U.S. dollar (USD) rally could see one last leg up, and higher implied earnings growth could cap the upward trend in earnings expectations. In a separate section, we make the case that excess savings, largely emanating from China, provides the best explanation for the era of secular low real rates that is just now coming to an end. As excess savings reaches a peak, rates should normalize toward nominal GDP in coming years. The recent outperformance of EM equities has moved valuations off unambiguously cheap levels, but they remain comfortably below historical norms. Valuations may now appear less compelling, but they by no means present a headwind to further gains. THE GLOBAL REFLATION THEME HAS TAKEN HOLD OF MARKETS, BUT WHAT DOES REFLATION MEAN, EXACTLY? The term is used loosely, and often imprecisely. In our view, reflation today is growth oriented and has much less to do with inflation, both at the global level and among emerging market Asia Pacific (EMAP) economies. In both developed and emerging markets, we see quite healthy macro- and micro-economic momentum. Despite a few setbacks and diminished expectations of U.S. fiscal stimulus, we are witnessing the best synchronized rebound in global growth since the financial crisis. AUTHOR George Iwanicki Emerging Markets Macro Strategist Emerging Markets and Asia Pacific Equity Team We are more optimistic about the prospects for emerging markets for a number of reasons. There has been a rebound in momentum. In a reflationary environment, we are finally seeing the longawaited turn in EMAP corporate earnings, and the spread of emerging market growth over developed market (DM) growth has rebounded off the lows from last year. When assessing the risks, EMAP equities face three potential challenges: an apparent peaking in China s mini-growth cycle, a potential last leg of the multi year USD rally, and the eventual ceiling to an upward trend in earnings expectations. In the following pages, we gauge economic momentum and consider the forces that might restrain it. In a separate section, we introduce a piece of new research, which finds that the unusually low real interest rates of the past decade appear to reflect excess saving, driven largely by China. That excess has peaked in global terms, suggesting that nominal interest rates will approach nominal GDP growth rates in the coming years. As always, we conclude our quarterly report with some actionable investment ideas.

2 Output gaps are signaling the end of disinflation but not yet an acceleration of inflation, especially in emerging markets EXHIBIT 1A: GDP GAPS BY REGION AND COUNTRY, E 4 Inflationary E Percent of potential GDP Disinflationary OECD U.S. E.U. Japan UK EM EXHIBIT 1B: UNDERLYING OECD ASSUMPTIONS OECD U.S. EU Japan UK Potential GDP growth NAIRU* Source: Organisation for Economic Co-operation and Development (OECD), Oxford Economics; data as of March 217. *NAIRU: Non-Accelerating Inflation Rate of Unemployment. 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. WHERE ARE WE IN THE GLOBAL CYCLE? To determine where we are in the economic cycle, we look not at the calendar which tells us that the global expansion is now seven years old but at an economy s output gap, which is its level of activity compared with its potential. The output gap reveals that while slack has nearly disappeared in the U.S. and possibly Japan, it remains prevalent in the rest of the world (EXHIBITS 1A and 1B). As a result, we are likely seeing the end of disinflation, but not yet an acceleration of inflation, which is especially true in emerging markets. Measures of core inflation over the past several years have been consistent with the output gap view. Headline inflation dropped sharply in and then rebounded last year while core inflation looks to have stabilized. This highlights that much of the volatility in headline inflation was reflecting the impact of commodity price swings, which now show signs of having run their course. With respect to growth, purchasing managers indices (PMIs) are showing strong and synchronized momentum in global manufacturing. Alongside the turn in EM growth, two brakes on DM growth fiscal austerity and private sector de-levering are now easing. What appears to be the end of a period of financial re-regulation signals more room for credit growth. In the developed world, the rate of credit growth is either approaching or has already reached that of nominal GDP growth rates. In corporate profits, we see evidence of the impact of this more hospitable environment. After declining for many years and flattening in 216, reported EM earnings are on the rise in 217 as measured in USD, local currency terms, and even when the commodity sectors are excluded. The EM earnings cycle has finally turned (EXHIBIT 2). We see unambiguous evidence of the long-awaited turn in the EM corporate earnings cycle EXHIBIT 2: EMERGING MARKETS EPS GROWTH, ; YEAR-TO-DATE 217 Percent 2 LTM EPS (USD) LTM EPS (Local) EM EPS x Commodities YTD Source: Markit, J.P. Morgan Asset Management; data as of April 17, 217. EM = emerging markets; EPS = earnings per share; LTM = last 12 months. 2 INVESTMENT INSIGHTS

3 POTENTIAL CAUSE FOR CONCERN: CHINA, USD, EARNINGS EXPECTATIONS China may be one of the outliers to the global trend of positive economic momentum. Our own supply and demand growth proxies have peaked as policy stimulus has been withdrawn over the past few months. In fact, the rebound in Chinese growth during 216 appears to have been unusually reliant on government credit growth, which suggests that the quality of recent China GDP growth has been low. To be clear, we do not envision a hard landing for the Chinese economy, but we do think that its mini-cycle of growth is likely peaking. While we believe that the bulk of the multi year U.S. dollar rally is behind us, we still see a risk of one last move higher, perhaps supported by investor expectations for tighter U.S. monetary policy. From a historical perspective, the current cycle looks quite advanced but not yet complete as the dollar failed to reach prior cyclical peaks at its high point in December 216. Using history as a guide, looking at the real effective exchange rate (REER, our preferred measure), the USD peaked in the last cycle (22) at approximately 2% above its 1-year moving average and 25% above its 1-year moving average in The risk remains that the dollar could once again reach the 2% level in a final phase of the USD rally. After 1995, global savings began to dominate investment and we began to see excess savings, mostly from China EXHIBIT 3A: GLOBAL EXCESS SAVING AND CHINA CURRENT ACCOUNT BALANCE, USD (billions) Source: International Monetary Fund (IMF); data as of October 216. *CAB: current account balance. Global excess saving China CAB* Our third concern focuses on the implied growth that is built into earning expectations. At the low point in the cycle for earnings estimates in early 216, EM equity analysts priced in an implied growth rate of just 4%, which was an easy hurdle to overcome. At the end of the first quarter of 217, the implied growth rate for emerging markets was 16%, signaling that the current positive earnings estimate revision cycle will likely hit a ceiling in the coming quarters. EXCESS SAVING AND THE ERA OF LOW REAL INTEREST RATES Given the role that very low interest rates have played in driving valuations across a wide variety of assets, we ve spent some time researching a simple question: Why have real interest rates remained so low over the past decade? Put another way, why have nominal interest rates remained so low relative to nominal GDP growth? Following an argument from Ben Bernanke who suggested a global savings glut while he was a Federal Reserve governor more than a decade ago we believe that excess savings, largely emanating from China, provides the best explanation for the era of secular low rates that is just now coming to an end. Over the past 2 years, as China has grown wealthier, its very high savings rate has helped push up the global savings share of GDP even as the global investment share of GDP remained generally stable (EXHIBITS 3A and 3B). Excess savings provides the best explanation for the era of secular low real rates EXHIBIT 3B: GLOBAL EXCESS SAVINGS AS SHARE OF GLOBAL GDP AND UST YIELD LESS GLOBAL GDP, SMOOTHED OVER THREE YEARS; Percent Source: International Monetary Fund (IMF); data as of October 216. *UST: United States Treasury. UST* yield less GDP (smoothed over 3 years) Excess saving (share of global GDP) J.P. MORGAN ASSET MANAGEMENT 3

4 While economic theory says global savings and global investment must equal each other, measurement by the IMF indicates otherwise. From 198 through the mid-199s, IMF aggregations highlighted the fact that investment was dominating savings, prompting a measured savings shortfall. Thereafter, savings caught up with and then, earlier this century, exceeded investment. Notably, the emergence of this excess saving correlated with the rise of China s current account surplus, which by definition means China was a growing net exporter of capital. When analyzing U.S. data, we can see that interest rate behavior has been consistent with the movements in relative saving. During the 198s savings shortage, nominal interest rates remained well above nominal GDP, creating a puzzle for economists at the time. As measured savings caught up with measured investment toward the end of the century, nominal interest rates normalized and moved toward nominal GDP. Over the past decade, as measured savings exceeded measured investment, nominal rates fell well below nominal GDP. Importantly, IMF projections show that this excess saving is now peaking, particularly as a share of global GDP. Of course, any U.S. fiscal stimulus that may emerge would likely speed the diminishment of excess saving. In sum, we believe that the peaking of global excess saving implies that nominal interest rates are poised to begin converging back toward nominal GDP growth in the coming years. CURRENCIES AND VALUATIONS: A TACTICAL VIEW Finally, we turn to a broader consideration of what is happening within EMAP markets. First, the recent outperformance of EM equities has moved valuations off of unambiguously cheap levels, but they remain comfortably below historical norms (EXHIBITS 4A and 4B). Valuations may now act as a less powerful tailwind, but they by no means present a headwind to further gains. In this sense a positive momentum environment is not yet challenged by high valuations, leaving us constructive on the asset class. Among EMAP currencies, most currencies remain modestly cheap or fairly valued, with the USD still leaning rich, albeit off peaks. Commodity exporter currencies have generally converged toward fair value as an echo of the rebound in commodity prices in 216. Notably, this commodity tailwind appears to have altered the pricing of political risk: Amid higher political uncertainty in both countries, the Turkish lira remains the cheapest of investable currencies in our coverage universe, while the South African rand is situated near fair value, alongside other commodity exporters. A similar view arises when looking at equity markets. On a tactical basis we seek cheaper markets with positive momentum. While North Asia and Eastern Europe continue to look favorable on this basis, we note that Turkish valuation multiples are nearly as low as those in perennially cheap Russia, while South African multiples are somewhat above average for the asset class. EM equities no longer trade at very cheap levels, but valuations remain comfortably below historical norms EXHIBIT 4A: MSCI EMERGING MARKETS P/B RATIO AND NTM RETURNS EXHIBIT 4B: GLOBAL P/E MULITPLES, Percent (%) 6 Current level NTM Returns Percent (%) Nov-79 Europe U.S. EMs Nov-82 Nov-85 Nov-88 Nov-91 Nov-94 Nov-97 Nov- Nov-3 Nov-6 Nov-9 Nov-12 Nov-15 U.S vs Long-term avg. Europe 18.1 vs. 2.4 Long-term avg. GEM 15.2 vs Long-term avg. Source: FactSet, MSCI, J.P. Morgan Asset Management; data as of March 31, 217. *Dots represent monthly data points between January 1997 through March 217. Guide to the Markets UK. P/B = price to book; NTM = next 12 months. Source: IBES, MSCI, J.P. Morgan Asset Management; data as of March 31, 217. PE = price earnings; S&P = Standard & Poor s; EM = emerging markets; GEM = global emerging markets. 4 INVESTMENT INSIGHTS

5 Accordingly, while we continue to favor Russia and North Asia, and Korea in particular, we are selectively rotating toward Turkey given the combination of inexpensive FX and attractive valuations. We remain quite bullish on the long-term growth story in India. We caution, though, that relative valuations are not only high in absolute terms but also relative to their historical premia, suggesting that investors should be quite selective in owning high-conviction names in this market. CONCLUSION We believe that global reflation is predominantly a growth (rather than inflation) acceleration story. Emerging markets are broadly participating, and importantly the EM earnings cycle has finally turned positive. Risks to this view remain China growth peaking, a possible last phase of USD strength, or a capping of positive earnings estimate revisions (given higher implied growth in current projections). Still, we are optimistic that the turn in momentum can drive additional performance for the asset class, particularly given that valuations are not yet at levels that challenge this improved momentum backdrop. J.P. MORGAN ASSET MANAGEMENT 5

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