Emerging market equities: Bounce or breakout?

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1 FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION Emerging market equities: Bounce or breakout? Emerging Market Strategy 2Q 216 IN BRIEF The first quarter rally is not in itself a sign of a breakout for emerging market (EM) equities. Within the bear market, EM equities rallied 1% or more in absolute terms on six separate occasions; four times they rose 5% or more relative to global equities. Driven (like prior bounces) by a marked improvement in investor risk appetite, the recent rally was accompanied by the sharpest retracing in the multi-year U.S. dollar rally. But history suggests that we may see one last leg of USD appreciation even if the current pause extends. The Chinese currency has fallen along with the USD, and this should help ease the intense deflationary pressures challenging China. Acceleration in Chinese credit will support economic growth in the near term and will remain an issue that needs to be addressed over the long term. Although a day of reckoning may be inevitable, it is not imminent. After hitting levels akin to bear market troughs in January, EM valuations now look measurably but no longer decisively cheap relative to history. PUTTING THE FIRST QUARTER RALLY IN PERSPECTIVE After a difficult start to the year, emerging markets and Asia Pacific led global equity markets in the first quarter of 216. Was this a mere bounce, destined to disappoint? Or was it a true breakout from the clutches of a bear market that has gripped emerging markets since 211? AUTHOR George Iwanicki Emerging Markets Macro Strategist Emerging Markets and Asia Pacific Equity Team In the following pages, we consider both sides of this question. We examine recent emerging market performance from a historical perspective; focus closely on the significant impact of the U.S. dollar, whose strength has been central to the headwinds facing emerging markets for the past five years; evaluate the complex case of China from both a near-term and a long-term perspective; and, finally, discuss what investment opportunities we are seeing within the asset class. In many ways, Q1 was a tale of two quarters. After a dismal 215, EM equities suffered a 13% decline during the first three weeks of the year, through January 21, before rising 2% to end the quarter up 5.7%, outpacing global equities. Despite the strong performance, the rebound is not in itself a sign of a breakout. Indeed, between , EM equities rallied 1% or more in absolute terms on six separate occasions; four times they rose 5% or more relative to global equities (EXHIBITS 1A and 1B, next page).

2 Recent gains for emerging markets have not eclipsed prior bear market bounces EXHIBIT 1A: EMERGING MARKET AND ASIA PACIFIC EXHIBIT 1B: EMERGING MARKET AND ASIA PACIFIC EX-JAPAN ABSOLUTE PERFORMANCE EX-JAPAN RELATIVE PERFORMANCE VS. GLOBAL APxJ 12 EM APxJ EM Index: 211 = 11 9 Index: 211 = Source: MSCI, J.P. Morgan Asset Management; data as of April 15, 216. Gross return indices. Source: MSCI, J.P. Morgan Asset Management; data as of April 15, 216. Gross return indices underlying relative performance calculations. How does this recent episode compare with past precedent? A change in risk appetite, the lone constant in past bear market bounces, was very much present in the first quarter, as exemplified by the narrowing of emerging market debt and high yield spreads, coupled with an increase in both price-tobook and cyclically adjusted P/E valuations. What distinguished this respite from past rallies: Valuations at the trough were more consistent with near-crisis or bear market levels. As it has in the past, the U.S. dollar played a critical role. The first quarter rally in EM equity, we underscore, was accompanied by the sharpest retracing in the multi-year USD rally. Some observers point to the USD shift as a sign of breakout. But history suggests that we may yet see one last leg of USD appreciation. Consider that in the current dollar cycle, the peak, which was reached about a month and a half ago, fell short of past overshoots of fair value. In other words, the cycle looks incomplete (EXHIBITS 2A and 2B). As highlighted in Exhibit 2, the period serves as a relevant comparison. It is the last time that the Federal Reserve (Fed) began to hike rates, in the later stages of a dollar rally, only to stall when global considerations came into play. As the chart illustrates, in there was one leg down and then a meandering pattern in the dollar before it resumed its rally as the Fed resumed its tightening. Our suspicion is that we are now seeing a pause, not a reversal, in the dollar rally. Even so, we could very well see range-bound After the sharpest retracing in the multi-year USD rally, history suggests we may yet see one last leg of appreciation EXHIBIT 2A: REAL BROAD EFFECTIVE EXCHANGE RATE, USD EXHIBIT 2B: REAL BROAD EFFECTIVE EXCHANGE RATE RATIO, USD Index: 21 = * Current vs. 1-yr MA, CPI-based Source: MSCI, J.P. Morgan Asset Management; data as of April 15, 216. *Gross return indices Source: J.P. Morgan Securities LLC, J.P. Morgan Asset Management; data as of mid-april EMERGING MARKET STRATEGY

3 trading or sideways movement of the dollar for a prolonged period of time. That alone would provide some welcome relief for EM equities, not to mention other assets that have been victims of the USD rally since 211. How much pain has the dollar caused? While moderate growth and low inflation have been recent hallmarks of the global economy, looking at three-year rolling global growth in nominal GDP (measured in dollars) makes clear that the strong USD has dampened nominal dollar global growth. Emerging markets have borne the brunt of the strong USD, which has weighed heavily on EM earnings in dollar terms. Between December 21 and December 215, EM EPS declined 26% when measured in dollars yet rose 17% in local currency terms. CHINA: DIMINISHED DEFLATIONARY PRESSURES Recent weakness in the USD has already alleviated some of the pressures on China. As we have discussed in prior reports, China effectively imported currency strength by tying itself to the strongest currency in the world. Deflationary pressures were the unavoidable result. Given the lingering link to the USD, the RMB has de-rated; we ve seen signs of the beginning of the end of the intense deflationary pressures in China. Taking advantage of that welcome respite, China instituted a number of rate cuts and reductions in the reserve requirement ratio in order to stimulate economic growth. We re starting to see the impact of that stimulus as debt-to-gdp levels rise. Is this acceleration in credit good or bad news? This is the issue at the heart of the debate between the China bulls and bears. Near term, the impact of the increase in credit is unambiguously positive, and we have already seen a pickup in activity on both the demand and supply sides of the economy. Using our proprietary composite of Chinese GDP growth, the country looks to be growing closer to a 6% annual growth rate; just a few months ago it was growing at a 5% rate. CHINESE CREDIT WORKOUT: INEVITABLE BUT NOT IMMINENT The longer-term impact of the credit acceleration is more difficult to assess. In trying to utilize credit growth to stimulate economic activity, China is returning to the use of old policy tools effectively going back to the credit well. Not only are credit-to- GDP ratios rising, but ratios of bank balance sheets to GDP are increasing as well. However, Chinese banks themselves do not seem over-levered. Using even the broadest definition of loans (including off balance sheet items such as trust assets), loan-todeposit ratios are generally at or below 9%, which, when compared with other large global economies, is not unusually high. Although the banking sector does not appear over-levered, the corporate sector certainly does (EXHIBITS 3A and 3B). A day of reckoning may be coming, but when? Exhibit 3B is helpful in addressing this point. Countries with high savings China s bank-intensive credit burden is concentrated in the corporate sector but supported by very healthy domestic saving EXHIBIT 3A: DOMESTIC NON-FINANCIAL DEBT AS PERCENT OF GDP, 215 % of GDP Household Non-financial corporate General government China U.S. Korea UK Euro zone Japan EXHIBIT 3B: DOMESTIC SAVING AND BANKING SECTOR ASSETS ASSETS OF BANKING SYSTEM, PERCENT OF GDP* % of GDP TR BR RU NG Gross domestic saving rate, TW TH IN MY KO ID CN SG Source: Haver, UBS estimates; data as of April 216. Source: Haver, UBS estimates; data as of April 216. *International Monetary Fund definition of net. J.P. MORGAN ASSET MANAGEMENT 3

4 rates that fund their own borrowing domestically are better prepared to deal with rising debt ratios and leverage in their banking systems. China, with one of the highest savings rates in the world, seems well equipped to manage its debt challenge. Although a workout of Chinese debt is inevitable, a hard landing is not imminent. For investors, timing will remain a critical factor. CURRENCIES AND VALUATIONS: AN UPDATE Let s shift our focus to a broader consideration of what is happening within the emerging market asset class. After suffering during the extended USD rally, the EMAP (emerging markets, Asia Pacific) basket of currencies has retraced and is generally within about 1% of notional fair value. That is, most currencies in our universe are modestly, but not compellingly, cheap. Since the Brazilian real has surged back, the lone exception is the Russian ruble, which remains very cheap relative to fair value despite the recent rebound in oil. As we have noted, in January EM equity valuations hit levels akin to bear market troughs. Valuations now look measurably but not decisively cheap relative to history. As illustrated in EXHIBIT 4A, the current price-to-book (P/B) ratio is 1.45x, slightly above what we tend to think of as the buy zone in emerging markets, which is generally 1.4x or below. The cyclically adjusted EM P/E ratio, which hit 9.9x at the low, has rallied back to 13.3x, leaving it at the bottom end of the historical range of not only EM stocks but global equities as well (EXHIBIT 4B). Whether one sees the first quarter EM comeback as a bounce or a breakout, valuations, at their current levels, should not constrain a continued equity rally. As we distinguish among EM countries for investment prospects, we look for cheaper markets with positive trends. We continue to favor South Korea, Turkey and Russia, given a reasonable combination of value and momentum; we continue to wait for a China catch-up in light of its cyclical rebound; and we are disinclined to chase Brazil, given lingering cyclical pressures, unattractive valuations and a currency that has retraced much of the distance back to fair value. CONCLUSION: THE DOLLAR S PATH WILL BE CRITICAL Returning to our opening question, is the recent EM rally a bounce or a breakout? The dollar s path may provide an answer. If the dollar has peaked and is now weakening, then there is potential for a breakout in EM equities. But if the dollar s rise has merely paused, we will likely look back at the first quarter rally and say it was a bounce a powerful bounce, but not the decisive upturn investors have been waiting for. After hitting near-crisis levels in January, EM valuations now look measurably cheap, but not decisively cheap relative to history EXHIBIT 4A: MSCI EMERGING MARKETS P/B RATIO AND NEXT 12-MONTH RETURN* USD, % Price/book value EXHIBIT 4B: FUNDAMENTAL P/E MULTIPLES Cycle adjusted valuations Europe (MSCI Europe) U.S. (S&P 5) Emerging markets (MSCI EM) Source: FactSet, MSCI, J.P. Morgan Asset Management, Guide to the Markets UK; data as of March 31, 216. *Dots represent monthly data points between December 1995 and December 215. Source: Consensus Economics, FactSet, MSCI, J.P. Morgan Securities LLC, J.P. Morgan Asset Management; data as of March 31, EMERGING MARKET STRATEGY

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