after the rally: are emerging markets still a buy?€¦ · since q2'13, pp c/a q4'15, %...

Investment Research

www.danskebank.com/CI

After the rally: are emerging markets still a Buy?

Jakob Ekholdt Christensen Head of Emerging Markets Research [email protected] +45 45 12 85 30 +45 30 58 4714

20 April 2016

Vladimir Miklashevsky Economist [email protected] +358 10 546 7522 +358 40 750 8104

Important disclosures and certifications are contained from page 37 of this report

2 www.danskebank.com/CI

Agenda

The rebound in Emerging Markets

Outlook for Emerging Markets External headwinds fading but domestic challenges

Investment implications


Key takeaways

• The recent months have seen a sharp comeback for emerging market (EM) assets. The question is: does the rally have further to go or will it fizzle out?

• In this presentation we take a closer look at the evolution in EM fundamentals over the past three years as well as the outlook for key external factors (Fed, China, and commodities).

• Based on our analysis, we expect that the EM rally has a bit further to go given still conducive external conditions from a cautious Fed, a rebound in the Chinese construction sector and higher and stabilising commodity prices, together with significantly improved external balances in most EMs.

• Given that we see a relative stable outlook for EM FX and a high yield pick-up in many

EMs compared with mature markets, we see interesting investment opportunities in this area especially for EMs with relatively strong external and internal fundamentals.

• On EM equities, we favour a tactical overweight of EM versus developed markets in 3-6 months. We are especially positive on China (and India and Asia in general), Eastern Europe (notably Poland and Hungary as well as Turkey) and Russia. We are cautious on Latin America, notably Brazil, but do see value in Argentina and Chile.

• We see medium-term growth challenges for EMs given still weak domestic fundamentals in many EMs due to high debt levels in the private and public sectors, low productivity and less conducive external financing conditions. Hence it is quite unlikely that we will see the same returns as in the boom years in the 2000s.


The rebound in emerging market assets


Previous EM headwinds have turned supportive in the past

three months…

Major G3 central banks have become more dovish, notably the Fed…

and Chinese financial markets have recovered,

supporting commodity prices.

Source (all charts): Macrobond Financial

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along with a rebound in emerging market equities

• After three rough years, emerging markets have staged a mini-rally with EM equities up 12% since the trough in mid-January.

• The rally has been driven by less hawkish major central banks, a more optimistic outlook for the Chinese economy and a rebound in commodities.


prompting a surge in capital inflows into emerging markets

in March.

• The rebound has consisted of debt and equity inflows.


USD-denominated emerging market ETFs have risen

sharply in 2016

• USD-denominated ETFs are rising on a weakening US dollar and very low base effect. Commodity producers are benefiting from higher commodity prices, while Turkey is attracting inflows with its surprisingly strong economic growth.

• Recovery from the deep panic levels in January-February 2016 for commodity exporters has room to continue, although at a slower pace as the commodity rally has stopped.


However, EM equities have underperformed equity markets

in advanced countries since 2013


Despite the recent rally, EM FX is significantly weaker than before the

sell-off, notably in commodity-dependent countries

Note: Weighted by the size of the GDP measured at PPP.

Source: Bloomberg, Danske Bank Markets

• Oil-producing and mining countries (ex. Middle-Eastern producers) have seen the sharpest weakening of their currencies but also the sharpest rebound.

• Manufacturing (oil-importing) countries have been much less hit by a weakening of their exchange rates, while recent strengthening has been more benign than commodity producers.

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Fuel Mining

Manufacturing China


Outlook for Emerging Markets

Fading external headwinds but domestic challenges


External and domestic conditions turned more conducive for EM

China

Fed

Commodity prices

EM fundamentals

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Current outlook 2013


Fading external headwinds

– China: turn in construction to be a game changer.

– Fed: a more dovish Fed so far paying attention to global financial stability.

– Commodity prices: modest increase in oil ahead; more bullish on base metals.


Where is China in the business cycle?

The long-term cycle

The short-term cycle

Where we see China today

Source: Danske Bank Markets


Turn in construction to be a game changer

• Chinese construction sector is at a turning point after a hard landing as oversupply is coming down and sales are up. This means that fears of a Chinese hard landing are vanishing, underpinning risk assets, supporting commodity demand and prices and EM commodity exporters/markets.

• Metal exporters could benefit the most given that China consumes around 50% of the world’s base metals.

Source: Macrobond Financial, Danske Bank Markets Source: Macrobond Financial, Danske Bank Markets

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Who will benefit from the rebound in the Chinese

construction sector?

• Notably, Latin American and African countries are set to benefit from the rebound in the China construction sector: Chile, Peru and South Africa are among the main winners.

• Brazil should benefit less than commonly perceived given that mining exports account for a relatively small share of GDP.

• Australia stands to gain the most among advanced countries.

Source: IMF Direction of trade statistics, Danske Bank Markets estimates.


So far, a more dovish Fed but it may turn hawkish earlier

than expected

• We view the Fed’s monetary policy as one of the major EM drivers at the moment. We continue to expect the markets to be bullish on EMs as the current market pricing is for less hawkishness than the current Fed ‘dots’ and our expectation.

• There is a risk, however, of the market underestimating the Fed, notably for 2017, which may stir Fed angst among EM investors. This could already happen over the summer if US data continue to improve.

• On the other hand, the Fed has lately signalled more concern about global financial markets’ stability, which may prompt a more cautious hiking cycle.

Source: Federal Reserve, Danske Bank Markets Source: Federal Reserve

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Strong US employment growth and muted wage growth is

good news for EMs

Source: Federal Reserve, Danske Bank Markets Source: Danske Bank Markets


Commodities—further rally in oil and especially copper but

to levels still significantly below recent years’ peaks

Source: Macrobond Financial, Danske Bank estimates Source: Macrobond Financial, Danske Bank estimates

Source: Macrobond Financial, Danske Bank estimates Source: Macrobond Financial, Danske Bank estimates


EM fundamentals

Narrowing external balances but rising fiscal challenges in many countries


FX adjustment has been a key shock absorber in most EMs

Source: Bloomberg

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Narrowing but still wide external imbalances in some

countries

Source: Macrobond Financial

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Most EMs have seen significant improvements in their current accounts (CA) balances and many now post surpluses. However, Turkey, South Africa, Brazil and Colombia are still struggling with large CA deficits despite sharp real depreciation of their currencies.


Fiscal accounts have weakened in many EMs

• Government deficits have increased in about half of the major EMs since 2013 due to slowing economic growth, falling commodity-related revenues and an expansionary fiscal stance in some countries.

• Public debt dynamics also turning nasty in a number of EMs, notably Brazil, Venezuela, Egypt, Colombia, China, South Africa and Mexico, which could create debt distress in the most indebted countries.



Diverging EM growth performance….

Source: Macrobond Financial , Danske Bank Markets

• Manufacturing EMs continue to enjoy solid economic growth, benefitting from lower oil prices and external demand, especially a strengthening US economy.

• However, oil producing and to some extent mining countries are witnessing a sharp growth slowdown as they adjust to lower commodity prices.


Despite tailwinds, GDP growth rates in EMs may grind lower

• Despite improved external conditions, inflows to emerging markets could be less than in the 2000s as the Fed is set to continue its tightening cycle. Furthermore, even though commodity prices have rallied, they are unlikely to go back to previous highs anytime soon==>adjustment still needed in many commodity-producing EMs.

• We see three additional factors that are likely to weigh on growth potential: 1) High leverage 2) Structural obstacles 3) Weak political environment in some EMs

• For the 10th time in a row the IMF lowered its EM growth forecast when it published its latest WEO forecast, expecting only an average growth of 4.7% in 2016-20 compared with 5% in the autumn forecast. In 2000-14, the average growth rate for EMs was 6%.

IMF emerging markets forecast from 2011-16

Source: IMF WEO


Growth challenge 1: high private and public sector leverage

in several EMs

Source: McKinsey Global Institute

•Many EMs have accumulated a significant amount of debt in their private and public sectors, financing consumption and investment since the financial crisis.

•EM corporates utilised cheap USD funding, notably in Chile, Turkey, and Russia.

•The high leverage is set to weigh on investment and consumption, although we do not expect an external debt crisis in the most exposed countries.

•The corporate debt problems may give rise to an increase in fiscal liabilities if government has issued implicit or explicit guarantees. However, the recent dollar weakness will make it easier for companies to service their dollar debt.

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Source: Bank of International Settlements


Growth challenge 2: structural obstacles

• The EMs cannot rely on debt-fuelled externally financed consumption and investment growth to the same extent anymore due to the higher total leverage in the economy and tighter external financing conditions.

• Productivity and external competitiveness likely to be more important than before.

• Generally, OECD EMs suffer from worse business environments than DMs.

• Structural barriers a particular problem in Indonesia, Brazil, Colombia, Turkey. In contrast, India has significantly removed some of its labour and product market rigidities.

Source: OECD

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Source: OECD


Doing Business ranking fuels hopes for long-term investors

• The World Bank Group’s Doing Business report shows that the majority of EM economies have made steps forward in order to increase regulatory quality and efficiency in the fight against bureaucracy.

• Poland, Romania, Russia, Turkey, and phillipines have seen the biggest improvements in business environment since 2012.

Source: The World Bank Group, Danske Bank Markets


Growth challenge 3: weak political and geo-political situation

• We see that political and geopolitical issues are creating downside risks to our expectations for some key emerging markets.

• Generally, weak political environments impede necessary fiscal adjustments and structural reforms needed in many EMs.

− The outcome of the Brazilian impeachment process and corruption scandal is uncertain. We see risks of significant political and social unrest over the next months.

− Similarly, political tensions continue to pose risks to monetary policy and implementation of fiscal and structural reforms in South Africa.

− Despite talks about revoking Russia sanctions, our base case scenario is that the EU and the US sanctions are set to continue.

− Turkey’s involvement in cross-border operations in the Middle East and terror attacks may weigh on foreign investors’ and tourists’ sentiments.


Conclusion

• External conditions should remain mildly conducive to EMs due to a rebound in China and its construction sector, moderate increases in commodity prices, while the Fed embarks on a cautious tightening of monetary policy.

• Domestically, the track record is more mixed as many EMs still struggle with twin current account/fiscal deficits, high private/public leverage and structural barriers to growth, hurting their productivity and ability to adjust. These factors are set to weigh on potential growth in EMs.

• The ability to carry out necessary structural and fiscal adjustments in many EMs is hampered by weak political environments.

• On a positive note, most EMs have managed to reduce their external imbalances due to a sharp weakening of their exchange rates. This should make them more resilient to external shocks.

• The main risk to our outlook for EMs is a more hawkish Fed than the market thinks. In our view, such a risk could become more apparent over the summer if US inflation picks up more than anticipated. The UK EU referendum in June could also weigh on risk sentiment versus EM but in our base case of no Brexit such impact will only be temporary.


Investment implications


General observations

• Given the significant improvement in external balances in many EMs and the sharp weakening of their currencies over the past few years (even after the rally), we think EM FX will remain relatively stable or strengthen slightly. A relatively large yield pick-up may make carry plays attractive in some countries.

• The stronger currencies will help bring down inflation in most EMs (despite the rebound in the oil price), which should allow central banks to lower interest rates. This makes local currency debt attractive.

• Short-term positive outlook for EM equities especially relative to developed markets (DM) given that many EM markets still look cheap and have a better growth outlook. Generally positive on Asia and Eastern Europe (including Russia), while negative on Latin America (except for Chile and Argentina).


Asset class Main factors

EM equities Fed’s late dovish stance and ECB’s action lead to another leg higher in the

risk rally. Follow through in terms of easing should be expected from other central banks globally. The weakening of the USD makes the world a better place. Commodities should stabilise further and it will be supportive of Chinese growth, as it provides an opportunity for PBoC to ease further. EMs should outperform DMs in this environment and in terms of sectors parts of the cyclical space will generally outperform defensives. Commodity exporters are the cheapest at the moment. Brazil’s expensive case stands apart as local political developments fuel expectations of economic reforms.

Short term: strongly positive Medium term: moderately positive

EM bond market

Medium and long term: moderately positive

Dovish major central banks are fueling 'hunt for yield' especially towards the local EM debt of countries with solid macro fundamentals like CEE region, Russia and Turkey as a weaker USD lowers inflation and opens doors for policy rate cuts. Yet, the EM debt remains quite vulnerable to risk sentiment and political uncertainties.

Credit spreads: tightening

EM FX

USD/RUB - Stronger view on the RUB as oil price stabilises. Fundamentals support the RUB in the medium to long term, downside risks from weaker oil.

USD/TRY - Rallying GDP growth and dovish Fed support the TRY. USD/TRY set to head slightly higher in the long term as rising oil is weighing on Turkey's current account.

USD/BRL - Beyond short-term political unrest, supported by Iron ore demand.

Short-term weakness due to political problems but medium to longer-term strengthening.

USD/ZAR – Undervalued currency should support a strengthening in latter half of 2016.


Many EM FXs are now relatively undervalued compared

with long-term averages even after latest rebound…

• The currencies hardest hit (ZAR, COP, MXN, BRL, MYR) are also the most undervalued relative to long-term averages.

• On the other hand, CNY, CZK and INR seem somewhat overvalued.

• Note of caution: equilibrium exchange rates in commodity producers may have depreciated after the drop in commodity prices.



and offer relatively attractive carry.

• The strengthening of EM currencies will put downward pressure on inflation in EMs despite the slight pickup in inflation.

• Central banks will have more room to lower policy rates.

• Carry-pick up attractive in several EMs compared with yields in advanced countries.

Source: Bloomberg, Danske Bank Markets estimates

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Many EM markets still look cheap even after the rally

• Commodities exporters are the cheapest relative to EM historical average valuation.

• Short term we are positive on EM and recommend tactical overweight in EM versus DM based on valuation and stronger growth outlook. Medium term moderately positive as EM growth will be somewhat weaker than over the past decade.

• We are particularly positive on China (and India and Asia more generally), Eastern Europe (notably Poland and Hungary as well as Turkey) and Russia.

• We are negative on Latin America, notably Brazil, with the exception of Argentina and Chile.

Source: Bloomberg, Danske Bank Markets calculations.


Disclosures

This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The authors of this research report are Jakob Ekholdt Christensen, Chief Analyst and Vladimir Miklashevsky , Analyst.

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after the rally: are emerging markets still a buy?€¦ · since q2'13, pp c/a q4'15, %...

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