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Emerging market strategy: Higher risk, higher reward?
Emerging Markets Strategy
February 2016
IN BRIEF
• Last year was a challenging one for emerging market (EM) equities, struggling against
a triumvirate of headwinds: falling commodity prices, lackluster earnings and a rising
U.S. dollar.
• Those headwinds are now joined by new risks, namely the commencement of Federal
Reserve (Fed) policy normalization and China’s shifting foreign exchange (FX) policy.
• Our analysis of the impact from the Fed is that EM performance reflects the interplay
between U.S. interest rates and the U.S. dollar (USD). The combination to date of a
rising USD and flat to falling market interest rates has historically been the most
unfavorable for EM equity.
• China’s policy of “shadowing” the rising USD has effectively imported deflation
pressures and imposed them on its economy, raising renewed questions about its debt
overhang and prompting an FX policy shift to escape those pressures.
• What we had previously viewed as a more benign USD “decoupling” strategy now looks
like a potentially more troublesome “opportunistic devaluation” strategy.
• While the headwinds to emerging market growth and performance persist into the new
year, valuations have moved closer to but not yet reached prior crisis lows.
To put the past year into perspective, we highlighted last October that 2015 was shaping up
to be what we called a forgettable year. Performance was not only weak in absolute terms—
down nearly 15% measured in U.S. dollars—but the asset class underperformed every other
segment of the global equity markets (EXHIBIT 1 , next page).
AUTHOR
The breakdown, i.e., the sources of those returns, emphasizes two things: Earnings numbers
themselves were very weak, and a significant de-rating of EM currencies drove further
declines for dollar-based investors.
SHOULD THE EMERGING MARKETS WORRY MORE ABOUT RISING U.S. RATES
OR A STRONGER U.S. DOLLAR?
George Iwanicki
Emerging Markets Macro Strategist
Emerging Markets and Asia Pacific
Equity Team
The impact of the FX de-rating—which, viewed from its flip side, is a re-rating of the U.S. dollar—
will depend largely on the path and timing of Fed rate normalization policy. (Given the risks
financial markets appear to be embracing as the year gets under way, it wouldn’t surprise us if
the Fed was beginning to debate not only the speed and timing of when it will move again but
also raising the question of whether to move again.) In terms of what Fed policy means for the
emerging markets, however, it’s important not to consider the Fed in isolation. What really
EMERGING MARKET STRATEGY: HIGHER RISK, HIGHER REWARD?
Currency weakness accounted for much of EM equities’ poor performance last year
EXHIBIT 1: COMPOSITION OF TOTAL RETURNS, 2015
20
Dividend
Valuation chg (LTM P/E)
Earnings growth
Currency effect
Total (in $)
15
9.9
Percent
10
5
1.4
0.1
0
-5
-7.5
-10
-9.1
-14.6
-15
-20
Japan
Europe (ex-UK)
S&P 500
UK
Asia Pac ex-Japan
EM
Source: FactSet, MSCI, J.P. Morgan Asset Management; data as of December 31, 2015. Past performance is not indicative of future results.
matters is the interplay between the response of market
interest rates and the response of the dollar as the Fed moves.
We analyzed this interplay over the past quarter century by
comparing EM equity index returns in different regimes,
made up of combinations of movements in the dollar and
movements in market interest rates, both of which were
influenced by the Fed (EXHIBIT 2 ). The exhibit’s four quadrants, covering rolling 12-month periods between December
1987 and December 2014,1 match regimes of rising and
falling interest rates with permutations of rising and falling
1
real trade-weighted currency exchange rates. The point that
we’d emphasize is that the most difficult relative and absolute performance environment for EM equities is one in
which the dollar is strengthening but rates are flat or falling.
That’s exactly where we’ve been stuck. As the Fed was moving toward tightening, market interest rates were not rising,
even though the dollar was strengthening. We are in an
environment where headwinds from FX (and commodities)
still persist, but in our view what is directionally positive is
that more of the damage from these headwinds is behind
rather than in front of us.
December 1987 to November 1988, January 1988 to December 1988, etc.
Fear a surging dollar, not rising U.S. rates; a quieter dollar would be quite positive for emerging markets
EXHIBIT 2: 12-MONTH ROLLING RETURNS, DECEMBER 1987-DECEMBER 2014, GROUPED BY FX/INTEREST RATE REGIMES
-12%
18%
17%
8%
Relative
11%
-2%
-12%
Absolute
Relative
10-year UST yield (bps)
-2%
Absolute
18%
8%
Rates rising
8%
14%
USD (%)
Rising dollar
Dollar flat/falling
16%
10%
-2%
?
?
-6%
-12%
Absolute
Relative
Median 12-month
returns
Rates flat/falling
18%
18%
8%
2011–15
-2%
-12%
-9%
Absolute
-11%
Relative
Source: FactSet, J.P. Morgan Asset Management. U.S. dollar measured by the U.S. Dollar Real Trade-Weighted Exchange Rate Index, Broad Definition. Absolute measures
12-month rolling returns of the MSCI Emerging Market Index. Relative measures MSCI EM Index returns vs. MSCI ACWI returns. Trigger to count EM returns if the dollar
rose more than 2% in the prior 12 months. Trigger to count EM returns if the 10-year yield rose more than 50 basis points in the prior 12 months. Shown for illustrative
purposes only. Past performance is no guarantee of future results.
2
E MER G IN G MA R K ET S S TRATEGY
EMERGING MARKET STRATEGY: HIGHER RISK, HIGHER REWARD?
The question we now ask is what quadrant will we move to
as the Fed proceeds. The important point to note is that
which-ever direction we move in, it should be toward a
better environment than the one that we have been in.
Obviously, the optimal environment for emerging markets is
one in which the dollar is falling. But even when the dollar is
rising and rates are rising, emerging markets have tended to
do better than in the current regime.
CHINA FX POLICY: DECOUPLING OR
DEVALUATION?
As much as any other emerging economy, the biggest—
China—reflects the challenges posed by the dollar’s rise. In
essence, the real debate in China is not only about its growth
prospects and the ongoing rebalancing of the economy away
from heavy industry toward services and consumer goods,
it’s also about monetary policy. In particular, it’s all about
the policy that the Chinese are pursuing regarding their
currency, the renminbi (RMB). From 2005 on, the Chinese
conducted a managed appreciation of what had been a cheap
currency relative to the dollar. In 2011, the Chinese currency,
which had been appreciating in the early period, began
shadowing the dollar as the dollar started becoming the
strongest currency in the world. The Chinese were thus
attaching themselves to an aggressively rallying currency. In
terms of its real effective exchange rate—that is, relative to
the broad array of currencies in the world—the RMB rallied
sharply as a result (EXHIBIT 3A ).
This unintended consequence contributed to some of the
slowdown in the real economy that many people have
focused on. EXHIBIT 3B , however, highlights what we think is
really relevant here: Nominal growth—inclusive of the contribution from inflation—has been slowing rather markedly in
China. The gray bars in the exhibit represent the real economic growth portion of nominal growth. The blue bars
reflect the contribution of inflation to nominal growth (i.e.,
the GDP deflator). As the two bars together show, in nominal
local GDP terms, China has shifted from being a strong double-digit growth economy to a single-digit growth economy,
largely as a result of its strengthening currency. When nominal GDP growth was quite strong, risks from China’s high and
rapidly growing debt levels were benign—largely because
nominal GDP is effectively the “pool” that services the debt.
Thus as nominal growth has decelerated, we—and financial
markets—have grown more concerned about debt problems.
China’s FX policy of shadowing USD FX has proven
unsustainable ...
... because it has prompted GDP deceleration
EXHIBIT 3A: CHINA REAL BROAD EFFECTIVE EXCHANGE RATE
(INDEX 2010 = 100)
EXHIBIT 3B: CHINA NOMINAL GDP GROWTH BY COMPONENT,
% GDP GROWTH, SMOOTHED OVER THREE YEARS
30
% GDP growth, smoothed over 3 years
120
115
20
105
100
15
10
Source: NBS, J.P. Morgan Asset Management; data as of December 31, 2015.
2014
2012
16
2010
14
2008
12
2006
10
2004
08
2002
06
2000
04
0
1998
02
5
1996
85
1994
90
1992
95
1990
Index: 2010 = 100
Real GDP
25
110
80
00
Deflator
Source: NBS, J.P. Morgan Asset Management; data as of December 31, 2015.
J.P. MORGAN ASSE T MAN AGE ME N T
3
EMERGING MARKET STRATEGY: HIGHER RISK, HIGHER REWARD?
CONCLUSION: THE ONGOING EM EQUITY
STRUGGLE
Looking beyond China to emerging markets as a whole, even
as the fundamental environment remains difficult with the
complications from Fed tightening and China FX policy,
modest valuations provide the potential of future reward
(EXHIBIT 4A ). Despite growth and momentum styles
exhibiting defensive characteristics and serving as “places to
hide,” price-to-book ratios for the asset class as a whole, as
of the end of January, have moved down to 1.30x–1.35x,
nearing the crisis lows seen in 1998 and 2008. At the same
time, fundamental or cycle-adjusted price-to-earnings ratios,
which use earnings smoothed over 10 years, show that EM
equities are not only the cheapest of the major global equity
segments, but they are beginning to approach single-digit
valuations, moving closer and closer to what we would call
crisis lows, although this time without an outright crisis.
Indeed, these fundamental valuations are at the 95th
percentile of attractiveness for the asset class.
So what summarizes the EM struggle right now is this:
increasingly cheap valuations, and the potential for higher
reward, juxtaposed against what we might call the summary
statistic of all the headwinds weighing on emerging markets:
a de minimis growth premium relative to what we’ve seen
historically vs. the developed world and unfolding risks from
Fed policy and China FX intentions (EXHIBIT 4B )—hence
higher risk, higher (potential) reward.
While long-term EM valuations are attractive ...
... growth dynamics remain unfavorable
EXHIBIT 4A: LONG-TERM VALUATION
EXHIBIT 4B: EM VS. DM GROWTH SPREAD AND RELATIVE EQUITY
PERFORMANCE
3.5
Price/book (lhs)
30
2.0
25
1.5
20
15
1.0
10
95th percentile
cheap
0.5
Jun-13
Mar-15
Sep-11
Dec-09
Mar-08
Jun-06
Sep-04
Mar-01
Dec-02
Jun-99
Sep-97
Dec-95
Jun-92
Mar-94
Dec-88
0
Source: MSCI, J.P. Morgan Asset Management; data as of December 31, 2015.
6
0.8
4
0.6
2
0.4
0
-2
95 96 97 98 9900 01 02 03 0405 06 07 0809 10 11 12 13 14 15*16*
Source: UBS; data as of December 31, 2015.
*Estimated
4
E M ER G IN G MA R K ET S S TRATEGY
1.2
1.0
5
0.0
Sep-90
GDP spread (EM–DM, %, lhs)
EM equity performance relative to DM (rhs)
8
GDP spread
35
2.5
Cyclically adjusted P/E
40
3.0
Price/book
10
45
Cyclically adjusted P/E (rhs)
0.2
Equity performance
The question of how to detach the RMB from the appreciating
dollar—and alleviate the downward pressure on nominal
GDP—presents a quandary for the Chinese. Does China simply
“decouple” from the dollar, target a currency basket and
allow the cross rate with the dollar to move on the basis of
what the dollar does? Or does China admit to having made
a mistake in letting its currency rally too far by attaching it
to the dollar? And will China then look for opportunities to
devalue the RMB and reverse some of that error? Our thinking
had been that China was decoupling, but reviewing the past
few months, it’s beginning to look like an “opportunistic
devaluation” strategy, whereby the Chinese seemingly wait
for times, like last August–September and the beginning
of this year, when they feel they can effectively accept or
engineer a partial devaluation.
EMERGING MARKET STRATEGY: HIGHER RISK, HIGHER REWARD?
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