INVESTMENT
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EME RG ING MA RK ET EQUIT Y STR ATEGY
In search of capitulation
April 2014
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IN BRIEF
• The extended slowdown in emerging market (EM) earnings has spurred a similarly
extended period of EM equity underperformance. Meanwhile, outperformance of
economic growth in developed markets (DMs) has spilled over into both earnings
and earnings expectations, explaining, in part, why DMs have outperformed EMs.
• Different sectors have demonstrated different degrees of cyclicality within
emerging markets: Sectors with “asset-heavy” balance sheets and exposure to
commodities and global demand have seen flat or falling profit growth over the
past three years, whereas those with operating leverage to domestic demand
have fared better.
• Encouragingly, the broad de-rating of EM currencies has set in motion a
measurable turn in the EM trade position, although the quality of the trade
improvement is uneven.
• Given the extended EM underperformance, we are monitoring a “checklist” across
a variety of market and cyclical indicators—including investor flows, valuation
measures and aspects of growth expectations—that may indicate a “capitulation”
or signs of a bottom.
Amid an extended slowdown in EMs and performance struggles relative to DMs, this
paper aims to provide insight into the drivers of that slowdown, as well as more evidence of why the EM slowdown has cyclical—rather than structural—origins, according
to Emerging Markets Macro Strategist George Iwanicki. This paper will also explore EM
valuations, flows, investor expectations and currencies for signs of a bottom, provide an
update on the “Fragile Five” and look at actionable ideas across countries and sectors.
Performance of EMs vs. DMs: Another angle on the cycle
AUTHOR
EMs have struggled relative to DMs, in part, because of the widening gap in economic
performance. As seen in Exhibit 1A (next page), the Purchasing Managers Indexes
(PMIs) for DMs relative to EMs started to decelerate from 2010 until mid-2012, at
which point the PMIs for DMs turned positive, while EM growth remained stagnant.
Meanwhile, the DM cyclical economic outperformance has traced equity market outperformance over that same period (Exhibit 1B, next page).
George Iwanicki
Emerging Market Macro Strategist
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DM cyclical economic outperformance has paced equity market outperformance
EXHIBIT 1B: PMI SPREAD AND EQUITY MARKET PERFORMANCE,
EXHIBIT 1A: PMI TRENDS, DMs VS. EMsDMs VS. EMs
6
Developed equity markets
Emerging equity markets
56
150
PMI Spread
MSCI World (DM)/MSCI EM
5
140
4
130
3
Index
Diff erence
54
52
2
120
1
110
0
100
-1
50
90
-2
48
2010
2011
2012
2013
2014
-3
2010
2015
Index, Jan 2010=100
58
2011
2012
2013
80
2015
2014
Source: J.P. Morgan, MSCI; data as of March 2014. Shown for illustrative purposes only.
Decomposing EM profit pressures
While the stalling of EM earnings has some investors wondering whether the slowdown is cyclical or structural, Exhibits
2A–2C show that EM sectors have generally performed as
expected in an environment reflective of cyclical downside
pressures. Drawing on the team’s analysis of the drivers of EM
earnings, EM sectors were divided into three buckets and
organized using asset turnover (or sales-to-assets) ratios to
determine which sectors were asset “light” (with high asset
turnover ratios) and which sectors were asset “heavy” (with
low asset turnover ratios). The asset-heavy sectors, in turn,
were categorized as either defensive or cyclical based on their
degree of exposure to the global economy.
Exhibit 2A shows that the actual earnings for asset-light
sectors, including consumer discretionary, consumer staples,
financials and information technology (all of which have less
operating leverage to the economy given their lighter balance
sheets), have generally held up reasonably well. Asset-heavy
defensive sectors (utilities, health care and telecoms) with limited exposure to global demand posted relatively flat profits in
a slow-growth environment (Exhibit 2B). Meanwhile, the assetheavy cyclical sectors with more global exposure to commodities, such as industrials and materials, have struggled with
falling profits and pricing pressures (Exhibit 2C, next page).
An exception is the energy sector, which has benefited from
higher sustained oil prices.
More evidence that the EM profit stall has cyclical origins
EXHIBIT 2A: REALIZED EPS*, ASSET “LIGHT”
CD
CS
FI
140
IT
130
130
120
120
110
Index, Jan 2011=100
Index, Jan 2011=100
140
EXHIBIT 2B: REALIZED EPS*, ASSET “HEAVY” DEFENSIVE
100
90
80
70
60
HC
TC
UT
110
100
90
80
70
60
50
50
40
Jan 10
40
Jan 10
Jul 10
Jan 11
Jul 11
Jan 12
Jul 12
Jan 13
Jul 13
Jan 14
Source: J.P. Morgan; MSCI; data as of March 2014. Shown for illustrative
purposes only. *EPS = Earnings per share
2 | Emerging Market Equity Strategy—In Search of Capitulation
Jul 10
Jan 11
Jul 11
Jan 12
Jul 12
Jan 13
Jul 13
Jan 14
Source: J.P. Morgan; MSCI; data as of March 2014. Shown for illustrative
purposes only. *EPS = Earnings per share
Fragile Five, the current account deficits appear to have stabilized
and peaked in India, Indonesia and Turkey, although current
account balances have deteriorated in Brazil and South Africa.
EXHIBIT 2C: REALIZED EPS*, ASSET “HEAVY” DEFENSIVE
140
EN
IA
MT
130
Index, Jan 2011=100
120
110
100
Signs of a bottom are piling up
90
80
70
60
50
40
Jan 10
Jul 10
Jan 11
Jul 11
Jan 12
Jul 12
Jan 13
Jul 13
Jan 14
Source: J.P. Morgan; MSCI; data as of March 2014. Shown for illustrative
purposes only. *EPS = Earnings per share
Improvement in trade surplus reflects a mixed bag
Against a backdrop of shifting global liquidity, EMs are going
through an adjustment process of their own. The good news is
that the broad de-rating of EM currencies since the start of 2013,
led by the Fragile Five (Brazil, India, Indonesia, South Africa and
Turkey), has prompted an improvement in competitiveness,
resulting in a $250 billion EM merchandise trade surplus.
The quality of that trade surplus, however, is mixed, since the
improvement stems from the relative weakness in imports, rather than a surge in exports resulting from stronger DM growth. EM
import growth is still relatively weak, which may reflect subdued
domestic demand (Exhibit 3A). The distribution of the trade surplus is also skewed toward Asia, which has moved from a modest
deficit to a modest surplus (Exhibit 3B). Meanwhile, among the
Amid the long underperformance period for EMs, we are at
the point of tabulating potential signs of capitulation across a
variety of cyclical and market indicators. Many of these measures are now near levels that are encouragingly pessimistic,
indicating that we may be close to a bottom.
• While near-term analysts’ earnings estimates are still falling, longterm (three-to-five years) earnings estimates for EMs have fallen
to sufficiently low levels relative to their usual bands. Meanwhile,
economists’ forecasts for GDP growth in EMs (ex-China) have continued to fall and are nearing relatively low levels of 3%.
• On an absolute basis, EM equity valuations are trading near
1.5x price-to-book value (P/BV). Cheaper entry points and
capitulation-like multiples would be in the 1-to-1.5x P/BV range.
• On a fundamental valuation basis, while the U.S. has moved
back to its long-term average, the valuation gap between
EMs and Europe has effectively disappeared, meaning that
investors can buy EMs’ long-term economic earnings story
at roughly the same multiple as slow-growth Europe. In
other words, relative EM valuations look quite cheap.
• The extended selling of EMs by retail investors over the last
three years has largely wiped out the inflows during the EM
boom period. But, after 22 consecutive weeks, retail selling
may have reached a peak in the first quarter.
Import compression alongside moderate export improvement, led by Asia
EXHIBIT 3A: EM TRADE PERFORMANCE
Exports
450
Imports
May 2013
400
Jan 2014
350
6
300
4
USD (bn)
% over year ago, using a 3-month
moving average (USD)
8
EXHIBIT 3B: EM MERCHANDISE TRADE BALANCES
2
250
200
150
100
0
50
-2
-50
0
EM
Asia
LatAm
EMEA
EM
Asia
LatAm
EMEA
Source: J.P. Morgan; data as of January 2014. Shown for illustrative purposes only.
J.P. Morgan Asset Management | 3 INVESTMENT
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In search of EM capitulation
EXHIBIT 4: LOOKING FOR BOTTOMS ACROSS A VARIETY OF INDICATORS
Market indicators:
Valuations
P/BV near 1.5x
?
Fundamental P/E ratios near lows and competitive with
those of DMs
√
Near-complete reversal of earlier retail inflows over
past four years
√
Flows
22 weeks of unabated selling
through Q1, 2014
√
Earnings estimates
Near-term estimates still falling;
implied growth still too healthy
X
Economic Forecasts
Consensus nearing 3% ex-China
√
Still falling
x
EM FX
EM Trade Position
Reversed all of “supercycle echo”
Aggregate improving in wake of
FX de-rating
√
“Fragile Five” leading the bounce
Uneven regional mix and not purely reflective of
export rebound
?
Bottom of range for long-term growth
√
Cyclical indicators:
√
?
Source: J.P. Morgan. Shown for illustrative purposes only.
Looking at a variety of market and cyclical indicators, Exhibit 4
provides a checklist of capitulation signs in EMs. The good
news is that there are several components that appear to indicate that EMs have hit a bottom. Some concerns, however—
such as whether the Fragile Five bounce-back is premature or
whether near-term earnings estimates will continue to fall—
are still under question.
Past performance is not indicative of future results.
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
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 notice. We believe the information provided here is reliable. These 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 be interpreted as,
recommendations. Past performance is no guarantee of future results. Please note that investments in foreign markets are subject to special currency, political, and
economic risks.
International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation
policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other
nations. Investments in emerging markets could lead to more volatility. As mentioned above, the normal risks of investing in foreign countries are heightened when
investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased
volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property. Diversification does not guarantee
investment returns and does not eliminate the risk of loss.
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