Outlook on Emerging Markets OCT Summary 2014

Outlook on Emerging Markets
Summary
• This year’s busy emerging
markets election cycle concludes in October, which
should mitigate political
risk and pave the way for
sought-after reforms.
• The launch of China’s
Stock Connect cross-border equity conduit,
expected for late October,
is a credible and important
first step in broadening
access to Chinese stocks
for onshore and offshore
investors, and could rejuvenate investment in the
Chinese market.
• Near term, based on deteriorating growth in China
and Europe, our debt team
has become more bearish
on risk markets and is
becoming bullish on flightto-safety assets.
OCT
2014
Lazard’s emerging markets platform consists of experienced investment teams with individual philosophies and portfolio management processes. Each team maintains independent
viewpoints that have been enriched by dialogue with colleagues on the platform and within
the broader firm. As a result, opinions across the platform may differ.
Emerging markets equity and debt pulled back in the third quarter amid macroeconomic
headwinds. The MSCI Emerging Markets Index declined 3.5% during the third quarter
in US dollar terms, with gains of 2.4% for the year to date. During the quarter, emerging
markets small-cap stocks outperformed their large-cap peers. Despite market volatility
from major elections and intensifying geopolitical tensions between Russia and Ukraine,
and in the Middle East, fund flows into the global emerging markets have been overall
positive, with institutional inflows offsetting retail outflows over the course of the year.
Broad-based losses were recorded across emerging markets debt, with local assets performing the worst, led by a sell-off in emerging markets currencies. The J.P. Morgan GBI-EM
Global Diversified Index declined 5.7% during the quarter, led by negative spot currency
returns, marking local debt’s third-worst quarter in the past five years. The J.P. Morgan
EMBI Global Diversified Index declined 0.6% in the quarter, driven by widening spreads
that were not fully offset by the rally in US Treasuries. Corporate credits held up relatively well, as the J.P. Morgan CEMBI Broad Diversified Index posted a minor loss of
0.3% for the quarter.
Emerging Markets Equity
From the viewpoint of Lazard’s emerging markets equity teams:
The emerging markets election cycle concludes in October in Brazil, mitigating the
political risk that has been a hallmark of this year. The prospect of meaningful change has
been powerful, as seen in India where stocks have rallied leading up to and following the
elections of the pro-reform Modi-led government. The leap from rhetoric to meaningful
action and successful implementation will invigorate local markets for the long term.
Meanwhile, Western sanctions on Russia have intensified. Our teams’ stock models
are individually designed to price in these risks, through risk scoring or adjustments to
growth rates and cost of capital. We believe that these sanctions are not currently an
operational encumbrance to the Russian companies held in our portfolios. Our relative value team estimates that it will take a couple
of years before real headwinds begin to set in for their Russian holdings, at current conditions.
• A correction in emerging
markets debt should contribute to an attractive 2015
for emerging markets debt
investors.
A rising-rate environment and emerging markets currency weakness pose advantages as well as drawbacks for companies and economies in the developing world. From a bottom-up equity point of view, investment decisions based on macro analysis alone are
of limited usefulness. While rising rates broadly imply a higher cost of capital for businesses, financing frameworks differ across
companies in emerging markets—some have very low debt, and others are more levered; some will have local financing, while others
are externally funded. Our teams across equity disciplines manage interest rate and currency risk through careful stock selection.
Companies with skilled management and good earnings quality are not only able to weather headwinds; they can capitalize on
them, for example by seizing market share from less agile competitors. By seeking out firms with competitive advantages and strong
fundamentals, we are able to build portfolios of stocks whose potential to outperform have little direct relationship to immediate macroeconomic conditions.
All eyes are currently on Hong Kong where large-scale, non-violent protests against Beijing’s attempt to influence the 2017 election
of Hong Kong’s Chief Executive took most of the world by surprise. At issue is differing interpretations of “universal suffrage” for
Hong Kong, a term used in a 2007 decree by the Chinese government. The pro-democracy Occupy Central campaign claims that
it means every citizen should be allowed to vote for their chosen candidate. The Chinese government in Beijing interprets this to
mean all Hong Kong citizens will be allowed to vote—but only from a list of three shortlisted candidates selected by a committee
RD12136
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that is influenced by Beijing. Our Asia ex-Japan team foresees some
short-term implications: (1) These protests could lower retail sales
growth as protestors are occupying key commercial areas and the
events coincided with a major holiday. This has hurt some retail and
property stocks. (2) Fewer tourist arrivals to Hong Kong and Macau
could further weaken sentiment toward Macau gaming companies.
(3) While the Hong Kong dollar is trading on the weak side of the
band, implying fund outflows, Hong Kong interbank rates have
remained steady. This team sees financial sector disruption from the
recent events as highly unlikely, however they will continue to closely
monitor the situation and assess the longer-term risks.
Despite the perennial controversy over China’s growth rate and
concerns that it will fall short of the official 7.5% growth target for
2014, fund flows into China have been positive for the year to date
through September. During this time, Chinese equities have gained
0.7% in US dollar terms. China’s growth mix is changing, bringing
with it a permanent adjustment to its growth rate. This is inevitable,
in our view, recognizing that there is nothing ordinary about double-digit growth sustained over thirty years. Beijing is winding down
the fixed-asset investment that was behind China’s recent boom. This
stimulus is no longer efficient as productivity generated from each
dollar of fixed-asset stimulus is now less than its cost. Meanwhile,
increasing affluence, especially among the middle class, is boosting
demand for goods and services, which is key to China’s long-term shift
to a consumption-driven growth.
Stock Connect at a Glance
Stock Connect links the Shanghai Stock Exchange,
which trades in onshore renminbi-denominated China-A
and China-B stocks, to the Hong Kong Stock Exchange,
which deals in US dollar– and Hong Kong dollar–denominated China-H stocks. Historically, offshore investors
have only had access to China-H shares (limited to 187
unique issuers); China-B shares (which represent less
than 1% of total onshore market capitalization); and
US-listed shares of Chinese companies (mostly concentrated in the technology sector).
Until now China’s closed capital account has prevented
any real arbitrage for dual-listed companies with both
China-A and China-H issuance. This has frequently
resulted in sizable pricing differentials between two
share classes of the same issuer. Fungibility between
these share classes should result in a convergence of
share prices, with premiums and discounts arbitraged
away. Markets have already reacted: Dual-listed China-H
shares trading at large premiums traded off following
news of the Stock Connect proposal in April.
Exhibit 1
Improved Access to Onshore Chinese Listings Signifies
Opportunity for Foreign Investors
Hong Konglisted
Domestic
China-listed
Total
Consumer Discretionary
42
239
281
Consumer Staples
21
86
107
Energy
16
54
70
Financials
61
141
202
Health Care
18
140
158
Industrials
61
410
471
Information Technology
23
225
248
Materials
31
239
270
7
6
13
Telecom Services
Utilities
Total
16
53
69
296
1593
1889
As of 30 September 2014
Number of companies with market capitalization above US$500 million.
Source: Bloomberg, LAM Singapore estimates
In a promising development, China’s Shanghai-Hong Kong Stock
Connect program will launch in October, representing a starting
point in a multi-year effort that will allow both onshore and offshore
investors to engage the Chinese equity opportunity more effectively. It
allows cross-border capital flows through an equity conduit and could
rejuvenate local and foreign investment by creating access to restricted
stocks. China’s three equity exchanges in Shanghai, Shenzhen, and
Hong Kong vary greatly in depth and breadth of listings, and its
onshore equity market is already the world’s third-largest after the
United States and Japan. The onshore Shanghai and Shenzhen bourses
have much greater company representation than the Hong Kong–
based Hang Seng Index, with consumer, industrials, and health care
companies a big draw for foreign investors (Exhibit 1). Meanwhile,
mainland investors will be granted access to Macau-based gaming,
telecom, and Internet stocks listed on the Hong Kong exchange.
Initially, about 600 stocks on the Shanghai Stock Exchange will
be open to offshore investors, subject to a limit of CNY250 billion
in daily net flows, roughly equivalent to US$40 billion. Mainland
Chinese investors meeting minimum brokerage balance requirements
will be able to invest in the constituents of the Hang Seng Composite
LargeCap and MidCap indices, limited to CNY300 billion in daily
net flows, or about US$48 billion.
Similar equity conduits have been introduced in the past without
much success, but this latest initiative appears to be better coordinated
and much more credible in the context of the new administration’s
goals of renminbi internationalization and interest rate and foreign
exchange liberalization.
In the Middle East, the harsh tactics of the Islamic State, also known
as ISIS or ISIL, have shocked the world, but there appears to have
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been little if any drag on the performance of equities in the region. Our Dubai-based Middle East and North Africa (MENA) equity team believes
that contagion risk is limited by the recently formed US-led global coalition to defeat the group. They also see no local support for the Islamic
State’s agenda. Despite the turmoil, oil prices have declined (due to increased supply from Kuwait and Nigeria). In addition, the S&P Pan Arab
Composite has outperformed both the MSCI Emerging Markets Index and the MSCI World Index this year. These gains appear to be the result
of a much clearer investor understanding of the region’s growth drivers, which are based on infrastructure investment and not oil production, as
commonly assumed.
Emerging small-cap stocks held up better than their large-cap counterparts during the quarter due to differences in sector and country exposures.
The MSCI Emerging Markets Small Cap Index benefited from its relatively lower exposure to Russia and its smaller allocation to commodities and
energy stocks, which were weighed down by lower pricing. Current currency dynamics, in the form of a strengthening US dollar and weakening
emerging markets currencies, could potentially create tailwinds for companies with US-bound exports, especially in North Asia.
Stock valuations in the developing world decreased slightly in September. At 10.9 times forward earnings as of month-end, emerging markets
stocks continue to trade at a meaningful 28% discount to the developed world (Exhibit 2). Corporate profitability in the emerging markets remains
relatively unchanged at 11.9%, based on return on equity, which is approximately in line with the developing markets (Exhibit 3).
As bottom-up investors, we remain bullish on the outlook for emerging markets equities and believe that current valuations are reasonable under all
scenarios other than a global recession.
Exhibit 2
EM Shares Are Trading at a 28% Discount to Developed Stocks…
P/E (x)
30x
25x
+2 Standard Deviations
20x
+1 Standard Deviation
15x
MSCI World Index
15.2x @ 30 September 2014
Long-Term Average 13.3x
MSCI Emerging Markets Index
10.9x @ 30 September 2014
-1 Standard Deviation
10x
-2 Standard Deviations
5x
0x
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
As of 30 September 2014
Data shown on a forward 12-month basis.
Not intended to represent any product or strategy currently managed by Lazard
Forward-looking data are not a promise or guarantee of actual results and are subject to change.
Source: IBES, MSCI, Morgan Stanley Research
Exhibit 3
…Even Though EM Returns Are Just as Strong
ROE (%)
18
MSCI World Index
12
MSCI EM Index
6
0
1991
1994
1997
2000
As of 30 September 2014
Not intended to represent any product or strategy currently managed by Lazard
Source: UBS, MSCI, Datastream
2003
2006
2009
2012
4
Emerging Markets Debt
From the viewpoint of Lazard’s Emerging Markets Debt team:
Over the last month, there have been significant changes in the world’s three primary economic centers (the United States, Europe, and China).
These events have altered our Emerging Markets Debt team’s near-term outlook for emerging markets debt, and have resulted in a change in
positioning across our portfolios. We have become more bearish on risk markets (including high-yield US dollar–denominated sovereign debt and
emerging markets currencies), and are becoming bullish on flight-to-safety assets, such as investment-grade US Treasury–sensitive dollar debt. As
such, we have cut our long-standing duration underweight across portfolios and have significantly reduced exposure to local markets.
First, European economic growth continues to fall short of expectations, with disappointing manufacturing, services, consumer confidence, and
leading economic indicators. More worrisome is that European malaise has led to lower inflation readings, which have now fallen below 1% on an
annualized basis. Over the past three years European Central Bank (ECB) president Mario Draghi has made a valiant effort to move the formerly
sluggish central bank to take a much more proactive role in setting aggressive monetary policy in the euro zone. He has rolled out multiple longterm refinance operations (LTROs), recently unveiled a new targeted LTRO, and has often used the power of the pulpit to discourage markets
from betting against Europe’s ability to stave off deflation. The most recent round of monetary action was the early September 2014 hint of further
action and the likely announcement in early October of new asset-backed security (ABS) purchases by the ECB. Unfortunately, due to the limited
size of the European ABS market, the passthrough effect of these purchases into real economic growth is likely to be limited. So, what is next?
Europe should continue to decelerate, inflationary pressures will likely be sparse at best, and the growing crisis of confidence within mainland
Europe will worsen. This will likely culminate in full-blown quantitative easing, which includes the purchase of sovereign bonds by the ECB. It is
our view that this type of aggressive, Fed-esque monetary policy is inevitable and is likely to be announced in the first quarter of next year. With
quantitative easing on the horizon, the euro should continue to be under pressure relative to all other currencies. That pressure will be magnified as
other areas of the world prepare to tighten monetary policy.
Second, China performed below expectations in September. Global market participants continue to debate whether or not China’s growth is at risk
of a sharp deceleration, and the pendulum seems to be swinging toward the hard landing. Most recently, Chinese production, fixed-asset investment, and retail sales data have missed expectations. In addition, real estate prices and the number of transactions have continued to contract for
nearly a year now. Chinese growth deceleration is certainly not news to investors, but it is coming at a time when other parts of the world are also
struggling. Now, two legs of the global economy’s three-legged stool are turning rotten. It is therefore increasingly likely that the thus-far-robust
US economy will stumble under the weight of negative global pressure. It is also important to mention that with US economic indicators hitting
record post-crisis levels, market expectations are extraordinarily high for future jobs and production data. As such, even a plateauing of growth in
the United States will be viewed as weakness by investors.
Chinese economic deceleration is now being reflected in lower commodity prices. It should be noted that some commodities that are more
levered to Chinese growth deceleration have borne the brunt of the correction, while commodities that are less dependent on Chinese demand
have corrected marginally. For example, iron ore prices are down 41% year to date, while the price of Brent crude oil is down 14%, and prices of
agricultural commodities are down 17%. The world is witnessing a commodity price correction that will pass through to developed markets in the
form of lower inflation. The United States is in the first stage of this transition, with core personal consumption expenditures (the Fed’s preferred
price inflation measure) having fallen to 1.4% in August. Under its dual mandate of price stability and maximum employment, the Fed is hesitant
to return to “normal” policy levels until inflation returns to 2.0%. We expect that inflationary pressures will continue to ease through year-end,
leading to a fourth quarter whereby inflation in both the United States and Europe could fall well below the long-term levels targeted by their
central banks. As such, we believe the market has jumped the gun in adjusting to higher US Treasury yields in anticipation of a mid-2015 lift-off
of monetary policy. We have therefore reduced our targets for US Treasury yields to the mid-2% range (for 10-year maturities), thus resulting in
duration appearing significantly more attractive for investors. As such, external US dollar–denominated long duration debt should be the largest
beneficiary of these dynamics. Lower commodity prices in the near term ought to also put pressure on emerging markets growth as the grand
majority of emerging markets sovereigns are commodity exporters. Lower growth typically accompanies currency depreciation in the initial stages of
an economic shift; hence, we have reduced exposure to local markets.
While our near-term outlook for the asset class has become decidedly negative, we anticipate that a correction will contribute to an attractive 2015
for emerging markets debt investors. Specifically, we envision three catalysts that ought to be supportive for emerging markets debt assets into the
New Year. First, should valuations correct another 2% in external debt and 4% in local debt (from September-end), both asset classes will offer
one-year forward returns that are slightly higher than their historic volatility. Put differently, investors will be paid handsomely for taking risk at
those levels. Second, markets will likely become more bullish on expected European growth and inflation upon the announcement of full-blown
quantitative easing. Therefore, should this occur earlier than widely expected, the market will have a positive reaction. Third, the wild card of China
stimulus is ever-present. It is rumored that the current head of the People’s Bank of China, Zhou Xiaochuan, who has been hawkish, might be
replaced in the near future by a more stimulus-friendly economist. If this were to happen, commodity prices would likely arrest their declines in
anticipation of increased near-term Chinese growth. Notwithstanding these three potentially positive catalysts, we intend to remain defensively
positioned across our portfolios in the near term, with limited exposure to local currency positions and a bias toward relatively safer long-duration
dollar assets.
Outlook on Emerging Markets
Important Information
Published on 7 October 2014.
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changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of
company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political,
social, and economic factors affecting companies in emerging-market countries.
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