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 2 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 3 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. This report is being provided for informational purposes only. It is not intended to be, and does not constitute, an offer to enter into any contract or investment agreement with respect to any product offered by Lazard Asset Management, and should not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. The information and opinions presented in this report have been obtained from sources believed by Lazard Asset Management to be reliable. Lazard Asset Management makes no representation as to their accuracy or completeness. All opinions and estimates expressed herein are as of the published date, and are subject to change. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, 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. An investment in emerging markets debt positions are subject to the general risks associated with fixed income investing, such as interest rate risk and credit risk, as well as the risks associated with emerging-market investments, including currency fluctuation, devaluation, and confiscatory taxation. Investments in global currencies are subject to the general risks associated with fixed income investing, such as interest rate risk, as well as the risks associated with non-domestic investments, which include, but are not limited to, currency fluctuation, devaluation, and confiscatory taxation. Furthermore, certain investment techniques required to access certain emerging markets currencies, such as swaps, forwards, structured notes, and loans of portfolio securities, involve risk that the counterparty to such instruments or transactions will become insolvent or otherwise default on its obligation to perform as agreed. In the event of such default, an investor may have limited recourse against the counterparty and may experience delays in recovery or loss. Investments denominated in currencies other than US dollars involve certain considerations not typically associated with investments in US issuers or securities denominated or traded in US dollars. There may be less publicly available information about issuers in non-US countries that may not be subject to uniform accounting, auditing, and financial reporting standards and other disclosure requirements comparable to those applicable to US issuers. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Past performance is not a reliable indicator of future results. 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