Relentless forces in emerging markets: The good in the bad news

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1 FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION May 15 INVESTMENT INSIGHTS Relentless forces in emerging markets: The good in the bad news Emerging Markets Strategy Executive Summary IN BRIEF Emerging market (EM) equity valuations remain range-bound, constrained by relentless pressure on earnings and earnings estimates, and the persistence of U.S. dollar (USD) strength. However, historically steep downward revisions to earnings estimates and a dollar trading near prior peaks could signal that emerging markets have already seen the worst of the performance drag from these trends. Concerns regarding external debt levels in the face of a strengthening USD have shifted from countries to companies, most relevant when evaluating companies with high levels of USD debt on their balance sheets that are not supported by USD revenues. China s seemingly relentless equity market rally does not appear threatened by either monetary tightening or a worrying valuation bubble. On a fundamental basis, EM equity appears to be the cheapest segment of the global equity market. It will take an earnings rebound, however, to unleash its long-term performance potential. AUTHOR EMERGING MARKET (EM) GDP GROWTH EXPECTATIONS HAVE STABILIZED after several years of decline, an indication that emerging and developed economies are no longer decoupling. Yet two relentless forces downward pressure on earnings and earnings estimates, as well as the rally in the USD, must abate before EM equity valuations can break out of their current belowaverage trading range. Counter-intuitively, perhaps, the fact that these headwinds seem to be blowing their hardest could be good news for EM performance. George Iwanicki Emerging Markets & Asia Pacific Equity Team

2 RELENTLESS FORCES IN EMERGING MARKETS: THE GOOD IN THE BAD NEWS The acceleration in EPS estimate reductions may be reflecting the beginnings of capitulation globally EXHIBIT 1A: EM EPS ESTIMATES EXHIBIT 1B: IMPLIED EPS GROWTH NEXT 12 MONTHS Mar-8 Oct-8 May-9 Dec-9 Jul- Feb-11 Sep Apr-12 Nov-12 Jun-13 Jan-14 Aug-14 Mar Median (-yr) Current Range (-yr) AC World US EAFE EM Source: IBES, J.P. Morgan Asset Management; data as of March 31, 15. EPS = earnings per share. Green horizontal bar (Exhibit 1B) indicates bottom of -year historical bands for implied EPS growth rates, omitting outsized declines associated with the collapse of Lehman Brothers in September 8. EPS REVISION PRESSURE NEARING AN END? EM earnings per share (EPS) estimates for a given year are often revised downward as the year progresses, but estimates for have shown a precipitous decline (Exhibit 1A). At the same time, current implied EPS growth rates (rates comparing analysts estimates of EPS over the next 12 months with actual EPS over the past 12 months) in emerging markets and globally are at or near the bottoms of their -year historical ranges (omitting outsized declines associated with the collapse of Lehman Brothers in September 8, denoted by the horizontal green line, in Exhibit 1B). While this may sound bearish for EM equities, it could also mark the beginning of a bullish signal suggesting that markets may already have experienced the worst of this downward pressure on earnings. USD HEADWIND WANING? The unrelenting strength of the USD can be a cause for concern for emerging markets on several fronts: History has shown that EM equity s performance relative to the rest of the world struggles as the USD strengthens. In contrast, U.S. equity s relative performance thrives when the USD strengthens. The good bad news for emerging markets regarding the USD rally is that in real effective exchange rate (REER) terms (the weighted average value of a country s currency relative to a broad basket of other currencies), the USD is, by our estimation, now more than % richer than our best estimates of its fair value and well within the range of peaks reached in the early to mid 8s or during the tech boom. Although it is likely too soon to call a top in the USD, the worst of the pressure from this relentless headwind may be subsiding. Investors concerned about EM external debt in light of the USD rally, should focus not merely on external-debt-to-gdp ratios but on the ratio of EM external debt to foreign currency reserves. As seen in Exhibit 2A, total EM reserves as a percentage of GDP (27%) today are roughly equivalent to total external debt as a percentage of GDP (29%). That is, EM countries have fortified their reserves and improved debt coverage since the Asian financial crisis of On the other hand, % or more of EM external debt now resides in the private sector (Exhibit 2B), suggesting investors need to be wary of companies with above-average levels of external debt on their balance sheets. USD debt can become an expensive source of financing and raise liquidity issues if EM borrowers without USD revenues have to purchase expensive dollars to pay back lenders. 2 EMERGING MARKETS STRATEGY

3 EXECUTIVE SUMMARY The ability to finance external debt is now a micro worry, not a macro worry EXHIBIT 2A: EM EXTERNAL DEBT AND RESERVES EXHIBIT 2B: EM PRIVATE EXTERNAL DEBT/TOTAL EXTERNAL DEBT Percent (%) Dec-91 Dec-93 Dec-95 28% % Dec-97 Dec-99 Dec-1 Dec-3 Dec-5 Dec-7 Total EM Reserves as % of GDP Total External Debt as % of GDP Dec-9 Dec-11 Dec-13 29% 27% Percent (%) 7 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 EM Ex-China EM Mar-95 Mar-97 Mar-99 Mar-1 Mar-3 Mar-5 Mar-7 Mar-9 Mar-11 Mar-13 56% % Source: Oxford Economics; data as of December 31, 14. CHINA DID YOU SAY BUBBLE? The sharp rebound in China A-shares that began in 14 has now begun to energize China H-shares, where discounted values are attracting investors. This may bring to mind the 6-7 China bubble, but there are some critical differences: Earnings multiples are still far below those seen in 6-7 (Exhibits 3A-3B), particularly for H-shares which are trading at single-digit forward price-to-earnings (P/E). Economic, inflationary and monetary indicators are not providing the People s Bank of China (PBoC) with a mandate to tighten, but rather, a mandate for easing. What s more, the 6-7 rally continued, even through the initial hikes in rates and reserve requirements by the PBoC. China s rally does not currently appear to face hurdles from either valuations or liquidity. A-share rally spilling into H-shares not 6-7 all over again EXHIBIT 3A: CHINA A-SHARE INDEX EXHIBIT 3B: CHINA H-SHARE INDEX 25 Forward PE multiple (X) Apr 15??? Forward PE multiple (X) Apr 15??? 5 5 (13) 6 (14) 7 (15) (13) 6 (14) 7 (15) 8 9 Source: IBES, UBS; data as of April, 15. J.P. MORGAN ASSET MANAGEMENT 3

4 RELENTLESS FORCES IN EMERGING MARKETS: THE GOOD IN THE BAD NEWS ACTIONABLE IDEAS Our analysis of equity valuations and momentum characteristics across emerging markets informs our portfolio positioning. Our current investment views include the following: Favor Eastern Europe (where Hungary has done quite well this year) and North Asia (including South Korea, though it has disappointed so far), as they continue to show positive combinations of value and momentum. Maintain an overweight in China. We are trimming some names where valuations have risen sharply, but staying overweight, as we believe valuations are reasonable and see no sign of PBoC tightening on the horizon. Start rotation back into Turkey. After first-quarter underperformance, we are willing to start rebuilding allocations to Turkey where discounts warrant, although we remain vigilant regarding macro risks. FUNDAMENTALLY ATTRACTIVE VALUATIONS Emerging market equities look cheap relative to their own aggregate history but remain range-bound as a result of relentless earnings pressure and USD strength. On a fundamental basis (price-to--year smoothed earnings), EM is hovering around its own historic lows. However, with the QE-induced bounce in European equities and the U.S. trading at or slightly above its long-term valuations, emerging markets now appear to be the cheapest segment of the global equity markets (Exhibit 4). In our view, this reflects EM equity s pent-up potential for future performance. While it would take an earnings rebound to unleash this potential, we suspect earnings expectations are now nearing a bottom. Be willing to hold India. We still see reform markets (Mexico, India, Indonesia and the Philippines) as generally expensive. Remain neutral on Brazil. Despite attractive valuations, we are waiting until a catalyst is identified before adding to holdings. Optimism about the U.S. and initial re-rating in Europe leaves emerging markets the cheapest segment of global equity markets EXHIBIT 4: PRICE-TO--YEAR AVERAGE EARNINGS Europe (MSCI Europe) U.S. (S&P ) Emerging markets (MSCI EM) Cycle-adjusted valuations (X) Year U.S vs Long-term average GEM 15.8 vs Long-term average Europe 17.3 vs..7 Long-term average Source: IBES, MSCI; data as of March 31, 15. Relative valuations are based on CAPE the cyclically adjusted P/E multiple using -year average EPS. 4 EMERGING MARKETS STRATEGY

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