Emerging markets (%)

Insights Emerging Markets Understanding the risks October 21 Please visit jpmorgan.com/institutional for access to all of our Insights publications. Emerging markets offer compelling long-term return potential, but continue to present risks that every investor should understand. In this paper, Richard Titherington, CIO of the Emerging Markets Equity Team at J.P. Morgan Asset Management, discusses the risks inherent to emerging markets and looks at the effect they have had on economic and investment performance. He also explains why globalisation and urbanisation mean that, for long-term investors who are aware of the risks, there is considerable reason for optimism about emerging markets. I believe in the long-term outperformance of emerging market equities as an asset class: if I didn t, I wouldn t be working as head of J.P. Morgan Asset Management s Emerging Markets Equity team. However, it is important for us and our clients to understand the risks inherent in the asset class. The Fundamentals Driving Emerging Market Equities First, it is worth restating the two fundamentals driving the development of the emerging market asset class. The first is the rebalancing of the world economy from the extreme of concentration of economic power typified by the creation of the G7 (the group of seven industrialised nations) in 1976, which meant that by the end of the Cold War in the early 199s the developed world of North America, western Europe, Japan and Australasia, approximately 12% of the world s population, represented 77% of global GDP. It is this extreme degree of economic imbalance that is unusual, not the more balanced world we are moving back towards. Author Exhibit 1: The really big picture Emerging markets rising share of global GDP Emerging markets (%) 1.8 3.4 North America (%) Developed Asia (%) Europe (%) 19.1 21.2 28.8 33.6 5.5 48.1 11.6 66. 41.8 19.1 Richard Titherington Managing Director Chief Investment Officer Head of the Emerging Markets Equity Team 182 1913 Today Source: J.P. Morgan Asset Management, Angus Maddeson 21, IMF as at end 29, GDP in PPP terms For Institutional Use Only

Emerging Markets The equivalent of half the population of Europe moving from the countryside to the city. The second key driver is urbanisation the continuing move of population from the countryside to cities which drives both productivity and consumption. Approximately 5% of the world s 6.8 billion people currently live in urban areas. However, more than 95% of the population of developed countries are already based in urban areas. In consequence, close to 1% of the productivity and consumption growth derived from urbanisation lies in the emerging world, sustaining faster economic growth. Exhibit 2: Urbanisation the big move 35m people forecast to move from rural to urban locations between 21 and 215 9 8 7 6 5 4 3 2 1 Emerging regions rural population Emerging regions urban population Total change from prior five-year period urban population Strategic Risks to Monitor 5 45 4 35 3 25 2 15 1 5 195 197 199 21 23 25 Source: World Bank Data. Data as at January 28. For illustrative purposes only. Having described the key positive drivers, let us look at the risks, and specifically at why many of the emerging nations of 1 years ago are still emerging today. There are two key reasons: revolution and inflation. The chart below lists the ten largest emerging markets and highlights their experience with these two destructive phenomena. Million people Exhibit 3: Ten largest emerging markets Revolution and inflation Proportion of the MSCI All-Countries World Index (%) Revolution Inflation China 2.47 1911, 1937 1949 199 1995 Brazil 2.14 1979 1993 Korea 1.8 191, 1945, 195 1953 1998 Taiwan 1.45 1911, 1949 India 1.8 1947 Russia.84 1917 1922, 1991 Mexico.57 191 198 1988 Malaysia.41 1963 1965 Indonesia.31 1945 1949 1998 Chile.24 1973 197 1975 Turkey.24 1918 1923 1973 24 Thailand.22 1998 Total 11.76 Source: MSCI, World Bank, IMF, CIA World Factbook, September 21. The economic consequences of political revolution are clear, with the Russian and Chinese examples of the twentieth century not requiring further elaboration. Many countries in the emerging world have witnessed less well known but equally damaging political upheavals, which make political and legal institutions less reliable and predictable than in the developed world. The impact of inflation is less obvious but more pernicious in preventing development and especially in perpetuating poverty. Over the last 1 years, Brazil has grown on average at 4.9% in real terms. This is considerably better than the USA, which grew at 3.5% over the same period. However, Brazil remains an emerging market, while the USA is the world s leading economy. Unlike most of the top ten emerging market countries, Brazil, despite periods of military rule, has not suffered from political revolutions, partition or war. Consequently, it should be a candidate for graduation from emerging to developed status. 2 Emerging Markets: Understanding the risk

The reason that Brazil has not emerged is inflation. From 1958 to 1968 and again from 1975 to 1994, Brazil suffered from high and even hyper inflation. In only 12 of the last 65 years has inflation been below 1%, and seven of those years have come in the last eight years. It is this change from high to low inflation that has allowed the Brazilian market to return 16% per annum since 1995: twice the return per annum of U.S. equities over the same period. Inflation increases inequality, impoverishing the majority of the population. It also undermines currency values, explaining why for most of the last 1 years emerging market currencies have been weak against G7 currencies. In consequence, the biggest financial risk we face as investors in emerging markets is a return to an environment of fixed exchange rates and high and rising inflation. We expect average inflation in the emerging world to be 5.5% over the next five years, based on our internal macroeconomic work. If that assumption is correct then, except for individual countries such as Venezuela, the inflation risk in emerging markets is low and on a completely different scale to that experienced in the period from 197 to 2. Therefore the two strategic risks that we need to understand and monitor are political upheaval, which leads to the appropriation of assets via revolution as in Russia, China, Turkey, Egypt, Chile, Cuba, Iran, Algeria and Vietnam, among others, and inflation, which destroys the real value of assets, as seen in Argentina, Brazil, Zimbabwe, Russia and Indonesia. Political risk need not be as dramatic as some of the revolutionary examples given, but may involve an undermining of the rule of law and a pervasive culture of bureaucratic and corporate corruption that siphons wealth from shareholders to domestic power brokers. As such, we should broaden our monitoring of political risk to governance in general rather than just revolution. Exhibit 4: Brazil inflation 1949 1979 1 9 8 7 6 5 4 3 2 1 1949 1952 1955 1958 1961 1964 1967 197 1973 1976 1979 Source: J.P. Morgan Asset Management. Exhibit 5: Brazil inflation 1979 1994 3, 2,5 2, 1,5 1, 5 1979 1982 1985 1988 1991 1994 Source: J.P. Morgan Asset Management. Exhibit 6: Brazil inflation 1994 29 3 25 2 15 1 5-5 1995 1997 1999 21 23 25 27 29 Source: J.P. Morgan Asset Management. J.P. Morgan Asset Management 3

Emerging Markets Tactical Issues Alongside the two strategic risks are the two tactical issues that should inform any equity investment, emerging or developed: earnings and valuation. Emerging market equities look cheap relative to emerging market debt. Exhibit 7: Comparing emerging market equity and bond yields Emerging market earnings and bond yields, 1991 August 21 2 15 1 5 EM bond yields 1 EM equity yields (forward) (E/P) Asset multiples are hovering near long-term averages; earnings multiples have fallen back below average Exhibits 9: Valuations GEM price to book: 1993 to August 21t 21 1,6 1,4 1,2 1, 8 6 4 2 MSCI EM MSCI EM long-term average P/B MSCI EM P/B (RHS) Jan-93 Jan-95 Jan-97 Jan-99 Jan-1 Jan-3 Jan-5 Jan-7 Jan-9 Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end August 21. 4. 3.5 3. 2.5 2. 1.5 1..5. Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-1 Jan-3 Jan-5 Jan-7 Jan-9 1 Re-weighted bond yields with equity weightings to make these two yields comparable. Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end August 21. Over the last ten years, emerging market debt has re-rated, reflecting a dramatic improvement in credit quality as the asset class approaches investment grade. Equities, in contrast, trade at levels similar to those of a decade ago, meaning emerging market equities currently appear cheap against emerging market debt. Exhibit 8: Comparing emerging market equity and bond yields Emerging market equities relative to debt, 1991 August 21 8 6 4 2-2 -4-6 Exhibits 1: Valuations GEM price to forward earnings: 1993 to August 21 25 23 21 19 17 15 13 11 9 7 5 Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end August 21. On an earnings and asset basis, emerging market equities also appear to be trading close to long-term averages. The great difference between bonds and equities is that the former trade on perceptions of solvency, the latter on perceptions of future profitability. Valuation is therefore not a concern on a tactical basis as long as market expectations for earnings and dividend growth are not unrealistic. -8-1 199 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 21 22 23 24 25 26 27 28 29 21 199 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 21 22 23 24 25 MSCI EM Fwd PE Rolling Average +/- 1 sd 26 27 28 29 21 Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end August 21. 4 Emerging Markets: Understanding the risk

Following the cyclical collapse of 28, earnings have grown very strongly, with the market expecting earnings growth of over 3% in 21. More important for future returns is the long-term outlook for earnings per share, which is the return enjoyed by shareholders rather than the GDP growth that most commentators focus on. The Emerging Markets Equity Team at J.P. Morgan Asset Management currently expects average earnings per share growth for the companies we cover to be over 15% per annum for the next five years. If this expectation is right then the combination of earnings per share growth at twice the global level, modest currency appreciation and a current dividend yield of 2.5% (likely to grow at 12% per annum) should give investors an attractive return from these levels over the next five years. Exhibit 11: GEM earnings per share growth USD per share 1 9 8 7 6 5 4 3 2 1.2% 29.9% Exhibit 12: Long term dividend growth tested by crisis (% p.a.) 5 4 3 2 1-1 -2-3 Emerging market dividend growth 1992 1995 1998 21 24 27 21E Source: MSCI, IBES, Morgan Stanley as at May 21, GEM universe. E = MS estimate. Exhibit 13 Dividend growth of key sectors (% p.a.) Dons Disc Cons Staples Financials Info Tech Telecoms 26 2.2 39.7 11.3 13.1 19.3 27 5.5 16.6 33.4 35. 47.5 28-12.6 1. 5.6 27.4-3.6 29E 16.4 -.9-3.3-33.9 9. 21E 14.9 15. 21.1 14. 17.2 211E 15. 16.5 26.6 27.8.6 199 1992 1994 1996 1998 2 22 24 26 28 21 Source: UBS as at 28 February 21. Source: MSCI, J.P. Morgan Asset Management, 21/11 J.P. Morgan Asset Management estimates. J.P. Morgan Asset Management 5

Emerging markets Conclusion The emerging markets story is by no means without risk, including the strategic risks of governance and inflation and tactical risks around earnings growth and valuation. Our current view on these risks is summarised in the table below. Governance risk Low at the national level among the larger countries. Ever present at the stock level, although rising average ROE suggests a positive trend. STRATEGIC Inflation Low by historical standards but cyclical pressure is upwards. Currency flexibility and economic orthodoxy are key to continued success. Emerging markets offer a combination of: Attractive growth and dividends Maturing growth and rising dividends Four key sectors Consumer (discretionary and staples) Financials Information technology Telecommunication services Valuation In line with historic averages, although high relative to developed markets. Wide company and sector variance makes stock selection crucial. Earnings A strong cyclical recovery is being followed by robust secular growth. Reduced dependence on G7 trade gives greater confidence in the sustainability of EPS and DPS growth rates. TACTICAL However, for investors who are comfortable with these risks, we believe there is considerable reason for optimism around emerging markets, driven by global rebalancing and by the long-term urbanisation trend, which is spurring dramatic improvements in productivity and consumption. jpmorgan.com/institutional

Author Richard Titherington, Managing Director, is the Chief Investment Officer and Head of the Emerging Markets Equity Team. An employee since 1986, Richard transferred to the Pacific Regional Group in 1994. He was appointed as a managing director in April 21 and appointed head of the global emerging markets business in December 21. Prior to 1994 Richard was a US and international pension fund manager, working in the UK until he transferred to Hong Kong in 1992. Before joining the firm, Richard spent two years as an analyst with UKPI in London. Richard obtained an M.A. in politics, philosophy and economics from Oxford University. J.P. Morgan Asset Management 7

Emerging markets FOR INSTITUTIONAL USE ONLY. NOT FOR PUBLIC DISTRIBUTION. This material is intended to report solely on the investment strategies and opportunities identified by JPMorgan Asset Management. Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan Asset Management and/or its affiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors; if you have any doubts you should consult your JPMorgan Asset Management Client Adviser, Broker or Portfolio Manager. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. You should consult your tax or legal adviser about the issues discussed herein. The investments discussed may fluctuate in price or value. Investors may get back less than they invested. Changes in rates of exchange may have an adverse effect on the value, price or income of investments. The risk of investing in foreign countries is 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. 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. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. 21 JPMorgan Chase & Co. INSIGHTS_Emerging Market: Understanding the risks jpmorgan.com/institutional