“The longer central bank liquidity is relied on to hold things together, the more excesses and distortions are being accumulated in the financial system” Institute of International Finance, in its latest analysis
That warning by the IIF is timely, because many of those excesses are building in the emerging markets, as a Fed exit looms in 2014/15. It’s a long time since the USD and global equity markets have been positively correlated for months on end, and comes as a surprise to gold bulls (de facto making a short dollar bet). As discussed in previous notes, a secular uptrend for the dollar is looming on sustained narrowing of the energy current account, shrinking fiscal deficit, early Fed exit etc. That scenario, as much as deteriorating external balances and trend GDP growth from India to Brazil, is a headwind for GEM relative performance, while the flood of Fed easy money is proving toxic for the macro discipline which was a key support for the EM debt re-rating, falling funding cost virtuous circle of the past decade. It’s sobering to recall that the two strong uptrend periods for the USD in 1978-85 and 1992-2001 helped precipitate the Latin American and Asian debt crises respectively. In Asia, the consequences of trying to keep currencies pegged to the rising dollar were destabilizing via the banking system. Now, despite still strong official reserves, rising consumer debt and deteriorating balance of payments trends and ever soaring property prices underline the risks. An even trickier problem for EM policymakers will be coping with a sustained portfolio flow reversal as US yields rise into 2014, with negative implications for local asset prices, and notably property.
EM equities have experienced negative returns so far this year in contrast with gains in developed markets. This reflects a combination of worsening EPS and currency trends versus DM, net long global portfolio positioning and deteriorating external balances alongside a steady rise in private credit to GDP ratios and a spate of looming elections driving political uncertainty. Furthermore, we have seen accelerating local retail selling offsetting strong DM fund inflows; China, India and Brazil are down YTD even though the MSCI BRIC index is valued at 9.2x 12-month earnings estimates, or about a 30% discount to the All-Country measure, while the overall DM premium to GEM in terms of forward PER is at its highest in at least five years.
The AXJ index is slightly down this year versus high single digits gains across DM, but most ASEAN markets have continued their stunning domestic consumption driven re-rating, with the Philippines, Indonesia and Thailand again leading the way within AXJ, up respectively 16%, 11% and 9% YTD in USD terms. Asia’s most cyclical markets – China, South Korea, Taiwan and Malaysia – have been among the worst performers in Asia, with the slumping JPY a key factor behind Korean and Taiwanese weakness, while Malaysia is seeing a political risk premium ahead of elections and after the bizarre and pretty incompetently handled mini-invasion of Sabah by Filipino militants.
The key issue is one I’ve long highlighted, which is the rapid rise in GEM credit (and real estate prices) as a function of ultra-easy DM policy; the BIS has just published a new database looking at this key topic. In a previous analysis, the BIS warned that: ‘Measures of debt service cost suggest that high EM debt levels could be a problem. The fraction of GDP that households and firms in Brazil, China, India and Turkey are allocating to debt service stands at its highest level since the late 1990s, or close to it.’ As the US has deleveraged, we’ve seen emerging economies leverage up; on a 3 year rolling basis we’ve seen compound credit growth, we’ve seen high single to mid double digit growth from Indonesia and Brazil to Turkey and Thailand, with China of course in a credit league of its own closer to 20%, as its overall leverage ratio has reached 200% of GDP.
A rising credit ratio may in principle represent “financial deepening” as the banking system captures household savings and reallocates then into productive investment, but can easily spill over into excessive consumer spending and asset speculation, boosting the value of collateral and thus driving further credit acceleration. The benign impact of rising exchange rates and imports plugging the gap between expanding domestic demand and a limited supply response has reversed from India to Indonesia, driving widening current account deficits and sliding currencies. In emerging Asia, credit ratios have risen further and faster than they did before the 1990s crisis, but bank loans haven’t outstripped deposits this time while domestic investment has generally matched domestic saving. In other words, a sudden withdrawal of foreign capital would be less destructive and Asia’s surplus countries should have enough resources to replace it, although the process would not be smooth. However, we’re at the point when the credit surge of recent years is beginning to show up in inflation pressures, and ‘stagflation’ is becoming the broad trend, with falling trend growth and sticky supply side inflation.
We’re entering an era where GEM country risk will become much more dispersed, as the commodity terms of trade boost of recent years has been squandered in Indonesia, Brazil etc. on overconsumption, and countries like South Africa face potential rating downgrades. Within Asia, Indonesia is the economy to watch; despite surging minimum wages, labour unrest is becoming commonplace while inflation rose 5.3% y/y in February, led by food prices (and prime office rents are up 70-80% y/y in Jakarta). Back in the 29th January note on Indonesia, I concluded that: ‘The government has been spending more on energy subsidies than on infrastructure or social welfare. Keeping fuel prices artificially low has boosted domestic demand, which, combined with record annual average Brent prices in 2012 and the weak rupiah, has inflated the oil product import bill and widened the current account deficit. So far investors have been indulgent in funding that deficit, but in the absence of subsidy reform that may well change by H2 if the central bank is perceived to fall behind the inflation curve…’
That danger remains very real; core inflation so far remains stable at 4.3%, but rising wages and higher electricity tariffs (expected to increase 15% over the year) will drive cost-push pressures, and both inflation and the current account deficit will be exacerbated by on-going IDR weakness. At this stage, inflation could average well above 5% for the year, and with the economy expanding around its long-term trend, fuel subsidy reforms now pushed back to post election and a rather controversial new BI governor likely, foreign investor enthusiasm for Indonesian bonds will be tested. This year, Indonesia expects to consume between 12-14bn gallons of subsidized fuel, compared with 11bn gallons in 2012. The subsidy bill cost $22bn last year and contributed to the $24bn current account deficit via oil product imports. Even if we don’t see a major reversal in portfolio flows, a tightening cycle taking rates above 6% within a year looks a good bet. I’ve been overweight Indonesian equities in the quarterly AXJ model portfolio since late 2011, but will be removing that bet. Elsewhere within Asia, factors ranging from domestic politics to the path of the JPY rather than earnings will be pivotal in driving re-rating potential.
The electoral exit of the long ruling National Front party in Malaysia would represent a potential buying opportunity as Malaysia desperately needs structural change to widen its tax base and reduce the chronic fiscal deficit, and tackle the dire impact on trend productivity of pro-Malay economic policies. The Philippines now trades at an 80% premium to the MSCI Asia ex-Japan on a forward PER basis. Indonesian stocks are priced at a near 30% premium and while Thailand overall still trades at only a 10% premium, its consumer stocks trade at almost 20x on average.
South Korean exports on a combined January and February basis to smooth out the impact of the Chinese New Year grew 0.6% y/y, marginally better than the 0.4% decline recorded in Q4. Similarly, Taiwanese exports increased 2.1% y/y in the two months, compared with the 2.5% rise recorded in Q4. Investors are betting that both countries will lose significant market share to Japan in autos and consumer electronics, but those fears are probably exaggerated given Japan’s loss of underlying competitiveness in many sectors and offshoring to the US and China of manufacturing by Korean and Japanese manufacturers. Meantime, the dramatic recent yen move is likely to consolidate in coming months. Overall, country, sector and only then stock selection matter more than ever within a GEM portfolio as the ‘rising tide lifting all boats’ scenario of the past decade ebbs and relative macro performance begins to diverge widely and with it local market performance. The upside is that it should provide an opportunity for active strategies to outperform passive broad GEM index led ones…