Cyclical Bet Remains Attractive…

‘I would overweight MSCI China in a GEM portfolio, and particularly H-shares. Deep cyclicals in China remain favoured on growing evidence of a fixed investment recovery. That backdrop would force side-lined investors, as yet unconvinced by the sustainability of the Q1 rally, to reallocate. From a technically driven repositioning rally, the next leg globally would see a shift to a positive net earnings revision trend and multiple expansion.’ Weekly Insight, 12th April

That unfashionable cyclical bet has paid off but while the RMB proxy short via H-shares (particularly banks) has been much reduced over the summer, global funds are still underweight offshore China by almost 300bps, near a decade high. A key theme is that you have to ‘reality check’ economic data points more than ever in the current environment of rapid structural change and low amplitude trend growth that leaves Japan and Europe repeatedly on the cusp of apparent recession.

That’s even truer in a global economy where incremental growth is digitizing and the global economy is becoming ‘lighter’; it is significant that services added more to global trade growth than manufacturing last year for the first time ever. The standard macro data points used by consensus analysis are increasingly misleading and as Silicon Valley giants start employing large teams of PhD economists, it seems clear that the web giants now have a uniquely powerful perspective on economic data flow from ‘live’ consumer prices to merchandise inventory levels. Investors will likely be buying proprietary data packages from Amazon, Google etc. within a few years that are far more powerful than anything Wall Street can offer (the ‘billion prices’ project at MIT is an early view of the potential of big data and real-time online transaction networks).

There are now hundreds of data releases every week that didn’t even exist a decade ago, with dozens of bank economists commenting on almost every one, but little of that activity is of any practical help in generating actionable insight.  Back in Q1, scanning the outlook statements from key global cyclicals would have reassured any investor paralyzed by ‘sell everything’ headlines from excitable IB strategists. The granular corporate evidence has been more reliable than economist extrapolations all year and remains broadly encouraging.

As for China, Komatsu has seen a 10% rise in excavator utilization hours, the seventh consecutive month of growth. I spoke to a client recently who had attended a major tech conference in Taiwan and thought confidence among companies he met was at levels he had rarely seen over the past decade. To do this job, you need to have an analytical telescope and microscope and most importantly know when to switch between them.

Growth, inflation and earnings expectations are all turning modestly but decisively higher. That  more than central bank actions will generate volatility near-term as complacent bond investors front running central bank buying reposition for a less pessimistic economic outlook. It’s also clear that even central bankers are accepting that monetary policy is at the limits of both creativity and effectiveness, and as Harvard’s Larry Summers has recently argued, fiscal policy focused on infrastructure spending now looks a more rational policy response. By boosting the velocity of money in the real economy, that would be inherently more inflationary medium term than endless monetary stimulus that ex asset inflation effects simply gets trapped in bank excess reserves.

While recent US data has been mixed in housing etc., historically low level of combined debt service and energy outlays at just 14% of disposable income are offsetting soft wage growth, while balance sheets and net worth continue to improve. We have seen some slowing in growth in corporate bank borrowing as more companies tap booming credit markets, but the slowing in corporate bank loans has been offset by an acceleration in real estate and consumer lending.

An interesting lead-indicator granular data point is the Chemical Activity Barometer, published monthly by the American Chemistry Council, up 3.9% y/y recently and suggesting that US industrial production will accelerate into early 2017 now that the energy/inventory adjustment drags are abating. The biggest surprise to a consensus still suffering ‘macro hypochondria’ would be a synchronised cyclical growth rebound over the next 3-6mths and our overweight cyclical risk asset strategy since Q1 remains in place.

Chronic Air Pollution Drives China toward Synthetic Gas and Solar

4th November 2013

Whenever I pass through HK airport, it strikes me that those grim glass boxes in the terminal crammed with smokers getting a pre-flight fix would be a good spot to acclimatize for a trip to Beijing; PM2.5 readings of 400-500, as seen in the Chinese city of Harbin recently (and Beijing in January), are roughly equivalent to those smoking boxes and levels at which schools have to be shut and strenuous outdoor activity is dangerous. Heavy smog afflicted Beijing once again during the recent Golden Week holiday, causing emergency airport and highway shutdowns, and this winter is likely to see the worst urban pollution yet and more importantly from a political perspective, far greater public awareness of the health risks. Policymakers are grappling for a solution, but the only real ones are to replace coal with cleaner energy sources like gas, nuclear and alternatives as well as suppressing energy demand growth via market pricing/’polluter pays’ green taxes.

This summer, the Brazilian government announced that it was launching an energy plan that looks to increase the role of renewable energy sources significantly over the next seven years. Development of the bioenergy, wind, and solar sectors were key points in the plan, with the goal to generate nearly 70% of its electricity from renewable energy sources by the year 2020, up from 55% today and ultimately China will have to make a similarly radical shift, in particular away from burning some of the world’s dirtiest coal. Renewables, natural gas and nuclear are likely to double as a share of total energy output from last year’s 13% to at least 26% by 2020, with wind and solar rising to 3-4% and gas (synthetic and shale) more than doubling its share to 12%.

In September, we reached a seminal moment in energy markets as China surpassed the US as the world’s largest consumer of foreign oil, importing 6.3m barrels per day. China’s growth in import demand can largely be attributed to its domestic oil demand growth, driven by gasoline demand due to the near-exponential increase in personal auto vehicles and diesel demand related to commercial trucking as China’s economy grows. By 2020 China will be second only to the US for the number of vehicles in circulation and oil imports will by then likely exceed 9m bpd. The per capita consumption differential remains vast, with an average Chinese citizen consuming a mere 2.9 barrels of oil per year or 14% or US per capita levels, and so far very low annual mileage Chinese drivers just beginning to explore the vast network of highways built in the recent infrastructure boom, albeit many of them expensive toll roads.

The core issues with pollution in China are a very wasteful energy model (e.g. fleets of trucks carry coal to power stations, sprawling cities with poor mass transit networks) and the pricing model for both energy and the pollution externalities from its use. In the near term, interim technologies like coal blending (to optimise burn efficiency by mixing different grades) and flue gas capture are gaining traction, but a wholesale move to cleaner energy is the only long-interim solution. As far back as 2007, the World Bank concluded that air and water pollution costs amounted to almost 6% of Chinese GDP; energy use per unit of GDP is vastly higher than other Asian countries like S. Korea and more than twice US levels.

Political Populism Means Thailand Continues to Underachieve…

9th October 2013

Thailand is probably the most disappointing emerging economy in Asia and possibly across GEM, in terms of economic and political progress over the past decade. While unemployment is practically non-existent, productivity has stagnated. Graduates from local universities are generally only fit for (and satisfied with) low skill call centre/retail work, while factories face a labour shortage as farm workers enjoying the subsidy bonanza stay in the rice paddies. Infrastructure investment has been a paltry 1.5% of GDP and trend GDP growth has stalled at around 4% over the past decade, while private sector credit to GDP has risen to 150%, after a consumer lending boom. Overall, the country’s competitiveness has been slipping versus regional peers; in the World Economic Forum’s latest competitiveness rankings, Thailand ranks 74st globally in health and primary education provision and 85th in the quality of its institutions, 50 places lower than Malaysia and significantly weaker even than Indonesia. The seven year build out of infrastructure to integrate the wider sub-region around Thailand as a logistics and finance hub will be critical to boosting the medium-term growth trend toward 5%.

The long-term challenges facing Thailand include a fast ageing population, out-dated infrastructure/ industrial plant and a weak education system at all levels. To boost trend growth to mid-single digits, Thailand will have to bring significantly more workers into the formal economy, boost productivity enhancing investment and reduce glaring income inequalities that have undermined political cohesion. For investors, a sustained period of political stability is important in tackling these structural issues, although the current subsidy program to boost rural incomes, while reducing extreme income inequality, is having unintended consequences.

Indeed, the central bank governor warned recently that the populist subsidies “add to micro-level risks by making households addicted to ‘easy’ money, while also adding to macro-level risks by stretching fiscal resources without enhancing competitiveness in any meaningful way.” Corn famers for instance have been protesting to force the government to extend the current subsidy program due to end in December for another four months. The country has seen a range of other special interest groups from rubber to corn farmers demand hand-outs of their own. The subsidies are adding to rising public spending, led by the 700bn baht, or $22bn to support rice farmers since the 2011 election. Thailand’s rice subsidies, which bought up rice from farmers at double the market price, also have knocked the country from its position as the world’s largest exporter of the grain as huge domestic inventories build, as cheaper rice from India and Vietnam took market share.

Thailand’s finance ministry recently cut its growth forecast for this year to 3.7% from 4.5%, which still looks a bit high – growth should rebound to 4.5% next year if the delayed infrastructure program begins to be implemented. Exports account for around 60% of GDP but Thailand is trapped in low end assembly operations, without the education system or infrastructure to move up the value chain. At the same time, the government’s goal of raising living standards and consumer spending in rural areas appears to be having unintended consequences. Some farmers are using the promise of guaranteed future incomes as a basis for borrowing more money. High prices guaranteed by the government are encouraging over-investment in farming.

Tax revenues are only 18% of GDP, and a proposed corporate tax cut to compensate for higher mandated wage costs will be hard to offset elsewhere. By law, public debt must not exceed 60% of gross domestic product, from 44% currently, but is forecast by the IMF to rise to 52% by 2018. On a net debt basis and excluding the liabilities of majority government-owned state-enterprises current debt is around 21% of GDP. While those debt levels look modest, private debt is the key concern, and the public debt picture is clouded by Thailand’s population ageing faster than any other in Southeast Asia apart from Singapore, with the proportion of the population over 60 in Thailand will reach 20% by 2025 with minimal pension provision, as mortality and fertility decrease steadily. Only South Korea and China face a similar demographic challenge in the wider Asian region while net foreign investment has been trending downwards, helping to exacerbate an overall shortfall in investment, which has run at under 30% of GDP in recent years.

The 2011 election campaign focused on tackling income inequality, which has become a key regional theme. Income inequality in Thailand is more extreme than in other regional emerging economies such as Indonesia, Malaysia and the Philippines, with the wealthiest 20% of Thais earning over 14 times more than the poorest 20%, compared to 9-11 times elsewhere in the region and 5-8 times in Europe and the US. The Puea Thai party offered to guarantee a uniform daily minimum wage of 300 baht ($10) throughout the country, rising to 1,000 baht by 2020, universal medical care for under a dollar a visit, a $500 monthly starting salary for graduates and a debt moratorium focused on low earning civil servants and farmers although the most expensive promise was the rice subsidy.

Despite the robust real growth in manufacturing since 2000 (an average of over 6% annually) the share of the workforce employed in factories has stayed at about 14%, with another 3% employed in export related logistics. Increased automation and worker productivity supported higher output, but did not contribute to integrating more Thai workers into the higher value-added export sectors.   The weak employment performance of manufacturing has fed the core political problem of growing wealth concentration (one which China also now faces). The country’s income inequality is the result of many divisions including the oft cited urban-rural divide, but also one between Bangkok and the rest of the country. Less than 20% of the Thai population lives in Bangkok and along the Eastern coastal region but generate over 70% of the country’s GDP and consume the bulk of public resources such as education and healthcare. This deep rooted inequality will continue to be a source of recurrent political instability in the months and years ahead, particularly if economic growth continues to lose momentum…

Will Emerging Market Slowdown Undercut S&P Earnings?

The global portfolio stance all year has been long DM versus GEM equities on relative GDP and earnings growth momentum, but there will be a negative feedback from the current EM turmoil on S&P earnings with Indian and Brazilian growth rates having halved since 2011. The import purchasing power of about 40% of the emerging economies has declined by 10-20% in USD terms in recent months, and while the pick-up in Europe will help, the earnings headwind is clear and geographical revenue exposure should certainly inform stock selection in coming months. Almost all S&P 500 companies have now reported Q2 earnings and while 72% have reported earnings above estimates, only 53% have reported sales above estimates, well below the average of 58% recorded over the past four years.

The blended earnings growth rate for the S&P 500 for Q2 2013 is 2.1% but the surge in financials sector earnings (28% y/y) flatters the aggregate data. The blended revenue growth rate for the index for Q2 is 1.7%. In terms of preannouncements, 85 companies have issued negative EPS guidance for Q3, while 19 companies have issued positive EPS guidance. As covered below, while rental versus mortgage costs are supportive, the housing market is showing signs of slowing after a 120bps spike in mortgage rates since May; the 25% slump in house builder stocks from recent highs is telling.

So are US stocks expensive or fairly valued on long-term valuation metrics? Value, like beauty, is in the eye of the beholder and the debate rages as to which metric to use from the 10-year cyclically adjusted real price earnings ratio (CAPE) to Tobin’s q (market valuation versus replacement cost, currently historically stretched above 1x for US stocks).  Like most LT valuation measures, CAPE isn’t often useful for 3-6 month tactical allocation and emerging market investors have tended to dismiss it, since local GDP trend growth (and thus in principle EPS) has been on an accelerating LT path over the past decade. The ‘shock’ slowdown in aggregate emerging economy GDP and earnings growth over the past couple of years should serve to shake that complacency and if we rewound back to April, when I advised avoiding India and ASEAN markets, the CAPE calculation below showed Europe offering the most attractive LT expected returns and markets like Indonesia clearly overvalued. Of course, the financial sector distorts the 10-year earnings analysis for developed economies given that peak pre-crisis sector profitability won’t be achieved again in the foreseeable future, particularly in Europe, but the allocation signal remains strong.

I was making the bearish ASEAN/India call on macro risks based on clearly deteriorating external balances as much as valuations, but this approach looks useful for GEM as a ‘reality check’. The MSCI Indonesia Index has declined by 34% in USD terms from its May high, while the MSCI Malaysia Index has fallen by 16%. Stretched starting valuations colliding with very predictable macro volatility created a bloodbath for careless investors. ASEAN still doesn’t look bargain basement. Indonesia is on a 12-mth forward PER of 12x and Malaysia on 14.3x; GDP growth will slow in both, and is probably headed sub 5% in Indonesia while ROE is falling across the region. Operating profit margins in Indonesia at 18-20% are one source of comfort but Thailand (10.6x) alongside the Philippines look the most attractive bottom fishing opportunities for those brave enough to move underweight amid the consensus euphoria back in Q1. I’d retain an overweight on China (8.5x) and Korea (8.2x) given their late cyclical global exposure and FX resilience.

India in Eye of GEM Currency Storm…

27th August 2013

Does history repeat itself, as if we learn nothing from one crisis to another?”

Duvvuri Subbarao, outgoing head of the Reserve Bank of India, speaking recently

Or rather another 1991 in India’s case. It’s remarkable how complacent GEM bond and equity investors have been regarding deteriorating external balances, a key factor which I’ve highlighted repeatedly over the past year as a driver of portfolio allocations. Korea or China might have had relentlessly negative earnings momentum, but no risk of a destabilizing margin call from global markets. We saw endless sound bites in recent years about how much stronger GEM solvency and fiscal dynamics were versus developed world, justifying the dramatic re-rating of EM debt. In fact, stripping out China and the Gulf oil exporters, the aggregate current account balance of emerging economies has slumped from a 2.3% of GDP surplus in 2006 to about a 0.75% deficit this year, the biggest since 1998. In recent months, that stark reality has begun to be reflected in divergent risk premia.

India has been a focus of that re-pricing; FX reserves now cover its CA deficit and short term debt (by residual maturity) by just over 100%, down from 400% in 2005. Coverage of total external debt plus the CA is down to just 60%. Only South Africa and Turkey are in such a weak funding position within major GEM economies; in contrast, Brazil’s reserves are double its gross financing needs.  Indonesia is in an ever weaker coverage position and saw the most savage selloff last week, with the IDR down 6% against the USD and the JSE down almost 9%. Policymakers in both India and Indonesia are flailing around with new policy initiatives to stem the panic. However, curbing the voracious local appetite for BMW imports in Jakarta with import tax hikes isn’t going to help much, and rates have to move positive to stem the rout, implying further hikes of at least 100-150bps and GDP growth slowing to sub 5% next year. As highlighted in several notes since last December, the country was a prime candidate for a panic like this.

About $22bn in private sector debt repayments are scheduled for H2 in Indonesia; the $119bn increase in total external debt position from 2006 to 2012 included private sector external debt rising by $48bn. The debt/export ratio stands at a current 120%, reflecting weak commodity export prices. Short-term Indonesian external debt by residual maturity stood at almost 59% of FX reserves as of end July. In other words, the panic is far from irrational as GEM portfolio inflows have reversed sharply since mid-May, and the question now is whether it feeds on itself or gradually calms. There are plenty of reasons to be relatively sanguine, not least the unseemly scramble by previously bullish but as ever momentum chasing IB analysts to slash FX and equity market targets.

Private sector debt as a ratio of exports was about 50% higher in Korea in 1997 than it is in India now; while India’s fiscal deficit is much bigger than those across Asia in the 1990s crisis, high nominal GDP growth means that India’s debt/GDP ratio has been declining even as deficits have remained high to about 66% now on IMF estimates. However, the debt situation is more ominous for the private sector should rates spike/funding dry up; many Indian companies have been on a borrowing binge. Since 2007, borrowing by the country’s 10 most indebted companies has risen from $20bn to about $120bn, with much of that denominated in foreign currencies as the offshore corporate bond market has boomed. Total short-term external debt has risen from $80bn to $170bn. Private firms that owe the bulk of India’s foreign debt will be under intense solvency pressure if the rupee stays below 60 for long. This makes the balance sheets of India’s state-owned banks ever more shot to pieces; they already have bad loans equivalent to 10-12% of their loan books, but in reality above 20% adjusting for ‘restructured loans’.  That second round impact of a weak rupee is one factor complicating the RBI’s task in focusing on growth.

The rupee’s fair value, taking into account India’s relative inflation and productivity is just under 60 versus the USD and after overshooting toward 70, we should eventually see the market stabilize at around that level by early 2014. Total FDI and portfolio investments amount to over 25% of GDP and sustaining foreign investor confidence will be key in coming months. The current account should start improving to sub 4% this FY on a belated export response and weaker gold imports (and gold prices in rupee terms are also at a record). The longer-term solution to the CA deficit has to be India’s domestic manufacturing sector, and industrial exports.

Does History Risk Repeating for Indonesia?

I’ve been cautious on Indonesia since late 2012, terming the country a ‘macro accident waiting to happen’ and moving underweight local equities in late Q1, but a late 1990s style capital flight crisis looks very unlikely unless local policymakers again display remarkable incompetence. So far, despite several missteps, they have retained credibility. Back in the 11th December weekly looking at Indonesia’s generous minimum wage hikes, I noted that: In 2013, there is a growing risk that either inflation lets rip or the trade deficit turns ugly. In either case, BI would be forced to hike rates to defend the IDR. Brazil offers a cautionary tale of excessive domestic consumption growth gone horribly wrong, in the absence of structural reform and infrastructure investment, with a crashing currency as the solution.’ 

And that just about sums up the past few months; the country’s GDP growth fell to 5.8% in Q2, and with a surge in inflation to 8.6% last month, sustained IDR weakness and overall a broad stagflation trend, echoing the pattern from India to Brazil in recent years. This is partly the result of the ‘terms of trade shock’ for commodity exporters, a key macro investment theme which is the flipside of China’s new lower trend growth rate.

Rising consumer spending has been a key pillar of Indonesia’s growth acceleration in recent years, alongside burgeoning natural resource exports, but the latter has been badly affected by the slowdown in China. The impact of this slump alongside the recent 75bps BI rate hikes is beginning to damage broader confidence in the economy and will dampen growth in domestic private consumption, the crux of the bull case. The IMF has recently estimated that each percentage point fall in Chinese trend GDP growth could cut as much as half a percentage points from Indonesian growth, via the commodity export impact.

International financing costs for local corporates are rising as markets anticipate a tightening of US monetary policy reflected in 10-year sovereign yields breaking 8%, a level at which as highlighted in recent notes inflation risks are fully priced in and which has attracted opportunistic foreign buying. Import costs, notably for capital goods, have been pushed up by the rupiah’s depreciation of nearly 9% against the dollar over the past year while business leaders also fear growing political interference in the economy ahead of the presidential election next year. Both factors are capping investment growth, critical to avoid an Indian stagflation style outcome.

Private consumption is still strong, boosted by those minimum wage hikes, expanding 5.1% y/y in Q2. However, investment growth slowed to 4.7% y/y from 5.8% in Q1, accounting for most of the overall slowdown and has now fallen for four consecutive quarters in an echo of India’s structural growth slowdown/supply side inflation crisis. Base-year effects skewed investment, which slowed in y/y terms to 4.7%, but bounced 3.1% q/q seasonally adjusted following a flat quarter in Q1. Policy makers have indeed now given up on supporting the IDR, which has broken decisively through 10,000 versus the USD and saw its worst monthly performance since 2009 in July, adding to inflation upside risks.

Are there echoes of the 1997/8 backdrop in Indonesia’s current outlook? Yes, to the extent there are also echoes of that period across much of Emerging Asia, after a period of rapid credit/GDP, real estate and wage growth with record carry trade driven foreign capital inflows across the region and wider GEM starting to reverse. Global funds pulled $3.6 billion from Indonesian stocks and bonds in the three months through July, amid a general GEM rout on USD strength; globally, this has been a year for a ‘barbell’ strategy of developed and frontier equity markets, with the BRICs a horror story and ASEAN markets turning volatile, with the JSE struggling to rebound from the Q2 selloff.

Longer term, like say Mexico, Indonesia offers a compelling secular consumer income EM growth story, but while Mexico has begun radical structural reforms and an ambitious multiyear investment program under its new government and is attracting a surge in manufacturing FDI, any sustained equity re-rating seems unlikely until the commodity/China growth cycle bottoms out and we have clarity on whether post-election policy making will continue along the recent haphazard but on-going reformist path. A 15x current year forward JSE multiple looks full until at least some of the macro uncertainties clear.

What Ails Lacklustre Emerging Markets?

“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…