Between recoupling and Fed policy normalization

INVESTMENT
INVESTMENT
INSIGHTS
INSIGHTS
EMERGING
STRATEGY
PORT FOLIOMARKETS
DISCUSSION
Between recoupling and
Fed policy normalization
October 2014
OUTLOOK &
OPPORTUNITIES
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IN BRIEF
• Economic growth in emerging markets (EMs) is starting to recouple with growth in
developed markets (DMs). The nascent rebound in growth is most visible in EM
countries that are manufacturing-intensive exporters, where we are seeing an
improvement in purchasing managers’ indexes.
• Legacy effects of recent quantitative easing (QE) should help EM equities as
growth improves. For one, QE expanded valuation multiples in countries with
earnings momentum, namely DMs. Since the lack of earnings momentum in EM
economies prevented EM equities from participating in that expansion, EM
equities should benefit from a “catch up” multiple expansion when earnings
growth eventually picks up. Another legacy of decoupling is that economic slack is
evident across most of the EMs, suggesting that there is little risk that recoupling
will create immediate inflationary pressures.
• EM equities and debt have historically struggled in an environment of rising interest
rates and a strengthening dollar. The impact of those headwinds, however, should
be mitigated. For one, within EM equities, commodities—which generally struggle
the most when the dollar is rallying—now make up a smaller proportion of EM
equity indexes. Within fixed income, some EM countries will be more vulnerable to a
rate increase and a higher dollar, while others will be well protected.
• EM valuations remain attractive on an absolute basis, but have moved toward the
upper portion of their more recent trading range, making further outperformance
more dependent on a stabilization in earnings estimates.
AUTHORS
George Iwanicki
Emerging Markets Macro Strategist
Global Emerging Markets Equity Team
In recent years, economic growth in EMs “decoupled”
from that of DMs. In other words, EM growth decelerated
even as DM growth improved. Such decoupling periods
are usually brief given the economic integration between
EMs and DMs.
Signs of selective recoupling
Joanne Baxter
Portfolio Manager
Emerging Markets Debt Team
Today, there are signs that the current decoupling period has reached an inflection point—
an indication that EM growth could soon accelerate. Exhibit 1 (next page), which shows
the correlation of forecast revisions for EMs and DMs, are typically positive as these economies usually move in the same direction. As we discussed this summer, there are
“decoupling” episodes when revisions move in opposite directions, but those episodes (as
indicated by the arrows) tend to be infrequent and short lived. Today, those correlations
are negative. At this point, one of two things can happen: 1) EMs can start accelerating
and catching up to the stronger growth in DMs; or 2) DM growth can start to slow.
INVESTMENT
INSIGHTS
PORTFOLIOrecoupling
DISCUSSION:
Title
Copy
Here normalization
Between
and
Fed
policy
The current EM/DM decoupling period is near an inflection point
EXHIBIT 1: EM/DM SPREAD VS. CORRELATION OF FORECAST REVISIONS (EMs VS. DMS)
6
EM/DM spread
Revision correlation: EM vs. DM
5
4
3
2
1
0
-1
Jul-14
Jul-13
Jan-14
Jul-12
Jan-13
Jul-11
Jan-12
Jul-10
Jan-11
Jul-09
Jan-10
Jul-08
Jan-09
Jul-07
Jan-08
Jul-06
Jan-07
Jul-05
Jan-06
Jul-04
Jan-05
Jul-03
Jan-04
Jul-02
Jan-03
Jul-01
Jan-02
Jul-00
Jan-01
Jul-99
Jan-00
Jul-98
Jan-99
Jul-97
Jan-98
Jul-96
Jan-97
Jul-95
Jan-96
Jul-94
Jan-95
Jul-93
Jan-94
Jan-93
-2
Source: J.P. Morgan, Consensus Economics; data as of August 30, 2014. Shown for illustrative purposes only. Past performance is no guarantee of future results.
Arrows indicate periods when economists’ EM and DM forecast revisions are moving in opposite directions.
The good news is that the manufacturing data in EM economies is showing signs of improvement due to the “selective
recoupling” discussed earlier this year. Exhibit 2 provides a
visual snapshot of global manufacturing momentum by looking at the various countries’ manufacturing PMIs in a heatmap format (for PMIs, a level of 50 or higher marks expansion, and lower than 50 indicates contraction). As the chart
shows, EM countries whose share of exports is predominantly
manufactured goods, such as Taiwan, Korea and Mexico, are
showing signs of improvements, while other EMs, and parts of
the eurozone, such as Italy and France, are still showing signs
of weakness. The stronger macroeconomic data are starting to
feed through to economists’ top-down forecasts for gross
domestic product (GDP), which look to be stabilizing. Analysts’
earnings expectations for EMs, however, have yet to break out
of the negative range they have been stuck in since 2011,
though analysts aren’t cutting their estimates as aggressively,
or as broadly, as they did during previous market lows.
Monitoring “selective recoupling” in EMs: PMI trajectories improving in EM, alongside mixed signals in DMs
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
50.1
54.0
50.4
50.6
46.1
46.0
44.6
46.7
44.6
41.4
51.4
44.3
45.0
51.5
50.7
50.1
50.6
54.7
51.1
57.1
50.0
51.4
55.8
50.5
51.0
47.9
49.8
42.9
47.8
46.1
41.7
50.3
40.2
47.7
52.3
49.7
49.9
51.5
53.2
53.2
55.0
52.0
50.8
54.3
51.7
48.1
47.9
50.3
43.9
45.8
46.8
43.0
51.5
45.6
48.5
50.4
50.5
50.9
50.2
54.2
52.5
53.4
52.0
51.0
54.6
49.3
50.2
46.8
49.0
44.0
44.5
44.2
42.1
48.6
44.4
50.4
51.6
51.3
52.0
51.2
52.0
51.8
52.2
50.8
50.2
52.1
50.1
50.6
46.7
48.1
44.4
45.5
44.7
45.0
48.0
36.7
51.1
50.4
51.7
52.6
50.7
51.0
50.8
51.7
50.6
50.4
52.3
53.2
52.2
48.3
49.4
46.4
47.3
48.1
45.3
49.7
43.8
51.5
49.2
51.6
51.1
47.1
50.1
50.4
51.8
50.4
50.4
51.9
52.4
52.8
48.8
48.6
48.4
49.1
50.0
45.4
50.3
49.6
52.3
48.2
51.0
49.4
49.5
50.3
50.4
51.3
51.7
50.6
53.7
52.0
55.0
50.3
50.7
49.7
50.4
49.8
47.0
51.0
42.0
50.7
47.7
50.7
47.2
48.6
50.1
48.5
49.7
49.2
51.5
53.1
52.1
57.4
51.4
51.8
49.7
51.3
51.1
48.7
52.0
46.4
52.2
50.1
48.5
47.5
50.0
48.5
49.4
50.8
49.4
51.6
52.8
54.2
56.4
51.1
51.1
49.8
50.8
50.7
47.5
52.7
51.7
52.5
50.2
50.2
49.7
52.0
49.6
49.9
50.0
49.4
51.9
51.8
55.6
56.1
51.3
51.7
49.1
50.7
50.9
47.3
54.9
53.2
54.2
50.9
50.9
50.2
53.0
49.6
50.2
50.2
51.8
52.9
54.7
55.3
57.9
51.6
52.7
48.4
51.4
48.6
49.2
52.4
47.7
55.1
50.8
50.3
50.4
53.4
51.3
49.7
51.9
49.4
52.9
55.0
53.5
57.0
52.7
54.3
47.0
53.3
50.8
49.6
53.5
47.6
55.2
50.5
50.9
50.8
55.2
50.7
50.5
52.6
48.8
53.0
53.7
51.7
56.5
54.0
56.5
49.3
53.1
52.2
51.2
52.8
46.7
56.6
49.5
51.0
50.9
55.5
51.4
50.8
54.0
48.0
53.2
57.1
52.9
56.4
53.2
54.8
49.7
52.3
52.5
51.3
52.9
48.6
55.5
48.5
50.5
49.8
54.7
52.5
50.4
52.0
48.5
52.4
55.5
53.3
55.6
53.0
53.7
52.1
52.4
52.8
49.7
55.5
47.9
53.9
48.0
50.1
50.4
52.7
51.3
50.6
51.7
48.3
51.9
55.4
52.9
57.2
53.4
54.1
51.2
54.0
52.7
51.1
56.1
44.8
49.4
48.1
51.1
50.2
52.3
51.3
49.3
51.8
48.5
52.2
56.4
52.2
56.8
52.2
52.3
49.6
53.2
52.9
51.0
55.0
49.2
49.9
49.4
52.4
49.5
52.4
51.4
48.8
51.9
48.9
52.6
57.3
53.5
57.2
51.8
52.0
48.2
52.6
54.6
49.4
55.3
48.9
51.5
50.7
52.7
48.4
54.0
51.5
48.7
51.8
49.1
52.4 52.5
55.8 57.9
54.3 54.8
54.7 52.2
51.8 50.7
52.4 51.4
47.8 46.9
51.9 49.8
53.9 52.8
48.7 50.1
55.4 57.3
50.7 47.3
50.5 52.2
51.7 50.2
52.7 49.5
49.3 50.3
55.8 56.1
53.0 52.4
49.1 50.2
51.5 52.1
51.0 51.0
Source: Guide to the Markets—U.S., J.P. Morgan Asset Management, Markit; data as of September 2014. Shown for illustrative purposes only.
Note: Heat-map colors are based on a PMI relative to the 50 level, which indicates acceleration or deceleration of the sector for the time period shown.
2 | Between recoupling and Fed policy normalization
Sep-14
Jan-13
49.7
52.8
50.4
48.0
46.2
46.8
44.5
45.1
45.3
41.8
52.4
44.3
46.5
50.5
51.5
48.2
47.4
53.7
52.2
55.6
52.2
Aug-14
Dec-12
48.9
51.0
51.4
47.7
45.4
46.0
43.7
45.5
43.5
41.0
52.1
42.8
46.9
49.5
51.9
47.4
47.8
52.9
50.2
55.5
52.9
Jul-14
Nov-12
Global
U.S.
Canada
UK
Euro Area
Germany
France
Italy
Spain
Greece
Ireland
Australia
Japan
China
Indonesia
Korea
Taiwan
India
Brazil
Mexico
Russia
Oct-12
EXHIBIT 2: GLOBAL PMIs INDEX FOR MANUFACTURING
52.2
57.5
53.5
51.6
50.3
49.9
48.8
50.7
52.6
48.4
55.7
46.5
51.7
50.2
50.7
48.8
53.3
51.0
49.3
52.6
50.4
Legacy impacts
QE led to multiples expansion in DMs, but not in EMs
15
13
Ratio
12
11
10
9
MSCI U.S.
Developed markets (ex-U.S.)
MSCI EM
2008
2009
2010
2011
2012
2013
Consumer
30
Financials
25
20
15
10
5
0
The second concern in a rising-rate environment is that a
sharp rise in long-term yields could hurt equity markets. But
based on the correlations of equity returns with long-term
rates, neither EM nor DM equities have struggled historically
when long-term yields have increased from low levels. When
yields are at levels high enough to make the Fed concerned
about inflationary threats, a rise in Treasury yields becomes
more problematic for EM (and DM) performance.
14
6
2007
Comm*
35
Source: J.P. Morgan, MSCI; data as of August 2014. Shown for illustrative
purposes only.
16
7
40
*Comm = energy and materials
EXHIBIT 3: PROSPECTIVE PRICE-TO-EARNINGS RATIOS
8
EXHIBIT 4: SECTOR WEIGHTS IN EMs
Dec-93
Aug-94
Apr-95
Dec-95
Aug-96
Apr-97
Dec-97
Aug-98
Apr-99
Dec-99
Aug-00
Apr-01
Dec-01
Aug-02
Apr-03
Dec-03
Aug-04
Apr-05
Dec-05
Aug-06
Apr-07
Dec-07
Aug-08
Apr-09
Dec-09
Aug-10
Apr-11
Dec-11
Aug-12
Apr-13
Dec-13
Aug-14
One of the legacy effects of central banks’ QE is that valuation
multiples expanded in countries, such as the U.S., where earnings momentum has been positive. But, because EMs stagnated, those markets did not experience the same degree of multiples expansion that QE has effectively driven in DMs. As
earnings start to accelerate again in EMs, equity multiples
expansion should follow (Exhibit 3). Another legacy of decoupling is that economic slack is evident across many EMs, suggesting that there is little risk that recoupling will create
immediate inflationary pressure within the asset class.
Reduced commodity share in EM market cap should limit U.S.
headwinds for EM equities
2014
2015
Source: Minack Advisors; data as of July 2014. Based on consensus earningsper-share forecasts. Shown for illustrative purposes only.
Should EM investors fear the Fed?
We are less concerned about the direct effects of normalizing
U.S. policy rates but are focused on two avenues that could
impact EM equities. First, EM equities have historically struggled in an environment of rising interest rates and a strengthening dollar, particularly since FX regimes in EMs became predominantly floating (i.e., post-1998). Hence, if Fed policy normalization extends the USD rally of the past few years, EM
equities could have trouble outperforming DMs. There is one
factor, however, that should mitigate the strength of that
headwind—the shrinking share of EM equity market cap that
tends to struggle when the dollar is rallying, namely commodities. Today, the commodity share of EM market cap—which had
spiked to 35% in early 2008—has fallen to below 20%, which
should limit the effect of a stronger dollar on the asset class
(Exhibit 4).
For EM debt, a sharp rise in U.S. long-term yields and a continued rise in the U.S. dollar would similarly provide the biggest
challenges, notwithstanding the longer-term competitiveness
benefits of the latter. Nonetheless, DM policies remain, in
aggregate, supportive as both the BoJ and ECB pursue quantitative easing of their own. EM’s structural vulnerabilities are
well-known and an environment of slowly improving U.S.
growth should broadly benefit EM economies. Of the so-called
“Fragile Five” EMs, those countries that have reduced their
current account deficits and their reliance on international
funding will be better positioned to take advantage of the
recoupling theme.
Exhibit 5 (next page) demonstrates the long-term adjustment
process that helps identify which countries stand to win or lose
from an improvement in global growth. That process begins
with a reduction in the current account deficit, followed by stabilization of a country’s currencies through central bank policies, and then the implementation of structural reform. As the
chart illustrates, countries such as India and Mexico, which are
in the stage of implementing reforms, are more likely to benefit from the recoupling than other countries, such as Brazil,
which are still struggling with a large current account deficit.
J.P. Morgan Asset Management | 3
INVESTMENT
INSIGHTS
PORTFOLIOrecoupling
DISCUSSION:
Title
Copy
Here normalization
Between
and
Fed
policy
From “Fragile Five” to economic reforms: Which EM countries will
benefit from recoupling?
EXHIBIT 5: AN ILLUSTRATION OF A COUNTRY’S EVOLUTION TO
ECONOMIC STABILITY
Mexico
India
Reform and
growth
Indonesia
Turkey
Brazil
Central bank
policy anchor
Countries able to
take advantage
of the recoupling theme
IMF Program
Current account deficit
• Currency devaluation
• Inflation
Pakistan
Countries unable to
take advantage
of the recoupling theme
Source: J.P. Morgan. For illustrative purposes only.
Reasonably attractive valuations,
actionable ideas
Within EM equities, Eastern Europe (which is benefiting from
improving eurozone growth) and Korea (which is a manufacturing-intensive exporter that is benefiting from the selective
recoupling story) show the best combination of value and
momentum. Despite geopolitical uncertainties, Russia remains
very cheap, and we have begun to take profits in China after
that country’s stretch of outperformance. Within sectors, we
remain cautious on materials, given lingering secular pressures,
as well as our view that this sector is the most vulnerable to a
monetary-policy-induced rally in the U.S. dollar. Meanwhile, EM
equity valuations remain reasonably attractive in absolute
terms, but have moved toward the upper portion of their more
recent trading bands, making further outperformance more
dependent on a stabilization in earnings estimates.
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. Investments in emerging markets
could lead to more volatility. As mentioned above, the normal
risks of investing in foreign countries are 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.
Diversification does not guarantee investment returns and
does not eliminate the risk of loss.
Past performance is not indicative of future results.
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject
to change without notice. We believe the information provided here is reliable. These views and strategies described may not be suitable for all investors.
References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as,
recommendations. Past performance is no guarantee of future results. Please note that investments in foreign markets are subject to special currency, political, and
economic risks.
JPMorgan Distribution Services, Inc., member of FINRA/SIPC.
J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co.
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© 2014 JPMorgan Chase & Co. | II_EMS_Normalizing

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