Emerging Markets Quarterly Outlook

Overview

World Economy: Still a Multi-Speed Recovery

The world economy is likely to be marked by a multi-speed recovery in 2013, not dissimilar from 2012. A combination of 1% growth in developed markets and 5% growth in emerging markets is likely to result in a 3% global aggregate in 2013. Growth in emerging markets will likely again be led by a 6% gain in Asia, with Consensus expectations at 3.8% and 3.7% for Latin America and Emerging Europe respectively. However, despite the highest regional growth rate, Asia is the region with the lowest expected inflation rate (see Table 2).

The key tectonic shift remains the private sector deleveraging and balance sheet repair process taking place in developed markets. While this is being compensated for by a public sector that continues to leverage up, it is proceeding at a declining rate as fiscal austerity is being imposed. By contrast, the private sector in emerging markets is witnessing an ongoing expansion of credit, partly the counterpart of strong capital inflows. As a result, many emerging markets remain in monetary easing mode and increasingly resort to macroprudential measures in order to deter excessive capital inflows and limit exchange rate appreciation.

Markets: Fuelled by Liquidity

The 'Great Reflation', aka rising tide that lifted all boats, is unlikely to be as dominant a theme this year as it was in 2012. Indeed, 2012 was a good year for emerging market equities as the MSCI Emerging Markets USD return of 15.1% outperformed the S&P500's 13.2%. Strong returns were recorded almost uniformly across all asset classes, with the exception of commodities (see Table 1). In 2013, this effect is likely to be much less pronounced as: 1) soaring asset prices have become increasingly divorced from lacklustre economic fundamentals, 2) the impact of ongoing quantitative and credit easing is beginning to exhibit diminishing returns and 3) policymakers are increasingly shifting focus from the benefits to the costs of their reflationary policies. As such, this likely heralds the end of indiscriminate risk-on/risk-off periods.

Consequently, local, idiosyncratic factors are likely to become increasingly important market drivers, requiring more careful differentiation on the one hand, but allowing greater alpha generation on the other. During Q1, asset classes already exhibited a much greater degree of variation, both in terms of securities and in terms of regions. With the S&P500 racing ahead of other markets (the Nikkei excepted), the obvious question is whether it is entering bubble territory. It is indeed true that the post-2009 stock market rally has outpaced all other recoveries during the past 40 years other than the one starting in 1982. But unlike these recoveries, the current rally has been associated with a sharp rise in earnings, resulting in a P/E ratio that is the lowest in comparison to other rallies (with the exception of the very languid 2001 recovery).

In recognition of these circumstances, our new country allocation reflects both a more differentiated and a more cautious stance. Rising concerns over the sustainability of high growth in China, stretched valuations and jitters about a premature end to US QE drive our more defensive posture. In particular, this has led us to reduce the scale of deviation from benchmark and raise the number of allocations to neutral.

To achieve greater country differentiation, our selection reflects the following principles: 1) reward countries with a solid reform agenda and penalize those that stall or regress, 2) favor countries with strong external balances and avoid countries with structural imbalances and 3) be sensitive to the funding composition of countries with external shortfalls.

In sum, we favor Mexico and the Philippines on the basis of their strong reform agenda and shifted India and Russia to neutral due to their more uncertain outlook. India also suffers from chronic current account deficits as does Indonesia, where we have scaled back our overweight allocation. However, we have moved Brazil from neutral to overweight and South Korea from underweight to neutral as their negative developments have been fully priced in and their valuations are now attractive by comparison.

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