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2013 a Year in Global Emerging Markets - Schroders Outlook

2013 a Year in Global Emerging Markets - Schroders Outlook

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December 2012

Schroders

Outlook
2013: A year in global emerging markets
Allan Conway, Head of Emerging Market Equities, looks ahead into 2013
Despite the fact that there has been little progress in resolving the underlying structural issues in the developed economies, 2012 has been a decent year for risk assets. Both developed and emerging equity markets have delivered reasonable returns against a difficult macroeconomic background. The MSCI World Index is up 13.7% year to date (as at 30 November) and the MSCI Emerging Markets Index is up 12.7% (both in US dollar terms). Over the last three months however, emerging returns have been stronger with the MSCI Emerging Markets Index up 6.7% versus the MSCI World Index which is up 3.4%.
This is a good result given the degree of uncertainty about global growth and the clear tail risks that exist. In particular, Europe has made little progress in terms of dealing with its sovereign debt issues or the major balance of payments problems and the disparity in competitiveness that exists between member states of the eurozone. Moreover, the US has been hindered in addressing its budget deficit by the presidential election and partisan opinions on the trade-off between tax increases and entitlement reductions. Finally, the slowdown in Chinese growth over the last year or so has resulted in elevated concerns that the economy will suffer a hard landing. What has clearly helped however, is the continued support in terms of abundant liquidity and other measures provided by central banks. Specifically, the US Federal Reserve announced its third round of quantitative easing (QE3) during September and arguably we will get ‘QE infinity’ if growth remains weak and unemployment stays high. In Europe, Mr. Drahgi announced in late July that the ECB would “do whatever it takes” to save the euro and followed this with the Outright Monetary Transactions (OMT) bond buying programme announcement in September. These measures have helped contain peripheral bond spreads and support equities. 2013: Continuation of “muddle-through” So what does this mean for global emerging markets (GEMs) next year? In all likelihood we will get a continuation of the muddling through and more of the same for equity markets. In other words, anaemic developed world economic growth (but much stronger emerging activity), plenty of liquidity, record low interest rates and generally positive equity markets. However, there is likely to be much dispersion of returns between markets, punctuated by periods of tail-risk uncertainty. In terms of the economic outlook, we expect the US to deliver around 2% GDP growth next year, the eurozone to shrink a further 0.3% but GEMs to experience a modest increase in GDP from around 4.7% this year to approximately 5.2% in 2013. GEMs to perform well in 2013 More specifically, we expect emerging market equities to deliver solid performance during 2013 and perform even better over the longer term. There are several reasons for this.

– We expect emerging market equities to deliver solid performance during 2013 and perform even better over the longer term. – Emerging markets look extremely attractive in terms of valuations. – We believe the Chinese economy has stabilised and will see a modest recovery next year and that tail risks in the developed world have been reduced for now by central bank policy.

Outlook 2013: A year in global emerging markets

“In all likelihood we will get a continuation of the muddling through and more of the same for equity markets. In other words, anaemic developed world economic growth (but much stronger emerging activity), plenty of liquidity, record low interest rates and generally positive equity markets.”

First, taken in isolation, GEMs look extremely attractive in terms of valuations, both absolute and relative to history as well as on a market capitalisation to GDP basis. For example, the forward price-earnings ratio (PE) for GEM currently stands at around 10 times, compared to an historic forward multiple of above 12 times. MSCI EM 12-month forward PE
22 20 18 16 14 Average 12 10 8 6 1994 1997 1999 2002 2004 2007 2010 2012

MSCI EM 12m Forward P/E Source: Schroders, FactSet, IBES, MSCI, data shown to September 18, 2012.

Moreover, in terms of market capitalisation to GDP, emerging markets are trading at more than one standard deviation below the historic average (see below). This measure has usually been a very good indicator of long term over- or undervaluation. GEM aggregate Index to GDP
300

250 +342% 200 +121% 150 -54% +396% -65% -57%

100 +154% 50

0 Dec 88 May 92 Oct 95 AVG Feb 99 +1STD Jul 02 -1STD Nov 05 Apr 09 Aug 12

GEM Aggregate Index/GDP

% moves in the MSCI EM Price Index

Source: UBS, data shown to August 31, 2012. Past performance is not a guide to future performance.

Second, two of the three most significant headwinds for risk assets in 2012 should begin to fade as we progress through next year. Specifically, Chinese economic growth appears to be responding to the modest easing measures that were implemented earlier this year. Third quarter GDP growth was up 7.4% year on year and there were signs that the economy was gaining momentum in the second half of the quarter. In particular, exports, consumer spending and leading indicators all suggest that the third quarter may have marked the bottom in terms of economic activity.

Outlook 2013: A year in global emerging markets

This is further supported by the most recent fourth quarter data and by the apparent stabilisation of the property market, as shown in the charts below. Price moves in 70 key Chinese cities
Number of Cities 60

50

40

30

20

10 0 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 New Build Price Declines (m/m) New Build Price Increases (m/m)

Source: Schroders. Thomson Datastream. Data to July 2012.

China property historical inventory months: Tier 1 Cities
50

40

30

20

10

0 May 06 Mar 07 Beijing Feb 08 Shanghai Jan 09 Shenzhen Nov 09 Oct 10 Sep 11 Jul 12

Guangzhou

Source: Morgan Stanley Research, Soufun. Data to July 31, 2012. Past performance is not a guide to future performance.

With inventories in many areas of the economy back to more normal levels and a new leadership about to take over in China, there is a strong possibility that concerns over a hard landing for the economy will fade early next year. We will also have a resolution to the US ‘fiscal cliff’ debate early next year. Our base case is that a compromise will be reached, even if it goes to the wire, and that the fiscal drag next year will be around 1.5% of GDP. This should translate into overall growth of around 2% in 2013. Whether this turns out to be correct remains to be seen, but at least the uncertainty created by this issue will be largely removed in the near future. The one remaining major overhang for markets is the eurozone crisis. In our opinion, this continues to represent the biggest risk for equity markets, including GEMs. As mentioned above, we are assuming a muddle-through scenario which means Greece stays in the eurozone, Spain asks for and receives a bailout and the eurozone experiences a mild recession.

Outlook 2013: A year in global emerging markets

If this proves to be the case and the ECB manage to continue containing bond spreads, the direct economic impact on emerging markets is expected to be relatively muted. As can be seen from the chart below, exports to the eurozone are not that significant for the major emerging market economies. Obviously the three Central European economies are the most exposed, but we continue to have only limited exposure to these markets. GEM exports to eurozone area (US$ by value)
100

75

2% 66% 1% 56% 2% 55%

50

4%

4% 32%

25

33%

6% 29% 8% 19% 11% 15% 11% 16% 11% 17%

42% 77% 13% 8% 9% 15% 8% 8% 7% 11% 7% 10% 12% 7% 7% 5%

18% 18%

14% 14%

0

Poland

Czech

Philippines

S. Africa

Russia

Egypt

Peru

Chile

India

China

Colombia

Malaysia

Thailand

Taiwan

Hungary

Indonesia

Eurozone

US

Others

Source: Morgan Stanley Research. MSCI, FactSet, Bloomberg, DataStream. Data as of August 31, 2012.

Given the deep-rooted imbalances and fundamental problems within the region however, it is highly likely that there will be a major scare at some point next year that will disrupt equity markets. This could easily emanate in Spain or possibly Italy, but could equally be triggered by a loss of confidence in France, as the chart below shows. If French bond yields were to rise sharply then the euro would come under significant pressure and all equity markets would almost certainly sell off aggressively, including GEMs. Total debt (% of GDP)
300 280 260 240 220 200 180

“Further out, we believe that the current risk aversion and cautious positioning with regard to equities will change significantly.”

160 140 1999 2000 2001 2002 France 2003 2004 2005 2006 2007 Spain 2008 2009 2010 2011 2012

Germany

Italy

Netherlands

Source: BCA, National Central Banks, OECD, Thomson Reuters. Data as at June 2012. Past performance is not a guide to future performance.

Mexico

Turkey

Brazil

Korea

Outlook 2013: A year in global emerging markets

“So, in our opinion, the cult of equity is not dead, simply snoozing.”

Cautiously positioned with a quality bias So how are we positioned for next year? Given that we believe the Chinese economy has stabilised and will see a modest recovery next year and that tail risks in the developed world have been reduced for now by central bank policy, it is possible that we will get a trading rally in some of the more cyclical markets and stocks as we enter 2013. But we are fundamental investors, not traders, and continue to believe that the best returns in 2013, which we expect will be another year of uncertain low economic growth and zero interest rates, will continue to be generated by companies that have strong business models and quality growth at attractive valuations. Consequently, the portfolio remains somewhat cautiously positioned with a quality bias. For example it has a higher returnon-equity (ROE) than the overall market, earnings per share growth that is in line and a PE that is lower than the index. Further out, we believe that the current risk aversion and cautious positioning with regard to equities will change significantly. Arguably, bond yields are being held at extremely low levels by central bank policy and are probably in bubble territory. It is quite likely however, that the unlimited money printing being pursued by the major central banks will keep interest rates at extremely low levels for quite some time to come. This may even be accompanied by financial repression as financial institutions and pension funds are forced by regulation to hold more in fixed income products despite their overvaluation than they otherwise would. But once deleveraging in the developed economies has run its course and rates begin to rise as economic activity normalises, the stage could be set for a powerful rally in equities. In such an environment GEMs should do extremely well due to their higher beta, attractive valuations and better fundamental growth prospects. As the chart below shows the equity risk premium for GEMs is close to its all-time high at around 9%. So, in our opinion, the cult of equity is not dead, simply snoozing.

Allan Conway Head of Emerging Market Equities Allan joined Schroders in October 2004 as head of Emerging Market Equities. He is a fellow of the Securities Institute (FSI), Member of the Institute of Chartered Accountants (ACA) and has a BA (Hons) Degree in Economics from York University. His investment career began in 1980 and he previously worked at WestLB Asset Management (where he was Head of Global Emerging Markets and later Chief Executive of WestAM (UK) Ltd) and LGT Asset Management (where he was Head of Global Emerging Markets).

MSCI Emerging Markets Equity Risk Premium (vs. US10yr yields)
(EPR, %)
12 10 8 6 4 2 0

Major EM Equity Market Troughs

9.2 Average

Major EM Equity Market Peaks
-2 Jan 92 Jan 95 Dec 97 Nov 00 Nov 03 Oct 06 Sep 09 Sep 12

Source: Morgan Stanley. IBES, MSCI. Data to September 2012. Past performance is not a guide to future performance.

Important information: The views and opinions contained herein are those of Allan Conway, Head of Emerging Market Equities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. Investing in emerging markets causes above average risk. Investors may not get back the amount originally invested as the value of investments and the income from them can go down as well as up. Exchange rate changes may cause the value of overseas investments to rise or fall. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroders & Co, 100 Wood Street, London, EC2V 7ER, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored. w42779

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