emerging neurosis - alpha ideasalphaideas.in/wp-content/uploads/2013/08/clsa-greed-fear... ·...

Christopher Wood [email protected] +852 2600 8516

Thursday, 22 August 2013

Emerging neurosis Verbier Not so surprisingly, the normalisation scare has picked up momentum over the past week with renewed focus on the ‘panic’ in the emerging market debt space and related equity markets. But if this is the topic of the moment, in GREED & fear’s view it is all becoming a little silly in the sense that the consensus is in danger of forgetting some of the fundamental positives that drive the emerging market story and in particular the Asian story. That is superior economic growth rates, healthy income growth and a continuing lack of welfare states and related dependency cultures.

Figure 1 US 10-year Treasury bond yield

Source: CLSA, Bloomberg

Figure 2 US Dollar Index


But having said that, the practical reality is that the emerging world, including Asia, will remain vulnerable to further selling so long as markets are anticipating normalisation of American monetary policy and a related strengthening in the US dollar. This for now appears to be the case with the further pick up in the 10-year Treasury bond yield over the past week (see Figure 1), even if this latest normalisation scare is different from the one that hit in June in that it has not been accompanied as yet by a sell-off in gold. Likewise, while the US dollar has rallied sharply of late against the likes of the rupee and the rupiah, that is not the case against the

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world’s major currencies, be it the euro, sterling or the yen. Thus, the US dollar index is now 81.4, whereas it was 83.1 at the end of last quarter (see Figure 2).

If the world was so sure of the relative strength of the American economy, surely the yen should be selling off more against the dollar. This suggests to GREED & fear that the normalisation story, which has been driving market action all this year, may be nearer an end than the beginning. Still the real test of it will come, as previously mentioned here (see GREED & fear - The “fiscal drag” hope, 25 July 2013), when the new fiscal year in America begins on 1 October. For then, based on the Federal Reserve’s forecast, the American economy is meant to accelerate with the end of so-called ‘fiscal drag’. If this does not happen as anticipated, then the issue will become whether the Fed is really prepared to exit unconventional monetary policy. That seems most unlikely under a Fed led by Billyboy or his deputy Janet Yellen. But the markets will be less sure under a Fed led by President Obama’s seeming favoured candidate, Larry Summers. This is why the uncertainty posed by an Obama decision to nominate Summers has the potential to trigger more of a normalisation scare in the form of a further back up in Treasury bond yields and a further sell-off in equities, be it Asian equities or American equities.

Figure 3 Indonesia 10-year rupiah government bond yield


For now, the ongoing normalisation scare and related back up in sovereign bond yields is causing research departments in Asia to recalculate their valuations based on the increase in the so-called “risk free” rates. Thus, the Indonesian 10-year rupiah government bond yield is up from 5.19% to 8.46% since the beginning of the year (see Figure 3). But the key driver here, for the most part, is the action in the US Treasury market. In this respect CLSA’s technical analyst Lawrence Balanco makes an interesting point in his latest weekly (Price Action – Where the markets stand, 20 August 2013). This is the correlation between the US 10-year Treasury bond price and emerging market assets so far this year. That is 0.93 with emerging market bonds, 0.81 with emerging market equities and 0.71 with emerging market currencies (see Figure 4).

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Figure 4 US 10Y Treasury bond and emerging markets bonds, equities and currencies


This is why the US 10-year Treasury bond remains the key price to watch globally. Under GREED & fear’s base case, where American economic growth does not improve materially over the current post-2008 trend real GDP growth rate of 2.2%, a major buying opportunity in Treasury bonds is approaching which, in turn, would lead to relative outperformance of interest rate-sensitive markets in Asia as excessive cyclical optimism on the US economic recovery fades. But given the timing issues related to the hoped for end of ‘fiscal drag’ and confirmation of a new Fed governor, such a buying opportunity may not be forthcoming until the start of the fourth quarter. In the meantime, there is scope for the normalisation scare to continue which means a further bond sell-off. Balanco’s technical target for the 10-year Treasury bond yield is 3.22%, compared with the current yield of 2.9%.

Figure 5 Indonesia quarterly current account balance

Note: Data up to 2Q13. Source: CLSA, CEIC Data, Bank Indonesia

If this is the “big picture” view it is also the case that, in terms of the market action in Asia, there have been self-inflicted aggravating factors in the cases of India and Indonesia, the two stock markets which have been under the most pressure in US dollar terms. In Indonesia the central bank’s decision not to raise rates at its most recent meeting on 15 August looked odd when the latest quarterly BOP data released on 16 August showed an unexpectedly large surge in the current account deficit. Thus, the current account deficit increased from US$5.8bn or 2.6% of GDP in 1Q13 to US$9.8bn or 4.4% of GDP in 2Q13 (see Figure 5).

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Investors should now probably factor in another 100bp of tightening by Bank Indonesia to stabilise the currency even in an environment where GREED & fear’s base case on American monetary policy turns out to be correct. For now with a GDP deflator running at 1.8%YoY (see Figure 6), the rupiah is already offering reasonable real returns given that the pickup in inflation of late should be a one-off driven by the cut in energy subsidies announced in late June. An aggravating factor is that Indonesia remains the Asian stock market most geared into the world of emerging market debt, in part because of the continuing large, albeit reduced, foreign ownership of its government bond market. Thus, foreigners still owned 31.4% of Indonesian rupiah government bonds on 20 August, down from 34.2% in April and a peak of 35.5% in July 2011 (see Figure 7).

Figure 6 Indonesia GDP deflator

Source: CLSA, CEIC Data

Figure 7 Foreign ownership of Indonesian rupiah government bonds

Source: CLSA, Indonesia Debt Management Office, CEIC Data

As for India, this remains to GREED & fear the Asian market and the Asian economy where the problems are most self-inflicted in terms of the continuing lack of an investment cycle and a growing currency crisis. The Reserve Bank of India’s tightening moves in July, which seem to have been ordered from Delhi in an attempt to shore up the currency, clearly backfired in large part because of misguided communication and conflicting signals. There have also over the past week and more been retrograde steps to impose restrictions on residents’ capital outflow. Thus, the limit for outward remittances was lowered from US$200,000 to US$75,000 per financial year. The result has been a further loss of investor confidence and a further decline in the currency.

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The rupiah has depreciated against the US dollar by 5.6% since the announcement to Rs65/US$, and is down 15.7% year-to-date and 31% since the start of 2011 (see Figure 8). It is also the case that the latest inflation data has also been less than stellar, which has further highlighted the lack of scope for easing. Thus, WPI inflation rose from 4.86%YoY in June to 5.79%YoY in July (see Figure 9).

Figure 8 Indian rupee/US$ (invested scale)


Figure 9 India WPI and CPI inflation

Source: CLSA, CEIC Data, Ministry of Commerce & Industry

The result is that India remains in GREED & fear’s view the Asian market most at risk of a sovereign debt crisis with chatter apparently growing in Delhi of a potential need to sound out the IMF. This is despite the fact that India does not have a debt market reliant on foreign capital given the lack of foreign ownership of rupee debt. Thus, foreign ownership of Indian government securities was only 1.61% at the end of March, though it is up from 0.88% at the end of March 2012 (see Figure 10). In this sense India is not directly correlated into emerging market debt dynamics. Where the foreign ownership is, of course, is in Indian equities. Foreigners currently own an estimated 22.4% of Indian equities (see Figure 11). Indeed, it remains remarkable how little foreign net selling of Indian equities there has been in recent years, given the macro distress and the related plunge in the GDP growth rate. CLSA’s economics team is now forecasting real GDP growth of 5.2% this fiscal year and 5.9% next (see CLSA research Infofax Daily – India GDP: Growth asphyxiation, 6 August 2013). Thus, FIIs

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have sold a net US$3.2bn worth of Indian equities since mid-June, after buying a net US$15.4bn since the beginning of this year (see Figure 12).

Figure 10 Foreign ownership of Indian government securities

Source: CLSA, RBI

Figure 11 Foreign ownership of Indian equities

Source: CLSA

Figure 12 Cumulative FII net equity investment and BSE Sensex


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The relative lack of foreign selling of Indian equities is explained by the fact, as previously discussed here (see GREED & fear – Tapered off?, 6 June 2013), that foreign investors are crowded into ‘quality’, albeit expensive, stocks that have outperformed. Still the devastation in the currency means that, in US dollar terms, the long term investment returns for foreign holders of the likes of a HDFC or an ITC have declined dramatically. Thus, the compound annual average return over five years of an owner of these two stocks in US dollars terms is now only 4% and 20% respectively compared with 13% and 30% in rupee terms. This is increasing the risk of foreign investor capitulation in such ‘quality names’, even if it is only done reluctantly as a result of redemptions.

The higher interest rates and the slower GDP growth also imply declining loan growth and rising NPLs in the banking system, most particularly in the ‘cheap’ state owned banks. Current Indian gross NPLs are 3.7% of total loans but there are also another 4.6% of loans which are in the ‘restructured’ category (see Figure 13 and CLSA research Indian Financials – A tepid quarter, 15 August 2013). Despite the temptation to buy “cheap” banks on a contrarian basis, GREED & fear will stick with the expensive quality private sector banks geared to the consumer space since it is far from evident that India has passed the worst. It is also the case that the credit problems are primarily in the corporate and related infrastructure space.

Figure 13 Indian banks’ total stressed loans

Source: CLSA

Meanwhile, amidst all these negatives, the one potential positive is that the gathering macroeconomic crisis could trigger an improvement in governance. In this respect, it hardly inspires confidence that Congress leader, Italian-born Sonia Gandhi, appeared in the Indian parliament this week talking up her expensive “food security” bill. The Indian stock market’s greatest hope in this respect is the emergence of Gujarat Chief Minister Narendra Modi as the BJP’s prime ministerial candidate. While the odds are definitely stacked against him, GREED & fear’s view is simply that the worse the sense of crisis the better Modi’s chance of winning. This is why a decision to go to the IMF would appear to be political suicide for the current Congress-led government. Modi is certainly raising the rhetorical level with his growing public attacks on a ‘direction-less’ government and his focus on the collapsing rupee. The rhetoric is increasing because the general election season is approaching. Remember that an election has to be held by May next year.

As nervousness has increased towards emerging markets, the sentiment on Euroland has been improving with the stabilisation of the GDP data for the second quarter based on flash estimates published by Eurostat on 14 August. Thus, Euroland real GDP rose by 0.3%QoQ in 2Q13, led by a 0.7%QoQ increase in Germany and a 0.5%QoQ rise in France. This is the first QoQ increase in Euroland real GDP in seven quarters (see Figure 14). But on a year-on-year

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basis, Euroland real GDP still declined by 0.7%YoY in 2Q13, compared with a 1.1%YoY decline in 1Q13. Meanwhile, European equities have also outperformed since late June. The MSCI Europe Index has risen by 11.1% in US dollar terms since 24 June, compared with a 6.1% increase in the MSCI AC World Index (see Figure 15).

Figure 14 Eurozone real GDP growth

Source: CLSA, Eurostat

Figure 15 MSCI Europe relative to MSCI AC World Index

Source: CLSA, Datastream

While a catch up rally in European equities is not surprising given the seeming stabilisation in the data, combined with the continuing hopes that Flexible Mario will be allowed to ease more aggressively after the German election, GREED & fear remains firmly of the view that the Eurozone crisis is not over. Indeed investors are now as complacent on the Eurozone as they are neurotic about emerging markets.

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Figure 16 Eurozone loans to the private sector

Source: CLSA, ECB

The first point to note about the hype generated by the stabilisation of the Eurozone GDP data is that it is based on flash estimates with no detail in terms of the breakdown of GDP components. The second point is that this is just a stabilisation of activity, not a meaningful pickup in growth. Indeed looking more closely there remains no sign of a meaningful pick up in either credit or investment. Rather the evidence is the opposite. Bank lending in the Eurozone continues to decline, while money supply growth continues to slow. Thus, loans to the private sector in the Eurozone shrank by 1.6%YoY in June, down from a 1.1%YoY decline in May (see Figure 16). While Eurozone M1 and M3 growth slowed to 7.5%YoY and 2.3%YoY respectively in June, compared with 8.4%YoY and 2.9%YoY in May (see Figure 17). As for investment, the latest data published by Eurostat on 30 July shows the lowest rate of corporate investment since the advent of the Eurozone. Thus, the business investment rate of non-financial corporations in the Eurozone, measured as gross fixed capital formation as a percentage of gross value added, declined from 19.5% in 4Q12 to 18.8% in 1Q13, the lowest rate since the data series began in 1999 (see Figure 18).

Figure 17 Eurozone M1 and M3 growth

Source: CLSA, ECB

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Figure 18 Euro Area and EU business investment rate

Note: Gross fixed capital formation as % of gross value added of non-financial corporations. Source: CLSA, Eurostat

For such reasons, GREED & fear would be tempted to reduce positions in European equities. The reason not to is that the German election on 22 September is almost bound to result in a new coalition government led by Angela Merkel, with Merkel benefitting electorally from the current sense of calm in the Eurozone. Such a victory will increase market expectations that Merkel will allow the ECB to move more overtly into unorthodox monetary policy. Similarly, there will be hopes of a more decisive move by the Germans away from austerity and towards eurobonds, banking unions and the like. Such expectations are likely to be met at least in part. This is because Merkel will depict the election result as a mandate for her European policy, of which the most significant aspect was the decision last year to back Draghi’s ECB over the Bundesbank.

Figure 19 Opinion poll result on September German federal election

Source: Allensbach (21 August 2013 poll results)

The one potential obstacle to this assumed way forward is if the recently established euro sceptical party, the Alternative für Deutschland (AfD), manages to secure 5% of the vote and therefore parliamentary representation. For this would mean an anti-euro party had a platform in the legislature which as a practical matter would likely reduce Merkel’s political room for manoeuvre. Official opinion polls continue to show AfD polling below 5% (see Figure 19). This is surprising since common sense would suggest that more than 5% of the German electorate has reservations about funding continuing ongoing bailouts of the periphery; though one explanation is that the AfD continues to be almost completely ignored by the establishment

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media in Germany. Still it is possible this party may derive better than expected support from the 18.2m voters who did not bother to vote in the last German federal election in 2009.

Meanwhile, the Latin part of Euroland is clearly hoping for a relaxation of German policies once the election is over and Frau Merkel receives her anticipated mandate. At that point ‘radio silence’ in the Eurozone will end and the supplicants in the periphery will start raising their voices. If their hopes for a softer Germany and easier ECB are not met to their satisfaction, then the question will become whether the politics in the periphery will continue to take the strain of the deflationary adjustment, most particularly in counties like Italy and France. GREED & fear is sceptical though for now it remains the case that opinion polls continue to show strong support for the euro in the periphery countries, even as these same polls show hostility to austerity.

Figure 20 Portugal PSI Financials Index

Source: Bloomberg

Figure 21 Contribution to Portugal real GDP growth

Note: Breakdown for domestic and external demand for 2Q13 not yet available. Source: Statistics Portugal

GREED & fear has looked in some detail at the specific example of Portugal over the past week where sentiment has improved considerably in recent weeks following a political scare in early July. Indeed the Portuguese banking sector has rallied by 22% since 3 July (see Figure 20). There are certainly some signs of progress. In terms of the macro data, net exports are making a growing contribution to GDP growth as domestic demand has weakened, helped by an increase in exports to countries outside the EU. Thus, net exports contributed 2.3ppt to real GDP growth in 1Q13 while domestic demand subtracted 6.4ppt (see Figure 21). Also

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Portuguese exports to countries outside the EU rose by 13%YoY in 2Q13, compared with 3.6%YoY in intra-EU exports (see Figure 22). As a result, the share of exports to countries outside the EU has risen to 30% of total exports, up from 20% in 2005.

Figure 22 Portugal export growth

Source: Statistics Portugal

Household deposits in Portugal have also remained remarkably stable given what has been going on in recent quarters. Thus, household deposits declined by only 0.1%YoY to €132bn in June and were up 11% since the end of 2010 (see Figure 23). Still in aggregate terms there remains a fundamental lack of growth even if the rate of contraction is slowing. Real GDP declined by 2%YoY in 2Q13, compared with a 4.1%YoY decline in 1Q13. Government debt remains perilously high at 127% of GDP (see Figure 24), while the banking system’s loan-to-deposit ratio is still 125% even if that is down from 161% in 2009 (see Figure 25).

Figure 23 Portugal deposits

Source: CLSA, Banco de Portugal

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Figure 24 Portugal gross general government debt as % of GDP


Figure 25 Portugal Banking System loan-to-deposit ratio (LDR)


The realities still facing the likes of Portugal means that the issue in the Eurozone will become whether Merkel’s post-election anticipated softening will happen with sufficient speed to keep politics in the periphery stable. Clearly, if this assumption is wrong and there is no such softening, European equity markets and periphery bonds will be vulnerable. And that sell-off will then create market pressure on Berlin to relax its stance. Meanwhile, Flexible Mario will surely also want to see the euro weaken.

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(%) Portugal loan-to-deposit ratio



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Key to CLSA/CLSA Americas/CA Taiwan investment rankings: BUY: Total return expected to exceed market return AND provide 20% or greater absolute return; O-PF: Total return expected to be greater than market return but less than 20% absolute return; U-PF: Total return expected to be less than market return but expected to provide a positive absolute return; SELL: Total return expected to be less than market return AND to provide a negative absolute return. For relative performance, we benchmark the 12-month total return (including dividends) for the stock against the 12-month forecast return (including dividends) for the local market where the stock is traded. We define stocks we expect to provide returns of 100% or higher including dividends within three years as “Double Baggers”. ©2013 CLSA Limited (for research compiled by non-Taiwan analyst(s)) and/or Credit Agricole Securities Taiwan Co., Ltd (for research compiled by Taiwan analyst(s)). Note: In the interests of timeliness, this document has not been edited. The analyst/s who compiled this publication/communication hereby state/s and confirm/s that the contents hereof truly reflect his/her/their views and opinions on the subject matter and that the analyst/s has/have not been placed under any undue influence, intervention or pressure by any person/s in compiling such publication/communication. CLSA group of companies (excluding CLSA Americas, LLC) (“CLSA”), Credit Agricole Securities Taiwan Co., Ltd. (“CA Taiwan”), CLSA/CA Taiwan's analysts and/or their associates do and from time to time seek to establish business or financial relationships with companies covered in their research reports. As a result, investors should be aware that CLSA and/or such individuals may have one or more conflicts of interests that could affect the objectivity of this report. Regulations or market practice of some jurisdictions/markets prescribe certain disclosures to be made for certain actual, potential or perceived conflicts of interests relating to research reports and such details are available at www.clsa.com/member/research_disclosures/. Disclosures therein include the position of CLSA, CLSA Americas, LLC and CA Taiwan only and do not reflect those of CITIC Securities International Company Limited, Credit Agricole Corporate & Investment Bank and/or their respective affiliates. If investors have any difficulty accessing this website, please contact [email protected] or +852 2600 8111. If you require disclosure information on previous dates, please contact [email protected] IMPORTANT: The content of this report is subject to and should be read in conjunction with the disclaimer and CLSA's Legal and Regulatory Notices as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on request from CLSA Publications or CLSA Compliance Group (18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone +852 2600 8888) and/or CA Taiwan Compliance (27/F, 95, Section 2 Dun Hua South Road, Taipei 10682, Taiwan, telephone +886 2 2326 8188). 05/08/2013

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