EM Equity in Two Decades: A Changing Landscape

- "Significant shifts in global equity markets: Over the next two decades, emerging equity market capitalization could increase substantially in absolute terms and overtake developed markets. The primary drivers are rapid economic growth and capital market deepening. China may exceed the US in market cap terms by 2030."
- "The EM landscape in two decades: Emerging equity cap could rise from $14tr to $37tr in 2020 and $80tr by 2030, bringing the EM share of global equity cap from 31% to 44% and 55% by these respective dates. The EM weight in the MSCI AC World index may also increase from 13% to 19% and 31% by 2020 and 2030. The BRICs’ share of world equity cap may be 30% by 2020 and 41% by 2030 vs. 18% now. For the N-11, the share could rise to 6% in 2030, from 5% now."
- "DM savings pools will need to own more EM: We estimate that developed market institutional asset managers currently hold 6% in EM equities within their total equity portfolio. This weighting may rise to 18% by 2030, implying net purchases of $4tr. The institutionalization of EM savings pools will also gather pace; this may help dampen EM equity volatility and valuation swings."
- "EM opportunities and challenges: EM equities offer investors attractive potential returns, but will require a greater allocation of business resources. Financial intermediaries have substantial revenue opportunities, but will need to localize further; operating costs and competitive pressures will rise."

QE and the Dollar: Lessons from QE-1 (Part I)

- QE and the Dollar: Lessons from QE-1 (Part I) "The potential for renewed Quantitative Easing (QE-2) has increased in recent months as the outlook for US growth has deteriorated. The first phase of Quantitative Easing (from December 2008 to March 2010) coincided with significant dollar weakening and our analysis shows that QE-1 was a key driver of the weakness, although not the only factor at play. Another round of Quantitative Easing (QE-2) is looking increasingly likely in coming months and this would be a latent catalyst for renewed USD weakening."
- Canada: A cut (hike) above "The Canadian economy is showing signs of a more sustained recovery, with strong domestic demand offsetting the drag from weaker US growth. With inflation well contained, the Bank of Canada is expected to continue to normalise rates. We also remain constructive on the outlook for CAD."
- Refining Flipping NOLI, and retaining a neutral view "We retain our neutral call on risky FX. Both Flipping NOLI and our alternative way indicate that there remains some error between actual and market-implied NOLI. However, the error has narrowed considerably since we recommended a tactically bullish stance (Flipping NOLI to reveal a positive side, 27 May 2010) – both as a result of prices of risky assets appreciating, and as a consequence of NOLI declining."
- SEK - Swedish National Debt Office starts to unwind long SEK positions "The Swedish National Debt Office (SNDO) announced that it will start to reduce its long SEK exposure, by gradually selling SEK in the market. The SNDO had accumulated a long position worth SEK50bn during the crisis, and may take up to a year to unwind its long SEK exposure. This suggests a daily pace of selling to the tune of EUR20mn, but the pace could be quicker, depending on market conditions. We do not think this will reverse the trend of SEK appreciation, but it does reduce the appreciation potential in the short term."
- New USD/JPY forecasts: A new all-time low? "USD/JPY has declined as the prospects of an economic recovery in the US have declined and expectations of lower US interest rates have taken hold. The situation in the US has a greater impact on USD/JPY than Japanese domestic policies and we think that any additional monetary easing by the BOJ or forex intervention by MOF is unlikely to halt the rise in JPY. We have therefore lowered our quarterly USD/JPY forecasts for end-September 2010 to end-March 2012 to take this into account. We cannot rule out the possibility that at some time between now and the middle of next year USD/JPY may briefly break below the all-time low of 79.75 it recorded in April 1995."
- Speculative positions/interest rate spreads and effectiveness of intervention to sell JPY "A growing number of market participants appear to take the view that with the BOJ now having eased monetary conditions, the monetary authorities' next move will be to intervene in the forex market. Using historical data on the size of speculative positions at the start of intervention and the US-Japanese interest rate spread once intervention began, we estimate the extent to which USD/JPY could rally if the monetary authorities intervene to sell JPY. We find that if USD/JPY declines to 82-83, intervention could trigger a brief rally, but probably to no more than 85-86 if US economic sentiment does not improve as well."
- BoK reinforces its pro-growth bias – stay received KRW IRS, long KTBs and long KRW "The Bank of Korea’s decision to keep policy rates unchanged today reinforces our view that the market continues to overestimate just how hawkish Asian central banks will be. We recommend investors stay received KRW IRS and long KTBs. In terms of the KRW IRS forward curve, the 1fwd 1yr offers the most attractive slide-to-volatility ratio, while we continue to look for opportunities to initiate a recommendation to buy the 10yr KTB. We also maintain our long KRW (vs. EUR) recommendation despite the BoK’s pause. Normalising monetary conditions via FX strength remains a possibility, while support should continue to come from a strengthening Balance of Payments and increasing global political pressure."

- Recommend long HKD 2y3y vol against rates level and term premium "We introduce a fair-value  ramework for swaption volatility based on overall rates levels and term premium. HKD 2y3y  volatility appears to be cheap according to our model. This seems to be a good time to build long 2y3y ATM straddles against HKD IRS 2s and 5s."

- INR OIS curve – Receive 1fwd1Y OIS "Following the Reserve Bank of India (RBI)’s last meeting on 27 July, OIS yields have moved sharply higher. Although yields have retreated from their highs, they are still well above levels before the meeting. However, Indian data releases following this policy meeting suggest that inflation and growth are moderating. Global data trends have also raised questions about the sustained global recovery. As the RBI highlighted explicitly the risks of weaker global growth and its impact on India in its previous policy meeting, we view the change in macroeconomic data as an opportunity to establish our bullish call on rates and believe that receiving the 1fwd 1yr is the most efficient way of expressing this view."

- Malaysia: Updated outlook for interest rate markets "The momentum of economic growth is fading rapidly in Malaysia, as it is across Asia and in the US. With Bank Negara Malaysia (BNM) comfortable with its neutral monetary policy stance, we retain a preference for long-duration positions in MYR interest rate markets. However, the recent rally in the MYR interest rate markets has removed much of the value from the front end of the IRS curve. For investors looking to express a long-duration view via MYR IRS, considerations of slide, volatility and liquidity suggest that receiving the MYR 2fwd 2yr offers greatest value."
- Recommend adding a long PHP trade "We recommend a long 3M PHP/INR (3M 1.0525) position which carries negatively by -0.40% over this period. We expect the Philippine government to be able to enjoy its honeymoon period, having been inaugurated only two months ago. We would also expect to see improvements in the Philippines' ability to attract investment. Despite the recent hostage stand-off, the security situation in the Philippines in general is as good as it has been for years. PHP is also supported by solid basic balance characteristics. The caveat is that President Aquino has a major task on his hands to sustainably improve the fiscal accounts. In addition, there is a risk that the president's popularity declines - his handling of the hostage situation received bad press, and as the typhoon season closes in, the government's crisis management abilities could come under further scrutiny."
- Recommend adding a short EUR/KRW trade "We have chosen to reopen our short EUR/KRW position. KRW remains undervalued and is backed by a relatively strong balance of payments (including increasing interest in the KTB market). At the margin, we would expect less aggressive intervention against KRW appreciation ahead of the G20 event in Korea on 11-12 November. We are also less concerned that the North Koreans could cause problems around this time. However, as the global economy slows, appreciation pressures on KRW may subside, and/or the authorities may be less likely to allow appreciation. Indeed, we try to provide some (imperfect) insulation against any global risk sell-off by expressing the trade against EUR. However, we also show indicative pricing for KRW versus JPY on a 3M basis, as it is against JPY that the valuation proposition seems clearest."
- EMFX RV can be simple: Buy MXN vs ZAR "Cross-continent relative value FX trades usually come across as a stretch to investors, though occasionally there are straightforward opportunities. Given the current state of the world on risky assets, return profiles (flat year-to-date) and the lack of interest on high-beta trades, we think selling ZAR/MXN is an interesting proposal."

Deflation: Will America and Europe Follow Japan?

- "Investors are asking whether America and Europe will follow Japan into deflation. We think not. Japan fell into secular deflation because of a unique combination of structural factors. These factors are (a) high central bank independence with low accountability, (b) advanced aging of the population, (c) an electoral system that strongly over-represents the interests of older voters, and (d) a current account surplus that dulls the need for structural reforms."
- "Japan will likely remain in deflation, because none of the structural factors is likely to change soon."
- "The US is unlikely to fall into deflation. The Federal Reserve is more accountable and transparent than the Bank of Japan. The US is young; the electoral system does not over-represent older voters; the current deficit increases pressure for structural reform."
- "Europe is less likely than Japan but more likely than the US to fall into deflation. This is because Europe lies between Japan and the US on the four factors."
- "The best investment strategy is to seek yield and monetary assets in Japan, and seek beta and real assets in the US. Europe falls between the two. Inflation linked bonds are attractive. They provide protection in high inflation countries and high real rates in low inflation countries."
- Risk Scenario - Global Inflation: "In the risk scenario, where common global factors overcome regional differences, all developed economies are likely to tilt toward inflation. Nominal assets in all countries would likely underperform, and real assets outperform. Linkers would be attractive in most countries."

Household deleveraging poses near term risks to consumer spending

- "Household deleveraging has been progressing at a substantial pace. The question is how much further it has to go, and the answer to this question is crucial to the outlook for GDP growth."
- "Progress on the debt side of the household balance sheet has been impressive. We estimate that the debt/income ratio has fallen from a peak of 136% of income in 2008 to less than 120% currently, and at the current rate of personal saving and loan defaults is on track to fall to near 100% by the end of next year. This implies that the household debt service ratio will fall below the range it has been in for several decades."
- "Movements in the saving rate, the key link between the household balance sheet and consumer spending growth, depend not just on debt and debt service, but also on the asset side of the balance sheet, or more specifically on movements in wealth--the gap between assets and debt. Household assets are up from their crisis lows thanks to the bounce in the stock market, though they have taken a hit in the middle of 2010 and remain far below their pre-crisis peak."
- "The key issue is how much more households will feel the need to adjust their saving rate up (and accelerate debt declines for a while longer) in reaction to the large net loss in wealth that has occurred over the past several years. We tested a wide range of specifications of the causal relationship between wealth and saving, and we find that households appear to respond to a three-year moving average of their wealth to income ratio relative to a longer term wealth goal that is best defined as a 20-year moving average of the wealth to income ratio."
- "Given current expected trends in household assets and debt, this relationship sees the saving rate rising further, into the 7-1/2 to 8% range by late 2011, after which it begins to recede slowly. The implication is that consumer spending will continue to be a significant drag on growth through next year, after which it will become a modest engine of growth (consumer spending growing faster than income). This finding reinforces the notion that the Fed will be on hold at least through 2011."

Right diagnosis, wrong cure

- Roundup: Right diagnosis, wrong cure "The President is right to look for ways to boost growth, but his latest proposals are unlikely to provide much support. We are keeping our forecasts unchanged."
- Outlook: more needed from Washington "The weak economy requires more policy stimulus – we believe it will be forthcoming."
- Preview of the week ahead "The retail sales report will help determine the extent of the consumer slowdown. We expect core CPI inflation to be about unchanged for another month."

Living on the edge

- Market Movers ahead
• "In the US focus will be on the August retail sales report and industrial activity indicators. We expect a positive surprise in retail sales."
• "In the euro area it will be a quiet week in terms of data, with the most interesting release being the German ZEW."
• "In Asia focus will be on developments in the yen, which has become a central theme in the leadership contest in the Democratic Party of Japan."
• "SNB is expected to keep rates on hold at the monetary policy meeting next week."
- Global Update
• "News out of Europe has been mixed. German industrial data disappointed and the German banking association said that Germany‟s 10 biggest banks may need EUR105bn of additional capital under Basel III rules."
• "This week offered further comfort in terms of better-than-expected US data from the labour market and from the trade balance."
• "In addition, Obama proposed further economic stimulus. In Japan focus is still on the strong yen and the possibility of Japanese intervention in the FX market to stem the appreciation. However, this issue has been complicated by increased Chinese buying of Japanese bonds."
• "In Sweden GDP data was revised substantially higher, but we continue to expect slower growth ahead."
- Focus
• "This week we published new global forecasts. A flow of disappointing news has led us to revise down our growth forecasts – in particular for the US."
• "While we see a limited risk of a recession, double-dip fears are likely to remain present for a while."

Back to School/Harvest Festival

- Pan-European — Back to School
• Revision — "Risk off in 2008. Risk on in 2009. Risk on and off in 2010. Mixed macro. Strong profits. Attractive valuation. Conundrums, crossovers & cults."
• Homework — "Key themes include: growth/EM, quality, size, country and deequitisation. We raised beta in early May and early July. We lower beta now."
- UK — Harvest Festival
• Autumnal colours — "Easing macro trends suggest earnings estimates are too high. But this looks more than priced into markets. We maintain our 6000 FTSE 100 target."
• Under the duvet — "Quality bias, backing earnings momentum, emerging markets exposure, de-equitisation and size tilt are the key themes."

Taking stock of monetary policy

- Global Letter • The coming surge in food prices
- Feature Articles
• Taking stock of monetary policy
• Australia: Strong, broad-based growth ahead
- Data Preview
• The week ahead
- Chart Alerts
• India: Monetary conditions move into restrictive zone
• Hong Kong: RMB deposits rose 85.5% y-o-y in July
- Outlook 2010-2012
• Australia: Growth momentum building
• China: Reform platform for sustainable growth
• Hong Kong: Moderating, but solid growth
• India: RBI may be close to pausing
• Indonesia: Reserve requirement hike begins normalisation
• Malaysia: Rate hikes are over for now
• New Zealand: Earthquake reconstruction to boost growth
• Philippines: Going for growth 
• Singapore: More property market measures
• South Korea: When doves cry
• Taiwan: Robust economic expansion continues
• Thailand: Still in the mood for normalisation 
• Vietnam: Some encouraging fiscal numbers 

Reality rests between slowdown and speed-up scares

- "The slowdown scare of mid-2010 has passed. The sum of purchasing managers’ reports from around the world probably captures the environment best: growth has slowed, but not so immodestly as to sustain fears of the dreaded double-dip relapse into renewed recession."
- "In the near term, we continue to expect the global economy to muddle through the frequent slowdown scares, albeit expanding at a slightly slower pace than our July estimates. Our 2010 global GDP forecast remained unchanged at 4.6%, while the growth forecast for 2011 moved down by one tenth to 4.3%."
- "While such expectations are reassuring as far as they go, even if realized they would leave a huge amount of global GDP still missing relative to the pre-crisis path (Exhibit 1). The global economy would need to grow much faster to restore the recessionary loss of GDP that nearly seven billion people rely upon for their material well-being."
- "Inflation pressures remain subdued. We expect the slow recovery, especially in the First World, to keep inflation low, with deflation an unlikely but not implausible contingency."
- "Against this backdrop, we expect major central banks including the Fed, BOJ, ECB, and BOE to continue to keep rates “lower for longer.” We also expect central banks in commodity-intensive economies like Brazil, Canada, and Australia to move to the sidelines in their tightening cycles earlier than our prior expectation. In Non-Japan Asia, we continue to expect the pace of interest rate “normalisation” to be slow this year (with the exception of India)."
- "The “reach for yield” required by pension plans and other financial structures linked to the First World’s entitlement culture is likely to continue to be very frustrating. The flow of capital to the outperforming emerging market segment of the global economy could intensify. More generally, financial markets, having just begun to shake off their slowdown scare, may now be at the threshold of incorporating a speed-up scare into their valuation psychology."

Onshoring: Is it a reality?

- "It is often suggested that there has been excessive offshoring, and that there will now be onshoring to OECD countries of industrial production formerly offshored to emerging countries. Some countries (France) provide aid to companies which onshore. Some companies may have problems with their offshored production: quality, response times, difficulties of supervision."
- "In this flash, we seek to ascertain whether, at the macroeconomic and not the anecdotal level, there are signs of onshoring in euro-zone countries, looking at employment, output, direct investment, market shares, the external balance, imports and production capacity. The answer is no: the trends in employment, output, direct investment and market share are not headed in the right direction; dependence on imports is not diminishing."

China: 2H10 Earnings Likely Mixed

- Earnings trend – "2H10 corporate earnings will likely face conflicting forces, moderating growth and persistent though benign inflation. We expect overall earnings growth to slow in the second half of the year alongside growth normalization."
- Earning surprises – "Price inflation and policy calibration could bring earnings surprises in related sectors. We expect CPI to stay above 3% in the 2H10 thanks to higher food prices and money velocity. Policy tightening in the property and energy sectors could also generate favorable earnings expectations for large listed companies."
- Sector outlook – "There is no clear evidence suggesting that valuations are converging across sectors. Economic and policy changes in the second half of the year would still favor high valuation plays. In our view, insurance and consumer staples are likely to see positive earnings surprises and will
outperform in 2H10."
- Top picks – "Ping An (2318.HK; HK$69.40; 1L) and Mengniu Diary (2319.HK; HK$23.05; 1L) may outperform in light of 2H10 earnings and economy outlook. Ping An posted a stronger 1H10 results and should be able to deliver strong operating momentum this year due to improving life business mix and P&C turnaround. For Mengniu Dairy, earnings momentum may start to pick up in 2H10 on 1) stabilizing raw milk cost, which management saw pull back somewhat since July, 2) improving product mix as Mengniu is shifting to higher value-added products, we recommend to buy on recent weakness."

Is it possible to live with a very high public debt ratio?

- "Some analysts believe that euro-zone countries facing problems with their public finances (Greece, Ireland, Portugal, Spain) will not succeed in reducing their fiscal deficits and in stabilising their public debts, and that the sovereign debt crisis will therefore resume."
- "We believe, conversely, that the efforts these countries have made, which are already visible, will enable them to stabilise their public debt ratios. Accordingly, we believe that we are not dealing with a short-term problem (continued high fiscal deficits, speculative attacks once again, default risk), but a medium-term problem: will these countries be able to live with a very high public debt, even stabilised, which will make it necessary to maintain a significant primary budget surplus, and hence a restrictive fiscal policy?"
- "The answer depends on the level of risk premia that these countries will have to pay and the political and social capacity to maintain restrictive fiscal policies. As examples, we look at the dynamics seen in the euro-zone countries where public debt ratios were high prior to the crisis: Italy and Belgium. These countries were able to implement a primary budget surplus of
6 percentage points of GDP. This is not very different from the order of magnitude needed in Greece, Ireland, Portugal and Spain if the countries’ risk premia (spreads over Germany) return to the level seen before the sovereign crisis."
- "However, if spreads remain at the current level, the permanent primary fiscal surplus needed to stabilise the public debt ratios would be huge (8 to 13 percentage points de GDP), and it is then very unlikely that the public indebtedness will be bearable in the medium term."

If the world’s confidence in the US economy is lost, the result would be a selffulfilling crisis

- "Many factors could cause a loss of confidence worldwide in the US economy:
• insolvency among part of the households and holders of commercial real estate loans, and as a result chronic weakness of retail banks, the real estate sector and the Agencies;
• enduring deterioration in the US labour market situation, especially due to far lower flexibility;
• ongoing weakening of wage incomes, deleveraging and impoverishment among households, condemning household demand - which was the engine of the US economy - to long-lasting weakness,;
• slimming-down and lower profitability in the finance sector, whose weight was considerable;
• persistent external deficit, due to the shortfall in savings that has not been corrected, and therefore a persistent risk of a long-run depreciation of the dollar that would logically discourage foreign investors (the People's Bank of China?);
• risk of insolvency of public finances at some point in the future."
- "If non-residents (including central banks) share this pessimistic view, they will stop investing in the United States, which will create a huge financing problem, leading to a sharp rise in interest rates, a worsening of all solvency problems (households, real estate, government, Agencies, etc.) and a decline in domestic demand, i.e. precisely the developments that non-residents dread. Such a loss of confidence cannot have the same self-fulfilling effects in countries that are self-sufficient in terms of savings, such as the euro zone."

Two irreversible changes in companies' behaviour due to the crisis?

- "We believe that the crisis may have irreversibly changed the behaviour of companies in OECD countries in two areas:
• policy of self-financing investment, and not depending on external financing; this is due to the problems created by the bank credit crunch and the freeze-up of financial markets in the aftermath of the Lehman bankruptcy, and implies striving for higher profitability, hence distortion of income sharing to the detriment of wage-earners, both by looking for productivity gains and by squeezing wages;
• acceleration of offshoring and hence the deindustrialisation of OECD countries (even in Germany, which is nevertheless less affected than the other countries), through the search for the lowest production costs to improve profitability, and due to the expected widening growth gap between emerging countries and OECD countries."
- "These two trends are very unfavourable to wage-earners' purchasing power: distortion of income sharing in favour of profits, accelerated destruction of industrial jobs, which are more skilled and pay higher wages than the average job."

China Properties: Forget Policy Worries; Pick the Key Names

- Strong sales volume rebound in Aug fully expected — "Transaction volumes in the primary market show an expected strong rebound in Aug. The 15 key cities we tracked in China posted an average 42% MoM increase in volume. ASP also recorded 4% monthly growth. Beijing, Hangzhou and Shenzhen were major contributors to the price rise; ASP in other cities remained flattish/ slightly up."
- Market fears of new measures — "Many investors believe the meaningful rebound in volume without a robust price decline may touch the nerves of the Central government and trigger another wave of measures to be rolled out soon. We do not rule out the chance of new policies being introduced and believe tightening would be essential for a more sustainable long-term growth for the sector."
- Don’t over-react even as the policies are unveiled — "In our view, after the introduction of powerful measures in mid April, the measures available now are really limited. In our view, property tax, restriction on pre-sales proceeds and LAT settlement could be potential measures, but the impact may not be as significant as thought, given the strength of demand. Moreover, in contrast to early 2010, when the policy impact was huge, given the policy switch from supportive in 2009's to early 2010's tough tightening, this time we already have tough tightening. The impact from additional measures may not that that significant. Leading developers that can operate effectively even in the tightening period could emerge as market consolidators and enjoy enlarging their market share."
- It’s time for govt to reassess the overall policy direction — "We believe developers are more cooperative in this round of tightening by staying low-profile and launching projects with lower prices. Many of them are also involved in the government's social welfare housing projects. Now, it’s a critical time for government to reassess its policy direction and the reasons for the market’s prosperity, which is not mainly caused by developers. In our view, further tightening measures may still be ineffective if the fundamental picture is not changed: 1) Ample liquidity, created by the government itself during the economic stimulus; 2) Huge wealth accumulation and the desire for anti-inflation investment vehicles of Mainland Chinese, and 3) Government being the largest taker in the property-profit cake."
- Stick to the big names — "We believe the current share price has factored in most of the bad news. In our view, we should not pay too much attention to policy. The sector is in tough tightening mode already and the impact from potential new measures may not be as significant as thought. We suggest investors add to positions at the moment, but stick to the big names such as Shimao, Agile, China Vanke, COLI."

Steady as she slows

- "Global growth settling below trend in 2H10"
- "Encouraging signs that weakness is not intensifying"
- "EM domestic demand holds up as manufacturing sector slows sharply"
- "Next week: Looking for rate hikes from the BoC and BoK; expecting the RBI to pause on September 16"