EPSTEIN
page 7 / 451 . OCR, unverified
which is entirely rational in our view. By contrast, DM financials are
trading in line with their historic valuation/return relationship.
•
The majority of non-financial sectors within GEM have margins which
have underperformed their DM peers; the overall ROE for EM non-
financial stocks is now below the level of DM non-financials, based on
an aggregate margin which has now almost converged with DM,
having historically been much higher.
•
There is a pronounced polarisation of valuations within the EM
universe on an ROE versus P/BV basis between sectors both in
absolute terms (Figure 2) and relative to DM (Figure 3). where
valuations and returns are more closely correlated. Financials and
Energy stocks have extremely low valuations, while the Healthcare
and Consumer Staples sectors appear very expensive. We identified
this gap as the biggest reason to be bearish EM one year ago because
it is driven by aversion towards those sectors which face the most
severe structural challenges, and nothing has changed in the past
twelve months.
'Figure 2: EM - PrBV (x) versus RoE (%)
4.5 -
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3.0
2.5
o. 2.0 -
2.5 mOust
Miles
Healt1/4aft
•
♦
Mon:*
Consumer Staples
Consumer
•
Finarmars
•
(norm,
iFigure 3: DM - P/BV (x) versus RoE (%)
-
3.0
IT 23
TOco
Telco
RIaltioa
4IT
2.0
•
WNics
231
1.0
ri
115
OS
ROE
(%)
tarot Onto* O&M arCOTD•Ig Amara LP
0.0
S
Energy
SHORT
RCIE (%)
San bank* int Scants. Rim* LP
Bette, governance and For growth necessary to unlock yalue. in EM equities
Given the extremely high level of valuations for the better governed higher ROE
sectors, the prospects for an upwards re-rating of EM in either absolute or
relative terms depends on prospects improving for the value-related markets
and sectors in our view. There are two potential catalysts. First is faster global
growth, which would revive the more cyclical and commodity-related sectors -
China is an especially important source of demand but one which would
benefit from an acceleration of economic activity in developed economies via
increased export demand. Second is that the markets may begin to detect a
marginal improvement in governance within EM, at either the sovereign and/or
the corporate level. We are sceptical that DM growth will come to the rescue
as in 2002-07, whilst there is very little indication of an incrementally positive
shift in governance across most emerging markets in our view, with the partial
exception of Mexico. (Rhetoric versus reality; governance drivers still mainly
negative, 6 November 2013).
Page 4
Deutsche Bank AG/London
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December 2013
GEM Equity Strategy Outlook 2014
Global growth is unlikely to become as EM friendly as in 2002-07
In the wake of the global financial crisis, the majority of economists and
investors failed to anticipate the resilience of the US economic and corporate
governance models, which has underpinned the massive outperformance of
US equities over the past three years. Whilst we retain a structurally bullish
view on the US economy, the growth cycle will continue to be qualitatively
different to the consumer debt driven growth that proved so beneficial for
emerging market exports between 2002 and 2007. There has been a further
shift of pricing power away from emerging market producers, which is
currently being exacerbated by the ongoing depreciation of the yen. The US
will become more competitive in industrial goods due to more favourable cost
comparisons in energy and labour as well as a technological shift to more
distributed manufacturing techniques. Meanwhile the structural slowdown in
emerging market economic growth is likely to have a pronounced impact on
the commodity intensive exporters which are a much bigger constituent of the
emerging market universe.
Micro structural factors threaten EM economies more than Fed taper
Investors are currently fixated on the impact of potential shifts in funds flows
on EM financial assets, through the Fed tapering policy and have a largely one-
dimensional view of risk based on the level of current account deficits in the
respective GEM economies. We believe that the real risk is that we are starting
to see a greater reluctance by foreign investors to put money to work in EM
because they are increasingly focusing on the underlying structural issues,
which up to now have been much more obvious at a corporate micro level
than in the macro-economic aggregates. The sudden break in correlation
between DM and EM equities at the start of 2013 preceded talk of Fed
tapering by several months and was the direct result of investors beginning to
discount more favourable structural factors for the US against the bulk of the