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Equity Research
21 June 2010

Key Trades and Risks

Emerging Markets Equity Strategy

• Equities are fundamentally attractive. Global growth in our view is Emerging Markets Equity Strategy
sustainable. This growth is combined with low inflation and interest Adrian Mowat
AC

rates. (852) 2800-8599

adrian.mowat@jpmorgan.com
• This is likely to be a volatile summer. Markets will focus on PMI data J.P. Morgan Securities (Asia Pacific) Limited
for evidence of financial market weakness feeding through to the real
Ben Laidler
economy. We believe investors are over estimating their influence on the (1-212) 622-5252
real economy. Regulatory reform and fiscal policy are additional sources ben.m.laidler@jpmchase.com
of volatility. J.P. Morgan Securities Inc.

• The rebalancing of the Chinese economy from investment to Deanne Gordon

(27-21) 712-0875
consumption is healthy. But mind the gap, the near term impact would deanne.gordon@jpmorgan.com
be lower commodity prices and potentially lower profit margins. We
J.P. Morgan Equities Ltd.
expect that commodity prices will correct this summer which could
potentially lead to weaker EM equities. Rajiv Batra
(91-22) 6157-3568

• Our key trades ranked by conviction are: rajiv.j.batra@jpmorgan.com

J.P. Morgan India Private Limited

• CEMBI Surfers; Overweight India and Turkey Sanaya Tavaria
(91-22) 6157-3312
• Growth surprise from developed, not emerging, sanaya.x.tavaria@jpmorgan.com
economies. Overweight Mexico, Taiwan and Turkey J.P. Morgan India Private Limited
plus technology and transportation.
Ankita Kochar
• Macro policy and rising inflation - QR not QE in EM: (91-22) 6157-3263
ankita.x.kochar@jpmorgan.com
Underweight Brazil, China, energy and commodities
J.P. Morgan India Private Limited

• The main risk to our view is that financial market stress results in
Figure 1: MSCI EM relative performance
weaker European growth than a bearish consensus. For more on risks
see page 8. 140
120
• Key asset allocation calls:
OW: Taiwan, Korea, India, Mexico, South Africa, Turkey and the 100 v s World
Philippines
80
OW: Technology and industrial cyclicals (i.e. transportation)
60
UW: China and Brazil
UW: Commodities, energy, telecoms and Utilities 40 v s USA
20
• For our ‘Key Trade’ stock ideas, click here to download the Bloomberg
96 98 00 02 04 06 08 10
sheet.
Source: Bloomberg, 14 June 2010.

See page 90 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

In this report, we highlight: Table of Contents

Our top trade ideas
Summer Swings........................................................................3
Risks
Risks to our strategy................................................................8
Our model portfolio
Global emerging markets model portfolio by country ........14
Valuation stress test

Key ratios for EMBIG 100

Global emerging markets model portfolio by sector...........15
Consensus country weights Key Trades ..............................................................................16
China: Mind the gap ...............................................................26
We have two pages on each Brazil: Better Outlook for Domestics....................................28
significant emerging market. The
first page has a qualitative South Korea: Buying opportunity .........................................30
review of events driving the past
12 months, the outlook and a Taiwan: Potentially Oversold ................................................32
comment on valuations; the
second page displays the Russia: Strong balance sheet and earnings ........................34
scorecard, which presents key
economic and equity market
India: Global concerns drag Indian equities ........................36
data South Africa: A low beta equity market................................38
Mexico: Cyclical Macro Momentum ......................................40
The extended markers: This
report contains 36 pages of data Malaysia: Reform agenda keeping the buzz ........................42
designed to help track emerging
economies and markets Thailand: Resilient despite turmoil .......................................44
Indonesia: An eye on politics ................................................46
The emerging market Turkey: Cyclical view… secular trend ..................................48
dashboards efficiently display
key economic, equity and debt Philippines: Market re-rating likely .......................................50
data, demonstrating change and
perspective. Extended markers ..................................................................53
Consensus Asset Allocation .................................................55
Hindsight trades: What has worked......................................56
Composite valuation indicators ............................................58
EMBIG100................................................................................62
Emerging Markets Strategy Dashboards .............................70

2
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Summer Swings
There is a conflict in our strategy. This is a serious economic advantages. It helps address China’s strained
conflict that could damage performance. Investors in our social contract by increasing household income as a share
view are too, and increasingly pessimistic, on the of GDP at the expense of corporate profits (see risk
sustainability of the recovery. Our base case remains that section on page 8). There is a leveraged impact on
the global recovery is led by the private sector and is discretionary income. Economists may argue that a
sustainable. Economic growth combined with falling stronger currency would indirectly boost real income due
core inflation is a strong fundamental backdrop for to lower inflation but there are higher tangible benefits to
equities. Note that J.P. Morgan's economists just pushed workers of higher wages rather than a lower cost of
out the first increase in Fed Funds rate to 4Q11 (See A imported goods.
change to our Fed call, Michael Feroli et al, 17 June
2010). But EM investors need to consider the risk of the Figure 2: Monitor European PMIs
correlation between EM equities and commodities. In our 65 Germany
view commodity investors are not pricing in China's 60
changing growth model. Euro area
55
50
Recognizing the conflict and risk, we are setting an
45
artificial time limit on the fear of a correction in
40 Spain
commodities. The time limit is September 2010. By then Greece
we believe that the decline in bulk commodity prices will 35
"scare" the new investors in commodities to redeem, 30
generating a broader correction. 25
Jun-07 May -08 Apr-09 Mar-10
Market confidence in a sustainable economic recovery is
Source: J.P. Morgan Economics, May 2010
waning. It is the risk of too rapid a fiscal consolidation
that is hitting confidence. We agree this risk has Figure 3: Domestic Savings as a percent of GDP in China
increased but we also believe that financial investors are
25 1997-99 2005-07 21 22
over estimating their influence on the real economy. Post
18
the sub-prime crisis, business and consumer respect for 20
financial institutions and markets has declined. In 13
15
responding to the conflicting signals of weaker capital 9
10
markets and stronger than expected demand (see Figure 3
2) manufacturers should be more influenced by their 5 1 1
customer orders than stock market levels. This is 0
Institutions
Enterprises

Households
Government
Financial

particularly true when investors appear shell-shocked in

their over-reaction to poor fundamental data.

Our expectation is that manufacturing PMIs will decline

Source: IMF
from their post recovery highs but remain in an
expansionary range. Growth should hopefully broaden to Figure 4: China consumption as a % of GDP
the service sectors. If this occurs then investor
55
confidence in a sustainable recovery would increase.

China's economic and policy dynamics are changing. 50

Consumption as a percentage of GDP declined in the last
decade. This is partly a function of the decline in the 45
share of household income as a percentage of GDP. The
tacit support for recent wage disputes may indicate a 40
more proactive policy to boost household income and
thus consumption (see Figure 4). Reducing China's 35
export competitiveness through higher wages, rather than 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
a stronger Renminbi, has a number of political and
Source: J.P. Morgan economics, 2008.

3
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

With such a clear policy to boost consumption investors Commodity markets are technically weak. Investor
will desire exposure. But only 11% of MSCI China is confidence in the asset class is falling due to poor returns
consumer companies. High growth and low free floats and a diminished diversification benefit. A broad
result in high relative valuations. There is a similar trend correction in commodity prices would require these
in US where the EPS CAGR, since 1973, for consumer investors to reverse a long standing trend to increase
discretionary at 10.5% is a premium to the market's asset allocation to commodities (See Figure 15 and
7.5%. Its long term average PE at 20 is also a premium to Figure 16).
the market average of 15.
Figure 5: China iron ore spot and contract prices
A recent Xinhau news article was critical of state owned 200
enterprises. It noted that SoEs’ scale and influence on the China iron ore spot price
Chinese economy may hinder economic growth. The 150
government controls these companies and can accelerate
the shift of GDP from corporate to household. Note that 100
80% of MSCI China is SoEs.
50
There is a Mexican stand-off in the property market.
Landed cost of contract iron ore in China
Successive anti-asset-price-inflation measures have 0
discouraged buyers who now expect prices to fall. But Apr 02 Apr 04 Apr 06 Apr 08 Apr 10
cash rich property companies and home owners mean a
lack of forced sellers. The result is a sharp decline in Source: Bloomberg. Note: The landed cost of contract iron ore are Vale's SSF cost +
freight costs from Brazil to China. For 3Q10 forecasts, Vale's SSF costs are calculated as
property transactions. This in turn would lead to a fall in the average of the spot prices from Mar 10 to May 10. The freight costs in 3Q10 are
construction activity. Infrastructure spending is assumed to remain unchanged at today's levels.
decelerating. Bank loans funded the bulk of last year’s
stimulus program. Greater regulatory scrutiny of lending Figure 6: MSCI EM Energy relative to MSCI EM
to local government funding vehicles is likely to lead to 130
less capital for infrastructure. These measures are
consistent with a policy to rebalance growth from 120
investment to consumption.
110

The demand for bulk commodities and energy is 100

declining as the growth driver shifts from fixed asset
90
investment to consumption in China. There is renewed
focus on energy efficiency. The five year plan target to 80
reduce energy use per unit of GDP by 20% has not been Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10
met. Beijing is putting pressure on energy intensive and
polluting industries to close capacity. The market is also Source: Bloomberg. Note: Index rebased to 100 from January 2007.
applying pressure with steel prices declining while
contract iron ore and coking coal prices increase. Chinese Figure 7: MSCI EM Materials relative to MSCI EM
steel mills could make a loss in 3Q10. 140

130
Weak steel and aluminum prices may already be
indicating a slowdown in FAI. If our rebalancing thesis is 120
correct then steel prices should continue to fall. It is this 110
signal that we believe could lead to a broader correction 100
in commodity markets. The numerous presentations on
90
China’s significant demand for commodities at our China
conference this month reflects China’s key role in the 80
commodity super-cycle debate. Evidence of slowing Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10
Chinese demand when combined with increased supply
could lead to disproportionate corrections in commodity Source: Bloomberg. Note: Index rebased to 100 from January 2007.

prices.

4
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

If the commodity market corrects then EM equities are Figure 8: MSCI Korea Forward PE relative to MSCI EM
likely to decline led by Brazil and Russia. This 1.3
potentially would lead to redemptions in EM funds
1.2
leading to a broader correction (See Figure 11and Figure
12). We would view this event as an exceptional buying 1.1 +1SD
opportunity.
1.0
Av g
Upgrading Korea to overweight 0.9

We upgraded Korea to overweight from neutral on 2 0.8

-1SD
June in both Asian and Emerging Market portfolios. The 0.7
market has underperformed EM by 3% since 3 May -05 Jan-06 Sep-06 May -07 Jan-08 Sep-08 May -09 Jan-10
September 2009. Prior to that, from 26 February 2008 to
9 March 2009, MSCI Korea outperformed MSCI EM by Source: IBES, MSCI, Datastream, 31 May 2010.
26%.
Figure 9: REER deviation from long term mean since 1975 -An
Our upgrade was opportunistic. On 20 May, the South undervalued Won
Korean government released a multinational combined 100
intelligence report that concluded that the South Korean 80
navy ship Cheonan was torpedoed by a DPRK 60
submarine. The report accelerated the correction in the 40
market and currency. 20
0
The Won declined by 9% in May. The result is that -20
MSCI Korea is the cheapest market in APxJ (PE 9.3) and -40
one of the most undervalued currencies in EM (REER). -60

IDR

TWD
PHP

THB
CHF

HUF
AUD

USD

KRW
BRL
RUB
CLP
CZK

CNY

TRY
ZAR

PLN

MXN

EUR
We are more positive on global growth than the
pessimistic consensus. This, plus a competitive currency Source: J.P. Morgan.

is positive for exporters (note Yen and NT dollar cross

Figure 10: Performance of KRW/USD
rates). Banks are inexpensive, in our view. The end of
price controls should boost domestic margins. 1600

Our preferred sectors are exporters, banks and domestics. 1400

Our top picks include Hyundai Mobis, HMC, Kia
05-07 Av erage FX rate: 969
Motors, Hyundai Department Store, Shinsegae, Lotte 1200
Shopping, KB Financial, Hynix and SEC.
1000
The risks to our view are: (1) a further deterioration in
the North Korean situation, (2) weaker global demand, 800
(3) price controls remaining, and (4) excessive tech Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
capex.
Source: Bloomberg, 21 June 2010.

5
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Conclusion 4. EM inflation and speed of policy normalization

Equities are fundamentally attractive with a backdrop of 5. Lack of G3 policy flexibility
sustainable growth and low core inflation. We wish to
6. Central banks target asset prices
add EM equity risk but fear a correction in commodity
prices. A change in China’s perceived demand for 7. Commodity EM equities feedback loop
commodities as its economy rebalances is the catalyst for
8. Trade friction
the correction in commodity prices. We hope this will
provide an outstanding buying opportunity. Evidence of 9. Tension between the two Koreas
China's slowing commodity demand should appear over
10. Thai political unrest
the next few months. If no correction occurs before
September we will review our thesis and are likely to add 11. Bond market volatility
risk then.
12. Election-induced volatility
Few investors share J.P. Morgan's optimism on For more details on these risks, please see page 8.
sustainable growth. European PMIs are forecast to
decline from recovery highs but remain above 50. Please see pages 26 to 50 for our detailed country views.

Key asset allocation calls Figure 11: S&P GSCI Industrial Metals Index
• OW: Taiwan, Korea, India, Mexico, South Africa, 2500
Turkey and the Philippines
2000
• OW: Technology and industrial cyclicals (i.e.
transportation)
1500
• UW: China and Brazil
1000
• UW: Commodities, energy, telecoms and Utilities
Our key trades ranked by conviction are: 500
1. CEMBI Surfers; OW India and Turkey Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10

2. Growth surprise from developed, not emerging, Source: Bloomberg

economies. OW Mexico, Taiwan and Turkey plus
technology and transportation Figure 12: Cumulative inflows into commodity fund by year (US
4billion)
3. Macro policy and rising inflation – QR not QE in
60 2004 2005 2006
EM: UW Brazil, China, energy and commodities 2007 2008 2009
50 2010 50.4
For more details on these key trades, please see page 16
40

Please see pages 13, 14, 15 for our Global Emerging 30

18.4
Markets model portfolio and descriptions of changes 20 16.3
10 16.0
made this month. 11.8
8.9
0
5.7
Risks – are many: -10
1. Strained social contract
Dec
Oct
Mar
Apr
Jan
Feb

Jun

Aug
Sep
Jul
May

Nov

2. Underestimating euro sovereign stress contagion risk

Source: J.P. Morgan, May 2010
3. Rising economic risks

6
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Focus on sectors within countries rather than country recommendations

The table below provides a level summary of our views on sectors within countries. Financials is 25%, Materials is 15% and
Energy is 14% of EM. All recommendations are relative to EM. The Industrials sector consists of an eclectic group of
stocks. We are overweight technology and transportation.
Table 1: Key country and sector recommendations
Country/Sector Weight Reco US$ Return (%) PE 09 PE PE EPS EPS EPS DY ROE ROE
10E 11E Growth Growth Growth 10E 10E
09 10E (%)
1 yr 3 yr 5 yr X X X (%) (%) CAGR % % 03-08
05-10E Avg
EM 100 -- 18 (3) 86 14.3 11.2 9.6 2 28 8.8 2.9 15.3 16.2
China 18.7 UW 5 10 157 15.8 12.6 10.7 17 25 13.3 2.9 16.2 16.1
China Financials 7.1 N 7 23 265 14.5 11.5 9.4 25 25 28.5 3.2 17.8 13.3
China Energy 3.2 UW 10 14 161 13.4 10.6 9.6 (5) 26 8.3 3.8 17.8 21.4
China Telecom 2.5 UW (6) 11 174 12.3 12.1 11.5 (4) 1 14.8 3.6 15.0 18.2
China Industrials 1.4 n/a (10) (25) 55 20.3 13.3 11.8 58 53 5.4 2.1 11.0 12.8
Brazil 16.1 UW 20 28 243 13.5 11.2 9.0 7 20 6.1 3.4 16.1 18.8
Brazil Materials 4.3 UW 31 29 308 19.2 9.3 6.6 (40) 106 10.1 3.2 19.2 27.9
Brazil Energy 3.7 N (0) 62 310 10.3 10.8 9.5 (5) (5) 2.8 2.5 15.5 25.3
Brazil Financials 3.8 OW 27 21 243 11.9 11.5 9.5 45 4 5.9 3.6 16.1 22.4
Korea 13.1 OW 23 (22) 47 13.8 9.5 9.1 56 45 8.4 1.2 15.4 14.3
Korea IT 4.0 OW 40 3 38 18.1 10.0 11.1 (2,217) 81 13.7 0.2 18.1 17.0
Korea Financials 2.2 OW 16 (43) 32 15.6 8.8 7.6 (31) 77 3.0 2.2 11.7 13.3
Korea Industrials 1.8 n/a (3) (49) 71 14.9 11.4 10.4 26 30 10.6 1.3 11.4 12.0
Korea Materials 1.7 N 27 0 173 10.7 8.9 8.2 (2) 20 7.7 1.2 32.1 17.6
Korea CD 1.8 OW 50 23 72 9.3 8.1 7.8 125 15 16.9 0.8 20.2 13.4
Korea CS 0.6 N 12 (25) 46 15.0 13.7 11.8 7 9 11.3 1.7 14.4 14.9
Taiwan 10.7 OW 12 (12) 15 24.6 12.8 11.3 36 92 5.1 3.8 13.5 13.3
Taiwan IT 6.5 OW 16 (17) 12 29.1 12.0 10.9 9 143 11.5 3.6 16.9 14.3
Taiwan Financials 1.5 N (4) (21) (19) 19.6 13.2 10.6 859 48 9.3 3.3 8.7 6.6
Taiwan Materials 1.3 UW 16 7 78 17.1 14.5 12.0 NM 18 (7.8) 4.8 10.5 20.7
India 8.0 OW 15 9 143 21.4 17.2 13.6 3 25 13.4 1.3 16.3 21.0
India Financials 2.0 OW 14 3 148 23.5 19.3 15.3 0 22 13.7 1.2 12.3 14.9
India Energy 1.2 N (7) 12 285 20.5 14.4 12.0 (0) 42 14.7 1.2 16.3 21.1
India IT 1.3 OW 54 3 104 24.2 21.1 17.4 5 15 16.1 1.2 24.4 31.3
South Africa 7.4 OW 21 4 93 16.6 12.3 9.8 (18) 35 10.7 3.2 16.3 19.1
SA Materials 2.1 OW 15 (13) 97 47.0 16.8 11.9 (54) 179 22.2 2.1 13.5 9.9
SA Financials 1.9 OW 36 8 82 13.1 10.7 8.8 (15) 23 5.9 4.5 15.0 19.6
SA Telecom 0.9 UW (2) (1) 95 12.3 10.2 8.7 (10) 20 10.2 3.0 20.0 28.9
SA Cons Discr 0.9 N 50 25 119 16.2 13.2 10.5 10 23 10.9 2.4 17.0 23.1
SA Energy 0.7 UW (5) 18 59 11.9 9.9 7.7 (22) 20 6.3 3.6 17.2 23.8
Russia 6.5 N 11 (31) 56 8.2 6.4 5.1 (21) 29 9.1 2.2 13.8 16.6
Russia Energy 3.8 N (2) (33) 34 5.7 5.0 4.6 (12) 14 6.0 2.3 13.7 16.6
Mexico 4.8 OW 38 (14) 102 18.0 14.4 12.1 2 25 7.7 2.7 16.7 19.1
Mexico Telecom 1.9 UW 33 (13) 154 14.3 12.4 10.9 (2) 15 16.4 4.1 36.5 31.2
Mexico CS 1.1 N 52 21 133 18.9 19.0 15.8 54 (0) 14.1 1.7 15.1 16.0
Mexico Materials 0.8 OW 45 (41) 32 30.8 14.6 10.9 (16) 111 (8.8) 1.6 8.0 15.8
Malaysia 2.9 N 28 7 96 18.2 14.8 12.7 (1) 23 7.5 3.5 12.5 13.2
Indonesia 2.3 N 44 53 206 16.3 13.8 11.9 21 18 16.4 3.0 23.8 25.4
Turkey 1.6 OW 56 7 88 11.0 9.5 8.3 3 16 12.8 3.1 17.4 17.2
Turkey Financials 1.0 OW 74 29 129 9.7 8.8 7.8 30 11 18.4 2.4 18.1 16.6
Chile 1.5 n/a 26 25 127 18.7 16.2 13.5 NM 15 19.1 2.3 11.2 10.1
Thailand 1.5 N 25 23 79 12.8 11.2 9.6 33 14 (0.9) 4.0 15.1 19.4
Poland 1.4 N 22 (39) 28 15.2 13.2 11.0 (26) 15 (1.4) 3.7 11.7 17.0
Hungary 0.4 N 11 (40) (8) 12.1 10.9 8.5 (37) 11 (2.7) 3.6 11.9 23.8
Philippines 0.5 OW 25 (6) 114 17.3 15.4 13.4 25 13 5.5 3.9 15.6 14.4
Source: J.P. Morgan Asian strategy team, MSCI, Datastream. Table sorted by descending weight in index, countries first followed by country-sectors, 10 June 2010.

7
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Risks to our strategy

Strained social contract banks continue to face a difficult funding environment.
Political and regulatory risk is high. The corporate sector The primary market for unsecured bank debt remains in
has emerged from the global recession and credit crunch hibernation. The contraction in the CP/CD issued by
stronger than the households. Note the profits as a share European banks in the US is accelerating. Note that
of GDP are near cycle highs but unemployment is 10%. European banks need to refinance nearly $130bn per
Policy makers constrained by high fiscal deficits are month for the remainder of the year.
likely to redress this imbalance through higher taxes and
increased regulation. Rising economic risks
Private payrolls at 41K for the month of May were
As is the case in the US, Chinese corporates share of disappointing. Note that firms are using their existing
GDP increased while the household share decreased. workers more intensively as they lengthen the work
Labour disputes and subsequent large pay increases may week, and companies cannot increase work hours
start to reverse this trend. This rebalancing is healthy and indefinitely. Private sector job creation should improve
should move China to a more sustainable growth model. over the rest of the year. However, if the job data
But near term the result is lower profit margins. continues to be below expectations, it could adversely
impact consumer spending and a sustained economic
Underestimating Euro sovereign stress contagion risk recovery.
After Greece, there is speculation that Spain might reach
out to the EU or IMF for financial support. The Spanish Figure 13: Strained social contract: US profit share and
banking system is under significant pressure to address unemployment
its solvency issues, especially among its saving banks. % sa
22 Profit share 0
These concerns have impaired the ability of Spanish
20
banks to raise market funding, and increased the 3
18
possibility of seeking external liquidity support. If this
16
were to be true, Spanish bond yields which have already 6
increased by 50 bps in the last one week would likely rise 14

further and issuance become more difficult. 12 9

Unemploy ment rate (inv erted)
10
Euro sovereign stress generates both economic and 8 12
market risk. The economic risk is that business in core 70 75 80 85 90 95 00 05 10
Europe slows investment decisions. As we witnessed in
2008, rational individual risk reduction results in a Source: J.P. Morgan. Note: Chart shows % share of gross value added, JPMorgan
forecast for 2010.
destructive downward spiral in risk assets.
Figure 14: Spread between Spanish and German 10 year bond
In Emerging Markets Outlook and Strategy, June 8, yield
2010, Joyce Chang, our Global head of Emerging
250
Markets and Credit Research, notes two scenarios.
Scenario 1: Deeper economic and financial crisis, but 200
contained to peripheral Europe. Scenario2: Crisis spreads
to core Europe due to contagion from the periphery, 150
pushing the Euro area into a double dip recession. If the
crisis were to spread to core Europe, it could have a 100
significant impact on emerging markets. In such a
50
scenario, emerging markets would reverse incipient
tightening. Emerging markets may also have to resort to 0
greater fiscal stimulus to offset the weakness in the Jan 08 Jul 08 Jan 09 Jul 09 Jan 10
private sector. (Please see Page 23 for more details)
Source: Bloomberg
The feedback loop between banks struggling to fund and
a subsequent reduction in the availability of credit is
another key risk. Nikolaos Panigirtzoglou in his weekly,
Flows and Liquidity, 4 June 2010 notes that: European

8
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

EM inflation and speed of policy normalization Tension between the two Koreas
Our base case is that inflation plateaus mid-year as the On 20 May, the South Korean government released a
base effect becomes more favorable. If we are wrong and multinational combined intelligence task force report that
inflation continues to rise then this is bearish for equities. concluded that the South Korean navy warship was
The EM dashboard has a sheet designed to help monitor torpedoed by a DPRK submarine on 26 March. The
inflation across EM countries. Remember modeling Korean Won has weakened by 5% in the last one month
inflation in emerging economies is difficult due to the to KRW/USD1213.
short history of floating exchange rates and large
weighting of food and other primary products. Thai political unrest
The Thai market and baht are remarkably resilient
Lack of G3 policy flexibility considering the violence in Bangkok.
High fiscal deficits and record-low interest rates limit
policymakers’ ability to respond to a relapse in growth. A Figure 15: Oil forward curve ($/bbl)
growth relapse is not our base case. If it occurred, it 95 Crude Oil, WTI : 6/9/2010
would be a serious blow to risk assets. Credit spreads
could widen and equities would fall. 90

85
Central banks target asset prices
Central banks are targeting asset prices in EM, notably in 80
China. These policies introduce economic and sector
specific risk. Note how poorly real estate stocks have 75
performed in EM despite low interest rates.
70

Commodity EM equities feedback loop Jul-10 Jul-12 Jul-14 Jul-16 Jul-18

Commodity markets are in our view vulnerable. Investors
are frustrated by low to negative returns due to the high Source: Bloomberg. 9 June 2010.

roll cost in forward markets in contango. In 2009, net

Figure 16: Underperformance of TR Crude Oil Index and Energy
retail inflows into commodity funds were $50billion; this vs WTI
year, subscriptions have slowed sharply. A combination
of negative momentum and Chinese economic 220 WTI JPM Crude Oil TR JPM Energy TR
rebalancing could be a catalyst for significant
190
redemptions. The liquidation of contango arbitrage
inventory (i.e. leasing supertankers to buy spot and sell 160
forward) adds to the downside risk for commodities.
Weak commodity prices will drive Brazilian, Russian 130
and Indonesian markets lower, in our view. It is
100
reasonable to expect redemptions in BRIC funds.
70
Trade friction Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10
It is no fun being a politician today. High fiscal deficits
in the developed economies and rising inflation in Source: Bloomberg.
emerging economies will mean uncomfortable policy
choices. In this environment it is appealing to look for
others to blame. A building risk is trade sanctions against
China. The rhetoric on the Renminbi is heating up.
China's priority is to manage a rebalancing economy. We
doubt Beijing wishes to add currency volatility to the
mix. Hopefully this war will be fought in the media
rather than with sanctions. Our overweight exporters is
very exposed to a trade war.

9
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Bond market volatility Figure 17: Global bond supply ($tr)

The end of QE plus banks’ unwillingness to add to $7 Gov ernment Agencies, Supra, Muni, etc
duration risk is a dangerous technical situation for Corporates incl Gov t Guranteed Securitized
government bonds. Risk assets typically struggle as bond
$6
yields rapidly increase to “normal” levels. EM equities
typically correct when bond market volatility rises. Our
work on quantifying the relationship between the $5
direction of US Treasury yields and EM equity returns
suggests that the probability of such a correction in 2010 $4
is high if UST yields rise rapidly and increases the risk of
a rapid adjustment. We advise investors to monitor the
$3
pace of change in 10-year UST yields in 2010.

Election-induced volatility $2
Brazilian elections in October 2010 are likely to be a
source of volatility rather than a change in macro- $1
economic policy.
$0
2009 2010

Source: J.P. Morgan. Global bond supply and demand 2009 and 2010 in $tr, demand and
supply figures are annualized, supply is calculated by the change in bond out standings at
face value, demand is calculated by the change in bond out standings at market value.

Figure 18: Global bond demand ($tr)

QE Banks
FX Reserv es Retail Bond Funds
$7 Insurance + Pension Other

$6

$5

$4

$3

$2

$1

$0
2009 2010

Source: J.P. Morgan. Global bond supply and demand 2009 and 2010 in $tr, demand and
supply figures are annualized, supply is calculated by the change in bond out standings at
face value, demand is calculated by the change in bond out standings at market value.

10
Adrian Mowat Emerging Markets Equity Research
(852) 2800-8599 21 June 2010
adrian.mowat@jpmorgan.com

Figure 19: Public Debt and Fiscal Balance as a % of GDP for EM and DM in 2010
0
Korea

Peru
-2 ChinaIndonesia
Thai
Mex ico Brazil
EM
Australia Turkey
Russia
-4
Phil Hungary
Chile Czech
Malay sia Italy
India Germany
Poland
-6 S Africa
Fiscal Balance

Portugal
Euro area

Japan